UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2013
OR
For the transition period from to
Commission file number 001-31343
Associated Banc-Corp
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(920) 491-7000
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
APPLICABLE ONLY TO CORPORATE ISSUERS:
The number of shares outstanding of registrant’s common stock, par value $0.01 per share, at July 31, 2013, was 165,947,367.
ASSOCIATED BANC-CORP
TABLE OF CONTENTS
PART I. Financial Information
Item 1. Financial Statements (Unaudited):
Consolidated Balance Sheets — June 30, 2013 and December 31, 2012
Consolidated Statements of Income —Three and Six Months Ended June 30, 2013 and 2012
Consolidated Statements of Comprehensive Income —Three and Six Months Ended June 30, 2013 and 2012
Consolidated Statements of Changes in Stockholders’ Equity — Six Months Ended June 30, 2013 and 2012
Consolidated Statements of Cash Flows — Six Months Ended June 30, 2013 and 2012
Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II. Other Information
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
Signatures
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PART I — FINANCIAL INFORMATION
Consolidated Balance Sheets
ASSETS
Cash and due from banks
Interest-bearing deposits in other financial institutions
Federal funds sold and securities purchased under agreements to resell
Investment securities held to maturity, at amortized cost
Investment securities available for sale, at fair value
Federal Home Loan Bank and Federal Reserve Bank stocks, at cost
Loans held for sale
Loans
Allowance for loan losses
Loans, net
Premises and equipment, net
Goodwill
Other intangible assets, net
Trading assets
Other assets
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Noninterest-bearing demand deposits
Interest-bearing deposits
Total deposits
Federal funds purchased and securities sold under agreements to repurchase
Other short-term funding
Long-term funding
Trading liabilities
Accrued expenses and other liabilities
Total liabilities
Stockholders’ equity
Preferred equity
Common stock
Surplus
Retained earnings
Accumulated other comprehensive income (loss)
Treasury stock, at cost
Total stockholders’ equity
Total liabilities and stockholders’ equity
Preferred shares issued
Preferred shares authorized (par value $1.00 per share)
Common shares issued
Common shares authorized (par value $0.01 per share)
Treasury shares of common stock
See accompanying notes to consolidated financial statements.
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ITEM 1. Financial Statements Continued:
Consolidated Statements of Income
(Unaudited)
INTEREST INCOME
Interest and fees on loans
Interest and dividends on investment securities
Taxable
Tax exempt
Other interest
Total interest income
INTEREST EXPENSE
Interest on deposits
Interest on Federal funds purchased and securities sold under agreements to repurchase
Interest on other short-term funding
Interest on long-term funding
Total interest expense
NET INTEREST INCOME
Provision for loan losses
Net interest income after provision for loan losses
NONINTEREST INCOME
Trust service fees
Service charges on deposit accounts
Card-based and other nondeposit fees
Insurance commissions
Brokerage and annuity commissions
Mortgage banking, net
Capital market fees, net
Bank owned life insurance income
Asset gains (losses), net
Investment securities gains, net:
Realized gains, net
Other-than-temporary impairments
Less: Non-credit portion recognized in other comprehensive income (before taxes)
Total investment securities gains, net
Other
Total noninterest income
NONINTEREST EXPENSE
Personnel expense
Occupancy
Equipment
Data processing
Business development and advertising
Other intangible asset amortization
Loan expense
Legal and professional fees
Losses other than loans
Foreclosure / OREO expense
FDIC expense
Total noninterest expense
Income before income taxes
Income tax expense
Net income
Preferred stock dividends
Net income available to common equity
Earnings per common share:
Basic
Diluted
Average common shares outstanding:
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Consolidated Statements of Comprehensive Income
Other comprehensive income (loss), net of tax:
Investment securities available for sale:
Net unrealized gains (losses)
Reclassification adjustment for net gains realized in net income
Income tax (expense) benefit
Other comprehensive income (loss) on investment securities available for sale
Defined benefit pension and postretirement obligations:
Amortization of prior service cost
Amortization of actuarial losses
Other comprehensive income on pension and postretirement obligations
Derivatives used in cash flow hedging relationships:
Net unrealized losses
Reclassification adjustment for net losses and interest expense for interest differential on derivatives realized in net income
Other comprehensive income on cash flow hedging relationships
Total other comprehensive income (loss)
Comprehensive income (loss)
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Consolidated Statements of Changes in Stockholders’ Equity
Balance, December 31, 2011
Comprehensive income:
Other comprehensive income
Comprehensive income
Common stock issued:
Stock-based compensation plans, net
Purchase of treasury stock
Cash dividends:
Common stock, $0.10 per share
Preferred stock
Stock-based compensation expense, net
Tax benefit of stock options
Balance, June 30, 2012
Balance, December 31, 2012
Other comprehensive loss
Common stock, $0.16 per share
Balance, June 30, 2013
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Consolidated Statements of Cash Flows
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
(Recovery of) addition to valuation allowance on mortgage servicing rights, net
Amortization of mortgage servicing rights
Amortization of other intangible assets
Amortization and accretion on earning assets, funding, and other, net
Tax impact of stock based compensation
Gain on sales of investment securities, net and impairment write-downs
(Gain) loss on sales of assets and impairment write-downs, net
Gain on mortgage banking activities, net
Mortgage loans originated and acquired for sale
Proceeds from sales of mortgage loans held for sale
(Increase) decrease in interest receivable
Decrease in interest payable
Net change in other assets and other liabilities
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Net increase in loans
Purchases of:
Investment securities
Premises, equipment, and software, net of disposals
FHLB stock
Proceeds from:
Sales of investment securities
Sale of FHLB stock
Prepayments, calls, and maturities of investment securities
Sales, prepayments, calls, and maturities of other assets
Sales of loans originated for investment
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits
Net decrease in deposits due to branch sales
Net increase in short-term funding
Repayment of long-term funding
Cash dividends on common stock
Cash dividends on preferred stock
Net cash provided by financing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosures of cash flow information:
Cash paid for interest
Cash paid (received) for income taxes
Loans and bank premises transferred to other real estate owned
Capitalized mortgage servicing rights
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These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with U.S. generally accepted accounting principles have been omitted or abbreviated. The information contained in the consolidated financial statements and footnotes in Associated Banc-Corp’s 2012 annual report on Form 10-K, should be referred to in connection with the reading of these unaudited interim financial statements.
NOTE 1: Basis of Presentation
In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the financial position, results of operations and comprehensive income, changes in stockholders’ equity, and cash flows of Associated Banc-Corp (individually referred to herein as the “Parent Company,” and together with all of its subsidiaries and affiliates, collectively referred to herein as the “Corporation”) for the periods presented, and all such adjustments are of a normal recurring nature. The consolidated financial statements include the accounts of all subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Certain amounts in the consolidated financial statements of prior periods have been reclassified to conform with the current period’s presentation. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, goodwill impairment assessment, mortgage servicing rights valuation, derivative financial instruments and hedging activities, and income taxes. Management has evaluated subsequent events for potential recognition or disclosure.
NOTE 2: New Accounting Pronouncements Adopted
In February 2013, the FASB issued an amendment requiring an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. These disclosures may be presented on the face of the income statement or in the notes to consolidated financial statements, depending upon the specific accounting guidance for the reclassification out of accumulated other comprehensive income. The amendments are effective prospectively for reporting periods beginning after December 15, 2012 with early adoption permitted. The Corporation adopted the accounting standard during the first quarter of 2013, as required, with no material impact on its results of operations, financial position, or liquidity. See Note 16 for the required new disclosures on accumulated other comprehensive income.
In July 2012, the FASB issued amendments intended to simplify how entities test the decline in the realizable value (impairment) of indefinite-lived intangible assets other than goodwill. The amendments permit an organization to make a qualitative evaluation about the likelihood of impairment of an indefinite-lived intangible asset to determine whether it should apply the quantitative test and calculate the fair value of the indefinite-lived intangible asset. The amendments do not change how an organization measures an impairment loss. Therefore, it is not expected to affect the information reported to users of the financial statements. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The Corporation adopted the accounting standard during the first quarter of 2013, as required, with no material impact on its results of operations, financial position, or liquidity.
In December 2011, the FASB issued amendments to require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. This information will enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements with certain financial instruments and derivative instruments. The amendments are effective for annual reporting periods beginning on or after January 1, 2013, with retrospective application to the disclosures of all comparative periods presented. The Corporation adopted the accounting standard during the first quarter of 2013, as required, with no material impact on its results of operations, financial position, or liquidity. See Note 11 for the required new disclosures on balance sheet offsetting.
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In September 2011, the FASB issued amendments intended to simplify how entities test goodwill for impairment. The amendments permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. Under the guidance, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying value. The amendments are effective for interim and annual periods beginning after December 15, 2011, with early adoption permitted. The Corporation adopted the accounting standard as of January 1, 2012, as required, with no material impact on its results of operations, financial position, or liquidity. See Note 7 for required disclosures on goodwill.
NOTE 3: Earnings Per Common Share
Earnings per share are calculated utilizing the two-class method. Basic earnings per share are calculated by dividing the sum of distributed earnings to common shareholders and undistributed earnings allocated to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share are calculated by dividing the sum of distributed earnings to common shareholders and undistributed earnings allocated to common shareholders by the weighted average number of common shares outstanding adjusted for the dilutive effect of common stock awards (outstanding stock options, unvested restricted stock, and outstanding stock warrants). Presented below are the calculations for basic and diluted earnings per common share.
Common shareholder dividends
Unvested share-based payment awards
Undistributed earnings
Undistributed earnings allocated to common shareholders
Undistributed earnings allocated to unvested share-based payment awards
Distributed earnings to common shareholders
Total common shareholders earnings, basic
Total common shareholders earnings, diluted
Weighted average common shares outstanding
Effect of dilutive common stock awards
Diluted weighted average common shares outstanding
Basic earnings per common share
Diluted earnings per common share
Options to purchase approximately 3 million shares were outstanding for both the three and six months ended June 30, 2013, but excluded from the calculation of diluted earnings per common share as the effect would have been anti-dilutive. Options to purchase approximately 9 million and 6 million shares were outstanding for the three and six months ended June 30, 2012, respectively, but excluded from the calculation of diluted earnings per common share as the effect would have been anti-dilutive.
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NOTE 4: Stock-Based Compensation
At June 30, 2013, the Corporation had one stock-based compensation plan. All stock awards granted under this plan have an exercise price that is equal to the closing price of the Corporation’s stock on the date the awards were granted.
The Corporation may issue restricted common stock and restricted common stock units to certain key employees (collectively referred to as “restricted stock awards”). The shares of restricted stock are restricted as to transfer, but are not restricted as to dividend payment or voting rights. Restricted stock units receive dividend equivalents but do not have voting rights. The transfer restrictions lapse over one, two, three, or four years, depending upon whether the awards are service-based or performance-based. Service-based awards are contingent upon continued employment, and performance-based awards are based on earnings per share performance goals and continued employment.
The fair value of stock options granted is estimated on the date of grant using a Black-Scholes option pricing model, while the fair value of restricted stock awards is their fair market value on the date of grant. The fair values of stock options and restricted stock awards are amortized as compensation expense on a straight-line basis over the vesting period of the grants. Compensation expense recognized is included in personnel expense in the consolidated statements of income.
Assumptions are used in estimating the fair value of stock options granted. The weighted average expected life of the stock option represents the period of time that stock options are expected to be outstanding and is estimated using historical data of stock option exercises and forfeitures. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the historical and implied volatility of the Corporation’s stock. The following assumptions were used in estimating the fair value for options granted in the first six months of 2013 and full year 2012.
Dividend yield
Risk-free interest rate
Weighted average expected volatility
Weighted average expected life
Weighted average per share fair value of options
The Corporation is required to estimate potential forfeitures of stock grants and adjust compensation expense recorded accordingly. The estimate of forfeitures will be adjusted over the requisite service period to the extent that actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures will be recognized in the period of change and will also impact the amount of stock compensation expense to be recognized in future periods.
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A summary of the Corporation’s stock option activity for the year ended December 31, 2012 and for the six months ended June 30, 2013, is presented below.
Stock Options
Outstanding at December 31, 2011
Granted
Exercised
Forfeited or expired
Outstanding at December 31, 2012
Options exercisable at December 31, 2012
Outstanding at June 30, 2013
Options exercisable at June 30, 2013
The following table summarizes information about the Corporation’s nonvested stock option activity for the year ended December 31, 2012, and for the six months ended June 30, 2013.
Nonvested at December 31, 2011
Vested
Forfeited
Nonvested at December 31, 2012
Nonvested at June 30, 2013
For the six months ended June 30, 2013 and for the year ended December 31, 2012, the intrinsic value of stock options exercised was immaterial. (Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock option.) The total fair value of stock options that vested was $8 million for the first six months of 2013 and $5 million for the year ended December 31, 2012. For both the six months ended June 30, 2013 and 2012, the Corporation recognized compensation expense of $4 million for the vesting of stock options. For the full year 2012, the Corporation recognized compensation expense of $9 million for the vesting of stock options. At June 30, 2013, the Corporation had $12 million of unrecognized compensation expense related to stock options that is expected to be recognized over the remaining requisite service periods that extend predominantly through fourth quarter 2015.
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The following table summarizes information about the Corporation’s restricted stock awards activity for the year ended December 31, 2012, and for the six months ended June 30, 2013.
Restricted Stock
The Corporation amortizes the expense related to restricted stock awards as compensation expense over the vesting period specified in the grant. Restricted stock awards granted during 2013 and 2012 to executive officers will vest ratably over a three year period. Restricted stock awards granted to non-executives during 2013 will vest ratably over a four year period, while restricted stock awards granted to non-executives during 2012 will vest ratably over a three year period. Expense for restricted stock awards of approximately $4 million was recognized for both the six months ended June 30, 2013 and 2012. The Corporation recognized approximately $7 million of expense for restricted stock awards for the full year 2012. The Corporation had $17 million of unrecognized compensation costs related to restricted stock awards at June 30, 2013 that is expected to be recognized over the remaining requisite service periods that extend predominantly through fourth quarter 2015.
The Corporation issues shares from treasury, when available, or new shares upon the exercise of stock options or the granting of restricted stock awards. The Board of Directors has authorized management to repurchase shares of the Corporation’s common stock each quarter in the market, to be made available for issuance in connection with the Corporation’s employee incentive plans and for other corporate purposes. The repurchase of shares will be based on market and investment opportunities, capital levels, growth prospects, and regulatory constraints. Such repurchases may occur from time to time in open market purchases, block transactions, private transactions, accelerated share repurchase programs, or similar facilities.
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NOTE 5: Investment Securities
The amortized cost and fair values of investment securities available for sale and held to maturity were as follows.
June 30, 2013:
U.S. Treasury securities
Obligations of state and political subdivisions (municipal securities)
Residential mortgage-related securities:
Government-sponsored enterprise (“GSE”)
Private-label
GSE commercial mortgage-related securities
Other securities (debt and equity)
Total investment securities available for sale
Investment securities held to maturity:
Total investment securities held to maturity
December 31, 2012:
GSE
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The amortized cost and fair values of investment securities available for sale and held to maturity at June 30, 2013, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
Total debt securities
Private label
Equity securities
Total investment securities
The following represents gross unrealized losses and the related fair value of investment securities available for sale and held to maturity, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2013.
Other debt securities
Total
The Corporation reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment. A determination as to whether a security’s decline in fair value is other-than-temporary takes into consideration numerous factors and the relative significance of any single factor can vary by security. Some factors the Corporation may consider in the other-than-temporary impairment analysis include, the length of time and extent to which the security has been in an unrealized loss position, changes in security ratings, financial condition and near-term prospects of the issuer, as well as security and industry specific economic conditions. In addition, with regards to its debt securities, the Corporation may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds, and the value of any underlying collateral. For certain debt securities in unrealized loss positions, the Corporation prepares cash flow analyses to compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.
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Based on the Corporation’s evaluation, management does not believe any unrealized loss at June 30, 2013 represents an other-than-temporary impairment as these unrealized losses are primarily attributable to changes in interest rates and the current market conditions, and not credit deterioration. The unrealized losses reported for residential mortgage-related securities relate to non-agency residential mortgage-related securities as well as residential mortgage-related securities issued by government agencies such as the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”). The unrealized losses reported for commercial mortgage-related securities relate to government agency mortgage-related securities. At June 30, 2013, the unrealized loss position of 12 months or more on other debt securities was attributable to a pooled trust preferred debt security. The Corporation currently does not intend to sell nor does it believe that it will be required to sell the securities contained in the above unrealized losses table before recovery of their amortized cost basis.
The following is a summary of the credit loss portion of other-than-temporary impairment recognized in earnings on debt securities for 2012 and the six months ended June 30, 2013, respectively.
Balance of credit-related other-than-temporary impairment at December 31, 2011
Reduction due to credit impaired securities sold
Balance of credit-related other-than-temporary impairment at December 31, 2012
Balance of credit-related other-than-temporary impairment at June 30, 2013
For comparative purposes, the following represents gross unrealized losses and the related fair value of investment securities available for sale and held to maturity, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2012.
15
Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank Stocks: The Corporation is required to maintain Federal Reserve stock and FHLB stock as a member of both the Federal Reserve System and the FHLB, and in amounts as required by these institutions. These equity securities are “restricted” in that they can only be sold back to the respective institutions or another member institution at par. Therefore, they are less liquid than other marketable equity securities and their fair value is equal to amortized cost. At June 30, 2013 and December 31, 2012, the Corporation had FHLB stock of $110 million and $96 million, respectively. The Corporation had Federal Reserve Bank stock of $71 million at both June 30, 2013 and December 31, 2012.
The Corporation reviewed these securities for impairment, including but not limited to, consideration of operating performance, the severity and duration of market value declines, as well as its liquidity and funding position. After evaluating all of these considerations, the Corporation believes the cost of these investments will be recovered and no impairment has been recorded on these securities during 2012 or the first six months of 2013. The FHLB of Chicago initiated tender offers for certain of its shares during the first quarter of 2013, whereby the FHLB would repurchase its shares at par. The Corporation participated in the tender offers and reduced its equity holdings in the FHLB of Chicago by $14 million during the first quarter of 2013. Based on the Corporation’s periodic review of FHLB stock required member holdings (which is based on asset size and other criteria), the Corporation purchased $28 million of additional equity holdings in the FHLB of Chicago during the second quarter of 2013.
NOTE 6: Loans, Allowance for Loan Losses, and Credit Quality
The period end loan composition was as follows.
Commercial and industrial
Commercial real estate—owner occupied
Lease financing
Commercial and business lending
Commercial real estate—investor
Real estate construction
Commercial real estate lending
Total commercial
Home equity
Installment
Residential mortgage
Total consumer
Total loans
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A summary of the changes in the allowance for loan losses was as follows.
Balance at beginning of period
Charge offs
Recoveries
Net charge offs
Balance at end of period
The level of the allowance for loan losses represents management’s estimate of an amount appropriate to provide for probable credit losses in the loan portfolio at the balance sheet date. In general, the change in the allowance for loan losses is a function of a number of factors, including but not limited to changes in the loan portfolio, net charge offs, trends in past due and impaired loans, and the level of potential problem loans. Management considers the allowance for loan losses a critical accounting policy, as assessing these numerous factors involves significant judgment.
A summary of the changes in the allowance for loan losses by portfolio segment for the six months ended June 30, 2013, was as follows.
Balance at Dec 31, 2012
Balance at Jun 30, 2013
Allowance for loan losses:
Ending balance impaired loans individually evaluated for impairment
Ending balance impaired loans collectively evaluated for impairment
Total impaired loans
Ending balance all other loans collectively evaluated for impairment
Loans:
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The allocation methodology used by the Corporation includes allocations for specifically identified impaired loans and loss factor allocations (used for both criticized and non-criticized loan categories), with a component primarily based on historical loss rates and a component primarily based on other qualitative factors. Management allocates the allowance for loan losses by pools of risk within each loan portfolio. The allocation of the allowance for loan losses by loan portfolio is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular category. The total allowance for loan losses is available to absorb losses from any segment of the loan portfolio.
For comparison purposes, a summary of the changes in the allowance for loan losses by portfolio segment for the year ended December 31, 2012, was as follows.
Balance at Dec 31, 2011
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The following table presents commercial loans by credit quality indicator at June 30, 2013.
The following table presents commercial loans by credit quality indicator at December 31, 2012.
The following table presents consumer loans by credit quality indicator at June 30, 2013.
The following table presents consumer loans by credit quality indicator at December 31, 2012.
Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, and appropriate allowance for loan losses, nonaccrual and charge off policies.
For commercial loans, management has determined the pass credit quality indicator to include credits that exhibit acceptable financial statements, cash flow, and leverage. If any risk exists, it is mitigated by the loan structure, collateral, monitoring, or control. For consumer loans, performing loans include credits that are performing in accordance with the original contractual terms. Special
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mention credits have potential weaknesses that deserve management’s attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit. Potential problem loans are considered inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged. These loans generally have a well-defined weakness, or weaknesses, that may jeopardize liquidation of the debt and are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Lastly, management considers a loan to be impaired when it is probable that the Corporation will be unable to collect all amounts due according to the original contractual terms of the note agreement, including both principal and interest. Management has determined that commercial and consumer loan relationships that have nonaccrual status or have had their terms restructured in a troubled debt restructuring meet this impaired loan definition. Commercial loans classified as special mention, potential problem, and impaired are reviewed at a minimum on a quarterly basis, while pass and performing rated credits are reviewed on an annual basis or more frequently if the loan renewal is less than one year or if otherwise warranted.
20
The following table presents loans by past due status at June 30, 2013.
Accruing loans
Total accruing loans
Nonaccrual loans
Total nonaccrual loans
21
The following table presents loans by past due status at December 31, 2012.
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The following table presents impaired loans at June 30, 2013.
Loans with a related allowance
Loans with no related allowance
23
The following table presents impaired loans at December 31, 2012.
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments, unless the loan is well secured and in the process of collection. Additionally, whenever management becomes aware of
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facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, amortization of related deferred loan fees or costs is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash and a determination has been made that the principal and interest of the loan is collectible. If collectability of the principal and interest is in doubt, payments received are applied to loan principal.
While an asset is in nonaccrual status, some or all of the cash interest payments received may be treated as interest income on a cash basis as long as the remaining recorded investment in the asset (i.e., after charge off of identified losses, if any) is deemed to be fully collectible. The determination as to the ultimate collectability of the asset’s remaining recorded investment must be supported by a current, well documented credit evaluation of the borrower’s financial condition and prospects for repayment, including consideration of the borrower’s sustained historical repayment performance and other relevant factors. A nonaccrual loan is returned to accrual status when all delinquent principal and interest payments become current in accordance with the terms of the loan agreement, the borrower has demonstrated a period of sustained performance, and the ultimate collectability of the total contractual principal and interest is no longer in doubt. A sustained period of repayment performance generally would be a minimum of six months.
Troubled Debt Restructurings (“Restructured Loans”):
Loans are considered restructured loans if concessions have been granted to borrowers that are experiencing financial difficulty. The concessions granted generally involve the modification of terms of the loan, such as changes in payment schedule or interest rate, which generally would not otherwise be considered. Restructured loans can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accrual status, depending on the individual facts and circumstances of the borrower. Nonaccrual restructured loans are included and treated with all other nonaccrual loans. In addition, all accruing restructured loans are reported as troubled debt restructurings, which are considered and accounted for as impaired loans. Generally, restructured loans remain on nonaccrual until the customer has attained a sustained period of repayment performance under the modified loan terms (generally a minimum of six months). However, performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and whether the loan should be returned to or maintained on accrual status. If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains on nonaccrual status. The Corporation had a $28 million recorded investment in loans modified in a troubled debt restructuring for the six months ended June 30, 2013, of which, $13 million were in accrual status and $15 million were in nonaccrual pending a sustained period of repayment.
As of June 30, 2013 and December 31, 2012, there were $70 million and $81 million, respectively, of nonaccrual restructured loans, and $119 million and $121 million, respectively, of performing restructured loans, included within impaired loans. All restructured loans are considered impaired in the calendar year of restructuring. In subsequent years, a restructured loan may cease being classified as impaired if the loan was modified at a market rate and has performed according to the modified terms for at least six months. A loan that has been modified at a below market rate will return to performing status if it satisfies the six month performance requirement; however, it will remain classified as a restructured loan. The following table presents nonaccrual and performing restructured loans by loan portfolio.
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The following table provides the number of loans modified in a troubled debt restructuring by loan portfolio during the three and six months ended June 30, 2013, and the recorded investment and unpaid principal balance as of June 30, 2013.
The following table provides the number of loans modified in a troubled debt restructuring by loan portfolio during the three and six months ended June 30, 2012, and the recorded investment and unpaid principal balance as of June 30, 2012.
Restructured loan modifications may include payment schedule modifications, interest rate concessions, maturity date extensions, modification of note structure (A/B Note), principal reduction, or some combination of these concessions. During the three and six months ended June 30, 2013, restructured loan modifications of commercial and industrial, commercial real estate and real estate construction loans primarily included maturity date extensions and payment schedule modifications. Restructured loan modifications of home equity and residential mortgage loans primarily included maturity date extensions, interest rate concessions, payment schedule modifications, or a combination of these concessions for the three and six months ended June 30, 2013.
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The following table provides the number of loans modified in a troubled debt restructuring during the previous 12 months which subsequently defaulted during the three and six months ended June 30, 2013, as well as the recorded investment in these restructured loans as of June 30, 2013.
The following table provides the number of loans modified in a troubled debt restructuring during the previous 12 months which subsequently defaulted during the three and six months ended June 30, 2012, as well as the recorded investment in these restructured loans as of June 30, 2012.
All loans modified in a troubled debt restructuring are evaluated for impairment. The nature and extent of the impairment of restructured loans, including those which have experienced a subsequent payment default, is considered in the determination of an appropriate level of the allowance for loan losses.
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NOTE 7: Goodwill and Other Intangible Assets
Goodwill: Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The impairment testing process is conducted by assigning net assets and goodwill to each reporting unit. An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is more likely than not, quantitative testing is required whereby the fair value of each reporting unit is calculated and compared to the recorded book value, “step one.” If the calculated fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of a reporting unit exceeds its calculated fair value, the impairment test continues (“step two”) by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value is computed by adjusting all assets and liabilities of the reporting unit to current fair value with the offset adjustment to goodwill. The adjusted goodwill balance is the implied fair value of the goodwill. An impairment charge is recognized if the carrying fair value of goodwill exceeds the implied fair value of goodwill.
The Corporation conducted its annual impairment testing in May 2013, utilizing a qualitative assessment as permitted by recent accounting pronouncements (see Note 2 for additional information on this new accounting pronouncement). Factors that management considered in this assessment included macroeconomic conditions, industry and market considerations, overall financial performance (both current and projected), changes in management strategy, and changes in the composition or carrying amount of net assets. In addition, management considered the significant increases in both the Corporation’s common stock price and in the overall bank common stock index (based on the Nasdaq bank index), as well as the Corporation’s improving earnings per common share trend over the past year. Based on these assessments, management concluded that the 2013 annual qualitative impairment assessment indicated that it is more likely than not that the estimated fair value exceeded the carrying value (including goodwill) for each reporting unit. Therefore, a step one quantitative analysis was not required. The annual impairment testing in prior years was based upon a quantitative measurement of the fair value of the reporting units. There were no impairment charges recorded in 2012, or through June 30, 2013. It is possible that a future conclusion could be reached that all or a portion of the Corporation’s goodwill may be impaired, in which case a non-cash charge for the amount of such impairment would be recorded in earnings. Such a charge, if any, would have no impact on tangible capital and would not affect the Corporation’s “well-capitalized” designation.
At June 30, 2013, the Corporation had goodwill of $929 million, including goodwill of $428 million assigned to the Commercial Banking reporting unit and goodwill of $501 million assigned to the Consumer Banking reporting unit. There was no change in the carrying amount of goodwill during 2012 or through the first half of 2013.
Other Intangible Assets: The Corporation has other intangible assets that are amortized, consisting of core deposit intangibles, other intangibles (primarily related to customer relationships acquired in connection with the Corporation’s insurance agency acquisitions), and mortgage servicing rights. For core deposit intangibles and other intangibles, changes in the gross carrying amount, accumulated amortization, and net book value were as follows.
Core deposit intangibles:
Gross carrying amount
Accumulated amortization
Net book value
Amortization during the period
Other intangibles:
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The Corporation sells residential mortgage loans in the secondary market and typically retains the right to service the loans sold. Upon sale, a mortgage servicing rights asset is capitalized, which represents the current fair value of future net cash flows expected to be realized for performing servicing activities. Mortgage servicing rights, when purchased, are initially recorded at fair value. As the Corporation has not elected to subsequently measure any class of servicing assets under the fair value measurement method, the Corporation follows the amortization method. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income, and assessed for impairment at each reporting date. Mortgage servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value, and are included in other intangible assets, net, in the consolidated balance sheets.
The Corporation periodically evaluates its mortgage servicing rights asset for impairment. Impairment is assessed based on fair value at each reporting date using estimated prepayment speeds of the underlying mortgage loans serviced and stratifications based on the risk characteristics of the underlying loans (predominantly loan type and note interest rate). As mortgage interest rates fall, prepayment speeds are usually faster and the value of the mortgage servicing rights asset generally decreases, requiring additional valuation reserve. Conversely, as mortgage interest rates rise, prepayment speeds are usually slower and the value of the mortgage servicing rights asset generally increases, requiring less valuation reserve. A valuation allowance is established, through a charge to earnings, to the extent the amortized cost of the mortgage servicing rights exceeds the estimated fair value by stratification. If it is later determined that all or a portion of the temporary impairment no longer exists for a stratification, the valuation is reduced through a recovery to earnings. An other-than-temporary impairment (i.e., recoverability is considered remote when considering interest rates and loan pay off activity) is recognized as a write-down of the mortgage servicing rights asset and the related valuation allowance (to the extent a valuation allowance is available) and then against earnings. A direct write-down permanently reduces the carrying value of the mortgage servicing rights asset and valuation allowance, precluding subsequent recoveries. The Corporation recorded an other-than-temporary impairment of $15 million on mortgage servicing rights by reducing the capitalized costs and the valuation allowance on mortgage servicing rights during 2012 due to the uncertainty of the recoverability of the valuation allowance on mortgage servicing rights associated with the long-term, consistently low rate environment. See Note 12, “Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities,” for a discussion of the recourse provisions on serviced residential mortgage loans. See Note 13, “Fair Value Measurements,” which further discusses fair value measurement relative to the mortgage servicing rights asset.
A summary of changes in the balance of the mortgage servicing rights asset and the mortgage servicing rights valuation allowance was as follows.
Mortgage servicing rights:
Mortgage servicing rights at beginning of period
Additions
Amortization
Other-than-temporary impairment
Mortgage servicing rights at end of period
Valuation allowance at beginning of period
(Additions) / Recoveries, net
Valuation allowance at end of period
Mortgage servicing rights, net
Fair value of mortgage servicing rights
Portfolio of residential mortgage loans serviced for others (“servicing portfolio”)
Mortgage servicing rights, net to servicing portfolio
Mortgage servicing rights expense(1)
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The following table shows the estimated future amortization expense for amortizing intangible assets. The projections of amortization expense for the next five years are based on existing asset balances, the current interest rate environment, and prepayment speeds as of June 30, 2013. The actual amortization expense the Corporation recognizes in any given period may be significantly different depending upon acquisition or sale activities, changes in interest rates, prepayment speeds, market conditions, regulatory requirements, and events or circumstances that indicate the carrying amount of an asset may not be recoverable.
Estimated amortization expense:
Six months ending December 31, 2013
Year ending December 31, 2014
Year ending December 31, 2015
Year ending December 31, 2016
Year ending December 31, 2017
Year ending December 31, 2018
NOTE 8: Short and Long-Term Funding
The components of short-term funding (funding with original contractual maturities of one year or less) and long-term funding (funding with original contractual maturities greater than one year) were as follows.
Short-Term Funding
Federal funds purchased
Securities sold under agreements to repurchase
Federal Home Loan Bank (“FHLB”) advances
Commercial paper
Total short-term funding
Long-Term Funding
FHLB advances
Senior notes, at par
Subordinated debt, at par
Other long-term funding and capitalized costs
Total long-term funding
Total short and long-term funding
Short-term funding:
The FHLB advances included in short-term funding are those with original contractual maturities of one year or less. The securities sold under agreements to repurchase represent short-term funding which is collateralized by securities of the U.S. Government or its agencies and mature daily.
Long-term funding:
FHLB advances: At June 30, 2013, the long-term FHLB advances had a weighted-average interest rate of 5.06%, compared to 1.79% at December 31, 2012. These advances all had fixed interest rates at both June 30, 2013 and December 31, 2012. During the first half of 2013, $400 million of long-term FHLB advances matured.
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Senior notes: In March 2011, the Corporation issued $300 million of senior notes at a discount. In September 2011, the Corporation issued an additional $130 million of senior notes at a premium. The 2011 senior note issuances mature on March 28, 2016 and have a fixed coupon interest rate of 5.125%. In September 2012, the Corporation issued $155 million of senior notes at a discount. The 2012 senior note issuance matures on March 12, 2014 and has a fixed coupon interest rate of 1.875%.
Subordinated debt: In September 2008, the Corporation issued $26 million of 10-year subordinated debt with a 5-year no-call provision. The subordinated debt was issued at a discount, has a fixed coupon interest rate of 9.25%, and is callable beginning in September 2013. Subordinated debt qualifies under the risk-based capital guidelines as Tier 2 supplementary capital for regulatory purposes, and is discounted in accordance with regulations when the debt has five years or less remaining to maturity.
NOTE 9: Income Taxes
For the first half of 2013, the Corporation recognized income tax expense of $44 million, compared to income tax expense of $42 million for the first half of 2012. The effective tax rate was 31.57% for the first half of 2013, compared to an effective tax rate of 32.61% for the first half of 2012.
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NOTE 10: Derivative and Hedging Activities
The Corporation facilitates customer borrowing activity by providing various interest rate risk management solutions through its capital markets area. To date, all of the notional amounts of customer transactions have been matched with a mirror swap with another counterparty. The Corporation may also use derivative instruments to hedge the variability in interest payments or protect the value of certain assets and liabilities recorded on its consolidated balance sheet from changes in interest rates. The predominant derivative and hedging activities include interest rate-related instruments (swaps, caps, collars, and corridors), foreign currency exchange forwards, written options, purchased options, and certain mortgage banking activities. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amounts to be exchanged between the counterparties. The Corporation is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. To mitigate the counterparty risk, interest rate-related instruments generally contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined from the credit ratings of each counterparty. The Corporation was required to pledge $54 million of investment securities as collateral at June 30, 2013, and pledged $70 million of investment securities as collateral at December 31, 2012.
The Corporation’s derivative and hedging instruments are recorded at fair value on the consolidated balance sheets. The fair value of the Corporation’s interest rate-related instruments is determined using discounted cash flow analysis on the expected cash flows of each derivative and also includes a nonperformance / credit risk component (credit valuation adjustment). See Note 13, “Fair Value Measurements,” for additional fair value information and disclosures.
The table below identifies the balance sheet category and fair values of the Corporation’s derivative instruments not designated as hedging instruments.
June 30, 2013
Interest rate-related instruments — customer and mirror
Interest rate lock commitments (mortgage)
Forward commitments (mortgage)
Foreign currency exchange forwards
Purchased options (time deposit)
Written options (time deposit)
December 31, 2012
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The table below identifies the income statement category of the gains and losses recognized in income on the Corporation’s derivative instruments not designated as hedging instruments.
Six Months Ended June 30, 2013
Interest rate-related instruments — customer and mirror, net
Six Months Ended June 30, 2012
Covered call options
Free standing derivatives
The Corporation enters into various derivative contracts which are designated as free standing derivative contracts. These derivative contracts are not designated against specific assets and liabilities on the balance sheet or forecasted transactions and, therefore, do not qualify for hedge accounting treatment. Such derivative contracts are carried at fair value on the consolidated balance sheet with changes in the fair value recorded as a component of Capital market fees, net, and typically include interest rate-related instruments (swaps, caps, collars, and corridors).
Free standing derivatives are entered into primarily for the benefit of commercial customers through providing derivative products which enables the customer to manage their exposures to interest rate risk. The Corporation’s market risk from unfavorable movements in interest rates related to these derivative contracts is generally economically hedged by concurrently entering into offsetting derivative contracts. The offsetting derivative contracts have identical notional values, terms and indices.
Mortgage derivatives
Interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments, and the fair value of these commitments is recorded on the consolidated balance sheets with the changes in fair value recorded as a component of mortgage banking, net.
Foreign currency derivatives
The Corporation provides foreign exchange services to customers. The Corporation may enter into a foreign currency forward to mitigate the exchange rate risk attached to the cash flows of a loan or as an offsetting contract to a forward entered into as a service to our customer.
Written and purchased option derivatives (time deposit)
The Corporation periodically enters into written and purchased option derivative instruments to facilitate an equity linked time deposit product (the “Power CD”). The Power CD is a time deposit that provides the purchaser a guaranteed return of principal at maturity plus a potential equity return (a written option), while the Corporation receives a known stream of funds based on the equity return (a purchased option). The written and purchased options are mirror derivative instruments which are carried at fair value on the consolidated balance sheets.
Other derivatives
During the second quarter of 2012, the Corporation began entering into covered call options. Under covered call options, the Corporation will sell options to a bank or dealer for the right to purchase certain securities held within the Corporation’s investment securities portfolio. These option transactions are designed primarily to increase the total return associated with the investment securities portfolio. These options do not qualify as hedges, and, accordingly, the changes in fair value of these contracts are recognized in interest income. There were no covered call options outstanding as of June 30, 2013 or December 31, 2012.
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NOTE 11: Balance Sheet Offsetting
Interest Rate-Related Instruments (“Interest Agreements”)
The Corporation enters into interest rate-related instruments to facilitate the interest rate risk management strategies of commercial customers. The Corporation mitigates this risk by entering into equal and offsetting interest rate-related instruments with highly rated third party financial institutions. The interest agreements are free-standing derivatives and are recorded at fair value in the Corporation’s consolidated balance sheet. The Corporation is party to master netting arrangements with its financial institution counterparties; however, the Corporation does not offset assets and liabilities under these arrangements for financial statement presentation purposes. The master netting arrangements provide for a single net settlement of all interest agreements, as well as collateral, in the event of default on, or termination of, any one contract. Collateral, usually in the form of investment securities, is posted by the counterparty with net liability positions in accordance with contract thresholds. See Note 10 for additional information on the Corporation’s derivative and hedging activities.
Securities Sold Under Agreements to Repurchase (“Repurchase Agreements”)
The Corporation enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Corporation may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Corporation to repurchase the assets. As a result, these repurchase agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the Corporation’s consolidated balance sheet, while the securities underlying the repurchase agreements remain in the respective investment securities asset accounts (i.e., there is no offsetting or netting of the investment securities assets with the repurchase agreement liabilities). The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Corporation be in default (e.g., fails to make an interest payment to the counterparty). In addition, the Corporation does not enter into reverse repurchase agreements; therefore, there is no such offsetting to be done with the repurchase agreements.
The following table presents the assets and liabilities subject to an enforceable master netting arrangement as of June 30, 2013 and December 31, 2012. The swap agreements we have with our commercial customers are not subject to an enforceable master netting arrangement, and therefore, are excluded from this table.
Gross amounts not offset
in the balance sheet
Derivative assets:
Interest rate-related instruments
Derivative liabilities:
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NOTE 12: Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities
The Corporation utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers and to manage its own exposure to fluctuations in interest rates. These financial instruments include lending-related and other commitments (see below) and derivative instruments (see Note 10). The following is a summary of lending-related commitments.
Commitments to extend credit, excluding commitments to originate residential mortgage loans held for sale(1)(2)
Commercial letters of credit (1)
Standby letters of credit (3)
Lending-related Commitments
As a financial services provider, the Corporation routinely enters into commitments to extend credit. Such commitments are subject to the same credit policies and approval process accorded to loans made by the Corporation, with each customer’s creditworthiness evaluated on a case-by-case basis. The commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. The Corporation’s exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of those instruments. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the customer. Since a significant portion of commitments to extend credit are subject to specific restrictive loan covenants or may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements. For both June 30, 2013 and December 31, 2012, the Corporation had a reserve for losses on unfunded commitments totaling $22 million included in other liabilities on the consolidated balance sheets.
Lending-related commitments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, and standby letters of credit. Commitments to extend credit are agreements to lend to customers at predetermined interest rates, as long as there is no violation of any condition established in the contracts. Interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments, and the fair value of these commitments is recorded on the consolidated balance sheets. The Corporation’s derivative and hedging activity is further described in Note 10. Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party, while standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.
Other Commitments
The Corporation has principal investment commitments to provide capital-based financing to private and public companies through either direct investments in specific companies or through investment funds and partnerships. The timing of future cash requirements to fund such commitments is generally dependent on the investment cycle, whereby privately held companies are funded by private equity investors and ultimately sold, merged, or taken public through an initial offering, which can vary based on overall market conditions, as well as the nature and type of industry in which the companies operate. The Corporation also invests in low-income housing, small-business commercial real estate, new market tax credit projects, and historic tax credit projects to promote the revitalization of low-to-moderate-income neighborhoods throughout the local communities of its bank subsidiary. As a limited partner in these unconsolidated projects, the Corporation is allocated tax credits and deductions associated with the underlying projects. The aggregate carrying value of these investments at June 30, 2013 was $33 million, included in other assets on the consolidated balance sheets, compared to $35 million at December 31, 2012. Related to these investments, the Corporation had remaining commitments to fund of $17 million at June 30, 2013 and $18 million at December 31, 2012, respectively.
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Contingent Liabilities
The Corporation is party to various pending and threatened claims and legal proceedings arising in the normal course of business activities, some of which involve claims for substantial amounts. Although there can be no assurance as to the ultimate outcomes, the Corporation believes it has meritorious defenses to the claims asserted against it in its currently outstanding matters, including the matters described below, and with respect to such legal proceedings, intends to continue to defend itself vigorously. The Corporation will consider settlement of cases when, in management’s judgment, it is in the best interests of both the Corporation and its shareholders.
On at least a quarterly basis, the Corporation assesses its liabilities and contingencies in connection with all pending or threatened claims and litigation, utilizing the most recent information available. On a matter by matter basis, an accrual for loss is established for those matters which the Corporation believes it is probable that a loss may be incurred and that the amount of such loss can be reasonably estimated. Once established, each accrual is adjusted as appropriate to reflect any subsequent developments. Accordingly, management’s estimate will change from time to time, and actual losses may be more or less than the current estimate. For matters where a loss is not probable, or the amount of the loss cannot be estimated, no accrual is established.
Resolution of legal claims are inherently unpredictable, and in many legal proceedings various factors exacerbate this inherent unpredictability, including where the damages sought are unsubstantiated or indeterminate, it is unclear whether a case brought as a class action will be allowed to proceed on that basis, discovery is not complete, the proceeding is not yet in its final stages, the matters present legal uncertainties, there are significant facts in dispute, there are a large number of parties (including where it is uncertain how liability, if any, will be shared among multiple defendants), or there is a wide range of potential results.
A putative class action lawsuit, Harris v. Associated Bank, N.A. (the “Bank”), was filed in the United States District Court for the Western District of Wisconsin in April 2010, alleging that the Bank unfairly assessed and collected overdraft fees and seeking restitution of the overdraft fees, compensatory, consequential and punitive damages, and costs. The case was subsequently consolidated into the Multi District Litigation (“MDL”), In re: Checking Account Overdraft Litigation MDL No. 2036 in the United States District Court for the Southern District of Florida. A settlement agreement which requires payment by the Bank of $13 million for a full and complete release of all claims brought against the Bank received preliminary approval from the court on July 26, 2012. By entering into such an agreement, we have not admitted any liability with respect to the lawsuit. The settlement amount was previously accrued for in the financial statements. In the second quarter of 2012, the Bank settled with an insurer for a $2.5 million contribution to the settlement amount and partial reimbursement of defense costs of up to $2.1 million.
A lawsuit, R.J. ZAYED v. Associated Bank, N.A.,was filed in the United States District Court for the District of Minnesota on January 29, 2013. The lawsuit relates to a Ponzi scheme perpetrated by Oxford Global Partners and related entities (“Oxford”) and individuals and was brought by the receiver for Oxford. Oxford was a depository customer of the Bank. The lawsuit claims that the Bank is liable for failing to uncover the Oxford Ponzi scheme, and specifically alleges the Bank aided and abetted (1) the fraudulent scheme; (2) a breach of fiduciary duty; (3) conversion; and (4) false representations and omissions. The lawsuit seeks unspecified consequential and punitive damages. At this early stage of the lawsuit, it is not possible for management to assess the probability of a material adverse outcome or reasonably estimate the amount of any potential loss at this time. The Bank intends to vigorously defend this lawsuit. A lawsuit by investors in the same Ponzi scheme, Herman Grad, et al v. Associated Bank, N.A., brought in Brown County, Wisconsin in October 2009 was dismissed by the circuit court, and the dismissal was affirmed by the Wisconsin Court of Appeals in June 2011 in an unpublished opinion.
The Bank is currently subject to a Consent Order with the OCC relating to its Bank Secrecy Act of 1970 (“BSA”) compliance. The OCC has issued a written notice to the Bank related to the Bank’s past BSA deficiencies. After the OCC’s review of the Bank’s response, the OCC may impose a civil money penalty related to these deficiencies. The Corporation is currently not able to estimate a reasonable range of losses relating to that possibility.
Residential mortgage loans sold to others are predominantly conventional residential first lien mortgages originated under our usual underwriting procedures, and are most often sold on a nonrecourse basis, primarily to the government-sponsored enterprises (“GSEs”). The Corporation’s agreements to sell residential mortgage loans in the normal course of business usually require certain representations and warranties on the underlying loans sold, related to credit information, loan documentation, collateral, and insurability. Subsequent to being sold, if a material underwriting deficiency or documentation defect is discovered, the Corporation may be obligated to repurchase the loan or reimburse the GSEs for losses incurred (collectively, “make whole requests”). The make whole requests and any related risk of loss under the representations and warranties are largely driven by borrower performance. As a result of make whole requests, the Corporation has repurchased loans with principal balances of $3 million and $5 million for the six months ended June 30, 2013 and the year ended December 31, 2012, respectively, and paid loss reimbursement claims of $2 million
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and $4 million during the six months ended June 30, 2013 and the year ended December 31, 2012, respectively. Make whole requests and claims had been relatively modest prior to 2012; however, similar to other banks, this activity steadily increased during the second half of 2012 and into the first half of 2013, and therefore, the Corporation had a repurchase reserve for potential claims on loans previously sold of $5 million at June 30, 2013, compared to $3 million at December 31, 2012. Make whole requests during 2012 and the first half of 2013 generally arose from loans sold during the period January 1, 2006 to June 30, 2013, which totaled $16.4 billion at the time of sale, and consisted primarily of loans sold to GSEs. As of June 30, 2013, approximately $7.1 billion of these sold loans remain outstanding. Management will continue to monitor this activity in 2013 and its impact on the reserve. The following summarizes the changes in the mortgage repurchase reserve.
Repurchase provision expense
The Corporation may sell residential mortgage loans with limited recourse (limited in that the recourse period ends prior to the loan’s maturity, usually after certain time and/or loan paydown criteria have been met), whereby repurchase could be required if the loan had defined delinquency issues during the limited recourse periods. At June 30, 2013, and December 31, 2012, there were approximately $51 million and $79 million, respectively, of residential mortgage loans sold with such recourse risk. There have been limited instances of repurchase for recourse under the limited recourse criteria.
In October 2004, the Corporation acquired a thrift. Prior to the acquisition, this thrift retained a subordinate position to the FHLB in the credit risk on the underlying residential mortgage loans it sold to the FHLB in exchange for a monthly credit enhancement fee. The Corporation has not sold loans to the FHLB with such credit risk retention since February 2005. At June 30, 2013 and December 31, 2012, there were $270 million and $321 million, respectively, of such residential mortgage loans with credit risk recourse, upon which there have been negligible historical losses to the Corporation.
For certain mortgage loans originated by the Corporation, borrowers may be required to obtain Private Mortgage Insurance (“PMI”) provided by third party insurers. The Corporation entered into reinsurance treaties with certain PMI carriers which provided, among other things, for a sharing of losses within a specified range of the total PMI coverage in exchange for a portion of the PMI premiums. The Corporation’s reinsurance treaties typically provide that the Corporation will assume liability for losses once they exceed 5% of the aggregate risk exposure up to a maximum of 10% of the aggregate risk exposure. As of January 1, 2009, the Corporation discontinued providing reinsurance coverage for new loans in exchange for a portion of the PMI premium. During the first half of 2013, the Corporation terminated its reinsurance treaties with all third party PMI mortgage reinsurance carriers. As a result, the Corporation’s estimated liability for reinsurance losses was $0 as of June 30, 2013, compared to $8 million at December 31, 2012.
Regulatory Matters
During the first quarter of 2012, the Bank entered into a Consent Order with the OCC regarding its BSA compliance. The Consent Order required the Bank to create a BSA-focused action plan, supplement existing customer due diligence policies and procedures, perform a BSA risk assessment and complete independent testing. The Bank has been working cooperatively with the OCC, and management believes it is in compliance with the Consent Order. The OCC has issued a written notice to the Bank related to the Bank’s past BSA deficiencies. After the OCC’s review of the Bank’s response, the OCC may impose a civil money penalty related to these deficiencies. The Corporation is currently not able to estimate a reasonable range of losses relating to that possibility.
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NOTE 13: Fair Value Measurements
Fair value represents the estimated price at which an orderly transaction to sell an asset or to transfer a liability would take place between market participants at the measurement date under current market conditions (i.e., an exit price concept). As there is no active market for many of the Corporation’s financial instruments, estimates are made using discounted cash flow or other valuation techniques. Inputs into the valuation methods are subjective in nature, involve uncertainties, and require significant judgment and therefore cannot be determined with precision. Accordingly, the derived fair value estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. Assets and liabilities are categorized into three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy in which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Corporation’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. Below is a brief description of each fair value level.
Following is a description of the valuation methodologies used for the Corporation’s more significant instruments measured on a recurring basis at fair value, including the general classification of such instruments pursuant to the valuation hierarchy.
Investment securities available for sale: Where quoted prices are available in an active market, investment securities are classified in Level 1 of the fair value hierarchy. Level 1 investment securities primarily include U.S. Treasury, certain Federal agency, and exchange-traded debt and equity securities. If quoted market prices are not available for the specific security, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows, with consideration given to the nature of the quote and the relationship of recently evidenced market activity to the fair value estimate, and are classified in Level 2 of the fair value hierarchy. Examples of these investment securities include certain Federal agency securities, obligations of state and political subdivisions, mortgage-related securities, asset-backed securities, and other debt securities. Lastly, in certain cases where there is limited activity or less transparency around inputs to the estimated fair value, securities are classified within Level 3 of the fair value hierarchy. Level 3 securities primarily include pooled trust preferred debt securities. To validate the fair value estimates, assumptions, and controls, the Corporation looks to transactions for similar instruments and utilizes independent pricing provided by third party vendors or brokers and relevant market indices. While none of these sources are solely indicative of fair value, they serve as directional indicators for the appropriateness of the Corporation’s fair value estimates. The Corporation has determined that the fair value measures of its investment securities are classified predominantly within Level 1 or 2 of the fair value hierarchy. See Note 5, “Investment Securities,” for additional disclosure regarding the Corporation’s investment securities.
Derivative financial instruments (interest rate-related instruments): The Corporation uses interest rate swaps to manage its interest rate risk. In addition, the Corporation offers customer interest rate swaps, caps, collars, and corridors to service our customers’ needs, for which the Corporation simultaneously enters into offsetting derivative financial instruments (i.e., mirror interest rate swaps, caps, collars, and corridors) with third parties to manage its interest rate risk associated with these financial instruments. The valuation of the Corporation’s derivative financial instruments is determined using discounted cash flow analysis on the expected cash flows of each derivative and, also includes a nonperformance / credit risk component (credit valuation adjustment). See Note 10, “Derivative and Hedging Activities,” for additional disclosure regarding the Corporation’s derivative financial instruments.
The discounted cash flow analysis component in the fair value measurements reflects the contractual terms of the derivative financial instruments, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. More specifically, the fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments), with the variable cash payments (or receipts) based on an expectation of future
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interest rates (forward curves) derived from observable market interest rate curves. Likewise, the fair values of interest rate options (i.e., interest rate caps, collars, and corridors) are determined using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fall below (or rise above) the strike rate of the floors (or caps), with the variable interest rates used in the calculation of projected receipts on the floor (or cap) based on an expectation of future interest rates derived from observable market interest rate curves and volatilities.
As of January 1, 2013, the Corporation changed its valuation methodology for interest-rate related derivative financial instruments to discount cash flows based on Overnight Index Swap (“OIS”) rates. Fully collateralized trades are discounted using OIS with no additional economic adjustments to arrive at fair value. Under-collateralized or partially collateralized trades are also discounted at OIS, but include appropriate economic adjustments for funding costs (i.e., a LIBOR-OIS basis adjustment to approximate uncollateralized cost of funds) and credit risk. The Corporation is making the changes to better align its inputs, assumptions, and pricing methodologies with those used in its principal market by most dealers and major market participants. The changes in valuation methodology are immaterial to the Corporation’s results of operations, financial position, and liquidity.
The Corporation also incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative financial instruments for the effect of nonperformance risk, the Corporation has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees. In conjunction with the FASB’s fair value measurement guidance, the Corporation made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.
While the Corporation has determined that the majority of the inputs used to value its derivative financial instruments fall within Level 2 of the fair value hierarchy, the credit valuation adjustments utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. The Corporation has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions as of June 30, 2013, and December 31, 2012, and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivative financial instruments. Therefore, the Corporation has determined that the fair value measures of its derivative financial instruments in their entirety are classified within Level 2 of the fair value hierarchy.
Derivative financial instruments (foreign currency exchange forwards): The Corporation provides foreign currency exchange services to customers. In addition, the Corporation may enter into a foreign currency exchange forward to mitigate the exchange rate risk attached to the cash flows of a loan or as an offsetting contract to a forward entered into as a service to our customer. The valuation of the Corporation’s foreign currency exchange forwards is determined using quoted prices of foreign currency exchange forwards with similar characteristics, with consideration given to the nature of the quote and the relationship of recently evidenced market activity to the fair value estimate, and are classified in Level 2 of the fair value hierarchy.
Derivative financial instruments (mortgage derivatives): Mortgage derivatives include interest rate lock commitments to originate residential mortgage loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors. The Corporation relies on an internal valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated pull-through rate based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment groups.
The Corporation also relies on an internal valuation model to estimate the fair value of its forward commitments to sell residential mortgage loans (i.e., an estimate of what the Corporation would receive or pay to terminate the forward delivery contract based on market prices for similar financial instruments), which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available. While there are Level 2 and 3 inputs used in the valuation models, the Corporation has determined that the majority of the inputs significant in the valuation of both of the mortgage derivatives fall within Level 3 of the fair value hierarchy. See Note 10, “Derivative and Hedging Activities,” for additional disclosure regarding the Corporation’s mortgage derivatives.
Following is a description of the valuation methodologies used for the Corporation’s more significant instruments measured on a nonrecurring basis at the lower of amortized cost or estimated fair value, including the general classification of such instruments pursuant to the valuation hierarchy.
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Loans Held for Sale: Loans held for sale, which consist generally of current production of certain fixed-rate, first-lien residential mortgage loans, are carried at the lower of cost or estimated fair value. The estimated fair value of the residential mortgage loans held for sale was based on what secondary markets are currently offering for portfolios with similar characteristics, which the Corporation classifies as a Level 2 nonrecurring fair value measurement.
Impaired Loans: The Corporation considers a loan impaired when it is probable that the Corporation will be unable to collect all amounts due according to the original contractual terms of the note agreement, including both principal and interest. Management has determined that commercial and consumer loan relationships that have nonaccrual status or have had their terms restructured in a troubled debt restructuring meet this impaired loan definition. 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.
Mortgage servicing rights: Mortgage servicing rights do not trade in an active, open market with readily observable prices. While sales of mortgage servicing rights do occur, the precise terms and conditions typically are not readily available to allow for a “quoted price for similar assets” comparison. Accordingly, the Corporation utilizes an independent valuation from a third party which uses a discounted cash flow model to estimate the fair value of its mortgage servicing rights. The valuation model incorporates prepayment assumptions to project mortgage servicing rights cash flows based on the current interest rate scenario, which is then discounted to estimate an expected fair value of the mortgage servicing rights. The valuation model considers portfolio characteristics of the underlying mortgages, contractually specified servicing fees, prepayment assumptions, discount rate assumptions, delinquency rates, late charges, other ancillary revenue, costs to service, and other economic factors. The Corporation periodically reviews and assesses the underlying inputs and assumptions used in the model. In addition, the Corporation compares its fair value estimates and assumptions to observable market data for mortgage servicing rights, where available, and to recent market activity and actual portfolio experience. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the fair value hierarchy. The Corporation uses the amortization method (i.e., lower of amortized cost or estimated fair value measured on a nonrecurring basis), not fair value measurement accounting, for its mortgage servicing rights assets. See Note 7, “Goodwill and Other Intangible Assets,” for additional disclosure regarding the Corporation’s mortgage servicing rights.
The table below presents the Corporation’s investment securities available for sale and derivative financial instruments measured at fair value on a recurring basis as of June 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
Assets:
GSE residential mortgage-related securities
Private label residential mortgage-related securities
Derivatives (trading and other assets)
Liabilities:
Derivatives (trading and other liabilities)
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The table below presents a rollforward of the balance sheet amounts for the year ended December 31, 2012 and the six months ended June 30, 2013, for financial instruments measured on a recurring basis and classified within Level 3 of the fair value hierarchy.
Assets and Liabilities Measured at Fair Value
Using Significant Unobservable Inputs (Level 3)
Balance December 31, 2011
Total net gains included in income:
Mortgage derivative gain
Total net gains included in other comprehensive income:
Unrealized investment securities gains
Balance December 31, 2012
Balance June 30, 2013
For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2013, the Corporation utilized the following valuation techniques and significant unobservable inputs.
Investment securities available for sale – other securities (debt and equity): In valuing the investment securities available for sale classified within Level 3, the Corporation utilized a discounted cash flow model and incorporated its own assumptions about future cash flows and discount rates adjusting for credit and liquidity factors. The Corporation also reviewed the underlying collateral and other relevant data in developing the assumptions for these investment securities. The significant unobservable input used within the discounted cash flow analysis was the discount rate, which was based on the 3 month LIBOR forward curve (the 3 month LIBOR forward ranged from 0.35% to 3.07%) plus the investment security spread, at June 30, 2013.
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Derivative financial instruments (mortgage derivative – interest rate lock commitments to originate residential mortgage loans held for sale): The significant unobservable input used in the fair value measurement of the Corporation’s mortgage derivative interest rate lock commitments (“IRLC”) is the closing ratio, which represents the percentage of loans currently in a lock position which management estimates will ultimately close. Typically the higher the closing ratio on the IRLC’s will result in an increase in the fair value if in a gain position or a decrease in fair value if in a loss position. The closing ratio calculation takes into consideration historical data and loan-level data, (particularly the change in the current interest rates from the time of initial rate lock). The closing ratio is periodically reviewed for reasonableness and reported to Mortgage Risk Management Committee. At June 30, 2013, the closing ratio was 90%.
Impaired loans: 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, resulting in discounts of 0% to 50%.
Mortgage servicing rights: The discounted cash flow analyses that generate expected market prices utilize the observable characteristics of the mortgage servicing rights portfolio, as well as certain unobservable valuation parameters. The significant unobservable inputs used in the fair value measurement of the Corporation’s mortgage servicing rights are the weighted average constant prepayment rate and weighted average discount rate, which were 14.4% and 9.6% at June 30, 2013, respectively. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the prepayment rate and discount rate are not directly interrelated, they will generally move in opposite directions.
These parameter assumptions fall within a range that the Corporation, in consultation with an independent third party, believes purchasers of servicing would apply to such portfolios sold into the current secondary servicing market. Discussions are held with members from Treasury and Consumer Banking to reconcile the fair value estimates and the key assumptions used by the respective parties in arriving at those estimates. The Associated Mortgage Group Risk Committee is responsible for providing control over the valuation methodology and key assumptions. To assess the reasonableness of the fair value measurement, the Corporation also compares the fair value and constant prepayment rate to a value calculated by an independent third party on an annual basis.
The table below presents the Corporation’s loans held for sale, impaired loans, and mortgage servicing rights measured at fair value on a nonrecurring basis as of June 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
Impaired loans (1)
Mortgage servicing rights
Certain nonfinancial assets measured at fair value on a nonrecurring basis include other real estate owned (upon initial recognition or subsequent impairment), nonfinancial assets and nonfinancial liabilities, and intangible assets and other nonfinancial long-lived assets measured at fair value for impairment assessment.
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During the first half of 2013 and the full year 2012, certain other real estate owned, upon initial recognition, was re-measured and reported at fair value through a charge off to the allowance for loan losses based upon the estimated fair value of the other real estate owned, less estimated selling costs. The fair value of other real estate owned, upon initial recognition or subsequent impairment, was estimated using appraised values, which the Corporation classifies as a Level 2 nonrecurring fair value measurement. Other real estate owned measured at fair value upon initial recognition totaled approximately $16 million for the first half of 2013 and $47 million for the year ended December 31, 2012, respectively. In addition to other real estate owned measured at fair value upon initial recognition, the Corporation also recorded write-downs to the balance of other real estate owned for subsequent impairment of $2 million, $5 million, and $8 million to asset losses, net for the six months ended June 30, 2013 and 2012, and the year ended December 31, 2012, respectively.
Fair Value of Financial Instruments:
The Corporation is required to disclose estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions are set forth below for the Corporation’s financial instruments.
The estimated fair values of the Corporation’s financial instruments at June 30, 2013 and December 31, 2012, were as follows.
Financial assets:
Investment securities held to maturity
Investment securities available for sale
FHLB and Federal Reserve Bank stocks
Bank owned life insurance
Accrued interest receivable
Interest rate-related agreements
Forward commitments to sell residential mortgage loans
Financial liabilities:
Noninterest-bearing demand, savings, interest-bearing demand, and money market deposits
Brokered CDs and other time deposits
Short-term funding
Accrued interest payable
Standby letters of credit (1)
Interest rate lock commitments to originate residential mortgage loans held for sale
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Cash and due from banks, interest-bearing deposits in other financial institutions, federal funds sold and securities purchased under agreements to resell, and accrued interest receivable—For these short-term instruments, the carrying amount is a reasonable estimate of fair value.
Investment securities (held to maturity and available for sale)—The fair value of investment securities is based on quoted prices in active markets, or if quoted prices are not available for a specific security, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows.
FHLB and Federal Reserve Bank stocks—The carrying amount is a reasonable fair value estimate for the Federal Reserve Bank and Federal Home Loan Bank stocks given their “restricted” nature (i.e., the stock can only be sold back to the respective institutions (Federal Home Loan Bank or Federal Reserve Bank) or another member institution at par).
Loans held for sale—The estimated fair value of the residential mortgage loans held for sale was based on what secondary markets are currently offering for portfolios with similar characteristics.
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Loans, net—The fair value estimation process for the loan portfolio uses an exit price concept and reflects discounts the Corporation believes are consistent with liquidity discounts in the market place. Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial and industrial, real estate construction, commercial real estate (owner occupied and investor), lease financing, residential mortgage, home equity, and other installment. The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for similar maturities. The fair value analysis also included other assumptions to estimate fair value, intended to approximate those a market participant would use in an orderly transaction, with adjustments for discount rates, interest rates, liquidity, and credit spreads, as appropriate. In addition, as part of the annual goodwill impairment assessment, the Corporation may consult with an independent party as to the assumptions used and to determine that the Corporation’s valuation is consistent with the third party valuation.
Bank owned life insurance—The fair value of bank owned life insurance approximates the carrying amount, because upon liquidation of these investments, the Corporation would receive the cash surrender value which equals the carrying amount.
Deposits—The fair value of deposits with no stated maturity such as noninterest-bearing demand deposits, savings, interest-bearing demand deposits, and money market accounts, is equal to the amount payable on demand as of the balance sheet date. The fair value of Brokered CDs and other time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. However, if the estimated fair value of Brokered CDs and other time deposits is less than the carrying value, the carrying value is reported as the fair value.
Accrued interest payable and short-term funding—For these short-term instruments, the carrying amount is a reasonable estimate of fair value.
Long-term funding—Rates currently available to the Corporation for debt with similar terms and remaining maturities are used to estimate the fair value of existing long-term funding.
Interest rate-related agreements—The fair value of interest rate swap, cap, collar, and corridor agreements is determined using discounted cash flow analysis on the expected cash flows of each derivative. The Corporation also incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.
Foreign currency exchange forwards—The fair value of the Corporation’s foreign currency exchange forwards is determined using quoted prices of foreign currency exchange forwards with similar characteristics, with consideration given to the nature of the quote and the relationship of recently evidenced market activity to the fair value estimate.
Standby letters of credit—The fair value of standby letters of credit represent deferred fees arising from the related off-balance sheet financial instruments. These deferred fees approximate the fair value of these instruments and are based on several factors, including the remaining terms of the agreement and the credit standing of the customer.
Interest rate lock commitments to originate residential mortgage loans held for sale—The Corporation relies on an internal valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated pull-through rate based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment groups.
Forward commitments to sell residential mortgage loans—The Corporation relies on an internal valuation model to estimate the fair value of its forward commitments to sell residential mortgage loans (i.e., an estimate of what the Corporation would receive or pay to terminate the forward delivery contract based on market prices for similar financial instruments), which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.
Purchased and written options—The fair value of the Corporation’s purchased and written options is determined using quoted prices of the underlying stocks.
Limitations—Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’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 of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
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NOTE 14: Retirement Plans
The Corporation has a noncontributory defined benefit retirement plan (the Retirement Account Plan (“RAP”)) covering substantially all full-time employees. The benefits are based primarily on years of service and the employee’s compensation paid. Employees of acquired entities generally participate in the RAP after consummation of the business combinations. Any retirement plans of acquired entities are typically merged into the RAP after completion of the mergers, and credit is usually given to employees for years of service at the acquired institution for vesting and eligibility purposes. The RAP and a smaller acquired plan that was frozen in December 31, 2004, are collectively referred to below as the “Pension Plan.”
The Corporation also provides healthcare access for eligible retired employees in its Postretirement Plan (the “Postretirement Plan”). Retirees who are at least 55 years of age with 5 years of service are eligible to participate in the Postretirement Plan. The Corporation has no plan assets attributable to the Postretirement Plan. The Corporation reserves the right to terminate or make changes to the Postretirement Plan at any time.
The components of net periodic benefit cost for the Pension and Postretirement Plans for the three and six months ended June 30, 2013 and 2012, and for the full year 2012 were as follows.
Components of Net Periodic Benefit Cost
Pension Plan:
Service cost
Interest cost
Expected return on plan assets
Amortization of actuarial loss
Settlement Charge
Total net periodic benefit cost
Postretirement Plan:
The Corporation’s funding policy is to pay at least the minimum amount required by the funding requirements of federal law and regulations, with consideration given to the maximum funding amounts allowed. The Corporation regularly reviews the funding of its Pension Plan. The Corporation made a contribution of $10 million to its Pension Plan in the first half of 2013.
NOTE 15: Segment Reporting
The Corporation utilizes a risk-based internal profitability measurement system to provide strategic business unit reporting. The profitability measurement system is based on internal management methodologies designed to produce consistent results and reflect the underlying economics of the units. Certain strategic business units have been combined for segment information reporting purposes where the nature of the products and services, the type of customer and the distribution of those products and services are similar. The three reportable segments are Commercial Banking, Consumer Banking, and Risk Management and Shared Services, with no segment representing more than half of the assets, liabilities or Tier 1 common equity of the Corporation as a whole.
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The financial information of the Corporation’s segments has been compiled utilizing the accounting policies described in the Corporation’s 2012 annual report on Form 10-K with certain exceptions. The more significant of these exceptions are described herein. The Corporation allocates interest income or interest expense using a funds transfer pricing methodology that charges users of funds (assets) interest expense and credits providers of funds (liabilities, primarily deposits) with income based on the maturity, prepayment and / or repricing characteristics of the assets and liabilities. The net effect of this allocation is recorded in the Risk Management and Shared Services segment. A credit provision is allocated to segments based on the expected long-term annual net charge off rates attributable to the credit risk of loans managed by the segment during the period. In contrast, the level of the consolidated provision for loan losses is determined using the methodologies described in the Corporation’s 2012 annual report on Form 10-K to assess the overall appropriateness of the allowance for loan losses. The net effect of the credit provision is recorded in Risk Management and Shared Services. Indirect expenses incurred by certain centralized support areas are allocated to segments based on actual usage (for example, volume measurements) and other criteria. Certain types of administrative expense and bank-wide expense accruals (including amortization of core deposit and other intangible assets associated with acquisitions) are generally not allocated to segments. Income taxes are allocated to segments based on the Corporation’s estimated effective tax rate adjusted for any tax-exempt income or non-deductible expenses. Equity is allocated to the segments based on regulatory capital requirements and in proportion to an assessment of the inherent risks associated with the business of the segment (including interest, credit and operating risk).
The management accounting policies and processes utilized in compiling segment financial information are highly subjective and, unlike financial accounting, are not based on authoritative guidance similar to U.S. generally accepted accounting principles. As a result, reported segment results are not necessarily comparable with similar information reported by other financial institutions. Furthermore, changes in management structure or allocation methodologies and procedures may result in changes in previously reported segment financial data. During 2013, certain organization and methodology changes were made and, accordingly, 2012 results have been restated and presented on a comparable basis.
A description of each business segment is presented below.
Commercial Banking – The Commercial Banking segment serves a wide range of customers including, businesses, non-profits, municipalities, and financial institutions. Business customers in this segment include companies with a sales size from $10 million to over $500 million and delivery of services is provided through our regional and middle market units, our commercial real estate unit, as well as our specialized industries and commercial financial services area. The financial solutions provided to our customers include but are not limited to: (1) Lending solutions, such as business loans and lines of credit, business credit cards, commercial real estate financing, construction loans, letters of credit, leasing, and asset based lending. For our largest clients we also offer syndications to meet their lending needs (2) Deposit and cash management solutions such as business checking and interest-bearing deposit products, safe deposit and night depository services, liquidity solutions, payables and receivables solutions, and information services (3) Specialized financial services such as insurance and benefits related products and services, risk management, and international banking solutions. In serving the commercial banking segment we compete based on an in-depth understanding of our customers’ financial needs, the ability to match market competitive solutions to those needs, and the highest standards of relationship and service excellence in the delivery of these services.
Consumer Banking – The Consumer Banking segment serves individuals and small businesses (up to $10 million in sales size) through our various Retail Banking and Private Client offices, and provides companies of varying sizes with fiduciary services such as administration of pension, profit-sharing and other employee benefit plans, fiduciary and corporate agency services, and institutional asset management. The services provided to our individual and small business customers include but are not limited to: (1) Transactional solutions such as checking, debit and pre-paid cards, online banking and bill pay, and money transfer services (2) Lending solutions such as residential mortgages, home equity loans and lines of credit, business loans and lines, and personal and installment loans (3) Investable funds solutions such as savings, money market deposit accounts, IRA accounts, certificates of deposit, market linked certificates of deposit, fixed and variable annuities, full-service, discount and on-line investment brokerage; as well as trust and investment management accounts. In serving the consumer banking segment we compete based on providing a broad range of solutions to meet the needs of our customers in their entire financial lifecycle, convenient access to our services through multiple channels such as branches, phone based services, online and mobile banking, and a relationship based business model which assists our customers in navigating any changes and challenges in their financial circumstances.
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Risk Management and Shared Services—The Risk Management and Shared Services segment includes Corporate Risk Management, Finance, Treasury, Operations and Technology functions, which are key shared functions. The segment also includes Parent Company activity, intersegment eliminations and residual revenue and expenses, representing the difference between actual amounts incurred and the amounts allocated to operating segments, including interest rate risk residuals (funds transfer pricing mismatches) and credit risk and provision residuals (long term credit charge mismatches). The earning assets within this segment include the Corporation’s investment portfolio and capital includes both allocated as well as any remaining unallocated capital.
Information about the Corporation’s segments is presented below.
Segment Income Statement Data
Net interest income
Noninterest income
Total revenue
Credit provision *
Noninterest expense
Income tax expense (benefit)
Return on average allocated capital (ROT1CE) **
Segment Balance Sheet Data
Average Balances for YTD 2Q 2013
Average earning assets
Average loans
Average deposits
Average allocated capital (T1CE) **
Average Balances for YTD 2Q 2012
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Three Months Ended June 30, 2013
Three Months Ended June 30, 2012
Average Balances for 2Q 2013
Average Balances for 2Q 2012
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Note 16: Accumulated Other Comprehensive Income (Loss)
The following table summarizes the components of accumulated other comprehensive income at June 30, 2013 and 2012, changes during the six and three month periods then ended, and reclassifications out of accumulated other comprehensive income during the six and three month periods ended June 30, 2013 and 2012, respectively. The amounts reclassified from accumulated other comprehensive income for the investment securities available for sale are included in investment securities gains, net on the consolidated statements of income, while the amounts reclassified from accumulated other comprehensive income for the defined benefit plans are a component of personnel expense on the consolidated statements of income.
Balance January 1, 2013
Other comprehensive loss before reclassifications
Amounts reclassified from accumulated other comprehensive income (loss)
Net other comprehensive income (loss) during period
Balance January 1, 2012
Balance June 30, 2012
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Balance April 1, 2013
Balance April 1, 2012
Other comprehensive income (loss) before reclassifications
Net other comprehensive income during period
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Special Note Regarding Forward-Looking Statements
This report contains statements that may constitute forward-looking statements within the meaning of the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, such as statements other than historical facts contained or incorporated by reference into this report. These forward-looking statements include statements with respect to the Corporation’s financial condition, results of operations, plans, objectives, future performance and business, including statements preceded by, followed by or that include the words “believes,” “expects,” or “anticipates,” references to estimates or similar expressions. Future filings by the Corporation with the Securities and Exchange Commission, and future statements other than historical facts contained in written material, press releases and oral statements issued by, or on behalf of the Corporation may also constitute forward-looking statements.
All forward-looking statements contained in this report or which may be contained in future statements made for or on behalf of the Corporation are based upon information available at the time the statement is made and the Corporation assumes no obligation to update any forward-looking statements, except as required by federal securities law. Forward-looking statements are subject to significant risks and uncertainties, and the Corporation’s actual results may differ materially from the expected results discussed in such forward-looking statements. Factors that might cause actual results to differ from the results discussed in forward-looking statements include, but are not limited to, the risk factors in Item 1A, Risk Factors, in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2012, and as may be described from time to time in the Corporation’s subsequent SEC filings.
Overview
The following discussion and analysis is presented to assist in the understanding and evaluation of the Corporation’s financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith.
Critical Accounting Policies
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, goodwill impairment assessment, mortgage servicing rights valuation, derivative financial instruments and hedging activities, and income taxes.
The consolidated financial statements of the Corporation are prepared in conformity with U.S. generally accepted accounting principles and follow general practices within the industries in which it operates. This preparation requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Management believes the following policies are both important to the portrayal of the Corporation’s financial condition and results of operations and require subjective or complex judgments and, therefore, management considers the following to be critical accounting policies. The critical accounting policies are discussed directly with the Audit Committee of the Corporation’s Board of Directors.
Allowance for Loan Losses: Management’s evaluation process used to determine the appropriateness of the allowance for loan losses is subject to the use of estimates, assumptions, and judgments. The evaluation process combines many factors: management’s ongoing review and grading of the loan portfolio, consideration of historical loan loss and delinquency experience, trends in past due and nonaccrual loans, risk characteristics of the various classifications of loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the appropriateness of the allowance for loan losses, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require additions to the allowance for loan losses or may require that certain loan balances be charged off
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or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. The Corporation believes the level of the allowance for loan losses is appropriate as recorded in the consolidated financial statements. See Note 6, “Loans, Allowance for Loan Losses, and Credit Quality,” of the notes to consolidated financial statements and section “Allowance for Loan Losses.”
Goodwill Impairment Assessment: Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The impairment testing process is conducted by assigning net assets and goodwill to each reporting unit. An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is more likely than not, quantitative testing is required whereby the fair value of each reporting unit is calculated and compared to the recorded book value, “step one”. If the calculated fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of a reporting unit exceeds its calculated fair value, the impairment test continues (“step two”) by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value is computed by adjusting all assets and liabilities of the reporting unit to current fair value with the offset adjustment to goodwill. The adjusted goodwill balance is the implied fair value of the goodwill. An impairment charge is recognized if the carrying fair value of goodwill exceeds the implied fair value of goodwill.
The Corporation conducted its annual impairment testing in May 2013, utilizing the qualitative assessment as permitted by recent accounting pronouncements (see Note 2, “New Accounting Pronouncements Adopted” of the notes to consolidated financial statements for additional information on this new accounting pronouncement). Factors that management considered in this assessment included macroeconomic conditions, industry and market considerations, overall financial performance (both current and projected), changes in management strategy, and changes in the composition or carrying amount of net assets. In addition, management considered the significant increases in both the Corporation’s common stock price and in the overall bank common stock index (based on the Nasdaq bank index), as well as the Corporation’s improving earnings per common share trend over the past year. Based on these assessments, management concluded that the 2013 annual qualitative impairment assessment indicated that it is more likely than not that the estimated fair value exceeded the carrying value (including goodwill) for each reporting unit. Therefore, a step one quantitative analysis was not required. The annual impairment testing in prior years was based upon a quantitative measurement of the fair value of the reporting units.
Mortgage Servicing Rights Valuation: The fair value of the Corporation’s mortgage servicing rights asset is important to the presentation of the consolidated financial statements since the mortgage servicing rights are carried on the consolidated balance sheet at the lower of amortized cost or estimated fair value. Mortgage servicing rights do not trade in an active open market with readily observable prices. As such, like other participants in the mortgage banking business, the Corporation relies on an independent valuation from a third party which uses a discounted cash flow model to estimate the fair value of its mortgage servicing rights. The use of a discounted cash flow model involves judgment, particularly of estimated prepayment speeds of underlying mortgages serviced and the overall level of interest rates. Loan type and note interest rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. The Corporation periodically reviews the assumptions underlying the valuation of mortgage servicing rights. While the Corporation believes that the values produced by the discounted cash flow model are indicative of the fair value of its mortgage servicing rights portfolio, these values can change significantly depending upon key factors, such as the then current interest rate environment, estimated prepayment speeds of the underlying mortgages serviced, and other economic conditions. The proceeds that might be received should the Corporation actually consider a sale of some or all of the mortgage servicing rights portfolio could differ from the amounts reported at any point in time.
Mortgage servicing rights are carried at the lower of amortized cost or estimated fair value and are assessed for impairment at each reporting date. Impairment is assessed based on the fair value at each reporting date using estimated prepayment speeds of the underlying mortgage loans serviced and stratifications based on the risk characteristics of the underlying loans (predominantly loan type and note interest rate). As mortgage interest rates fall, prepayment speeds are usually faster and the value of the mortgage servicing rights asset generally decreases, requiring additional valuation reserve. Conversely, as mortgage interest rates rise, prepayment speeds are usually slower and the value of the mortgage servicing rights asset generally increases, requiring less valuation reserve. However, the extent to which interest rates impact the value of the mortgage servicing rights asset depends, in part, on the magnitude of the changes in market interest rates and the differential between the then current market interest rates for mortgage loans and the mortgage interest rates included in the mortgage servicing portfolio. Management recognizes that the volatility in the valuation of the mortgage servicing rights asset will continue. To better understand the sensitivity of the impact of prepayment speeds and refinance rates on the value of the mortgage servicing rights asset at June 30, 2013 (holding all other factors unchanged), if refinance rates were to decrease 50 bp, the estimated value of the mortgage servicing rights asset would have been approximately $7 million (or 11%) lower. Conversely, if refinance rates were to increase 50 bp, the estimated value of the mortgage servicing rights asset would have been approximately $7 million (or 10%) higher. However, the Corporation’s potential recovery recognition due to
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valuation improvement is limited to the balance of the mortgage servicing rights valuation reserve, which was $2 million at June 30, 2013. The Corporation believes the mortgage servicing rights asset is properly recorded in the consolidated financial statements. See Note 7, “Goodwill and Other Intangible Assets,” and Note 13, “Fair Value Measurements,” of the notes to consolidated financial statements and section “Noninterest Income.”
Derivative Financial Instruments and Hedging Activities: In various aspects of its business, the Corporation uses derivative financial instruments to modify exposures to changes in interest rates and market prices for other financial instruments. Derivative instruments are required to be carried at fair value on the balance sheet with changes in the fair value recorded directly in earnings. To qualify for and maintain hedge accounting, the Corporation must meet formal documentation and effectiveness evaluation requirements both at the hedge’s inception and on an ongoing basis. The application of the hedge accounting policy requires strict adherence to documentation and effectiveness testing requirements, judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings, and measurement of changes in the fair value of hedged items. If in the future derivative financial instruments used by the Corporation no longer qualify for hedge accounting, the impact on the consolidated results of operations and reported earnings could be significant. When hedge accounting is discontinued, the Corporation would continue to carry the derivative on the balance sheet at its fair value; however, for a cash flow derivative, changes in its fair value would be recorded in earnings instead of through other comprehensive income, and for a fair value derivative, the changes in fair value of the hedged asset or liability would no longer be recorded through earnings. See also Note 10, “Derivative and Hedging Activities,” and Note 13 “Fair Value Measurements,” of the notes to consolidated financial statements and section “Interest Rate Risk.”
Income Taxes: The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. Quarterly assessments are performed to determine if valuation allowances are necessary. Assessing the need for, or sufficiency of, a valuation allowance requires management to evaluate all available evidence, both positive and negative, including the recent trend of quarterly earnings. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carryback and carryforward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g., cumulative losses in recent years, history of operating loss or tax credit carryforwards expiring unused) exists, more positive evidence than negative evidence will be necessary. The Corporation has concluded that based on the level of positive evidence, it is more likely than not that the deferred tax asset will be realized. However, there is no guarantee that the tax benefits associated with the deferred tax assets will be fully realized. The Corporation believes the tax assets and liabilities are properly recorded in the consolidated financial statements. See also Note 9, “Income Taxes,” of the notes to consolidated financial statements and section “Income Taxes.”
Segment Review
As discussed in Note 15 of the notes to consolidated financial statements, the Corporation’s reportable segments have been determined based upon its internal profitability reporting system, which is organized by strategic business unit. Certain strategic business units have been combined for segment information reporting purposes where the nature of the products and services, the type of customer, and the distribution of those products and services are similar. The reportable segments are Commercial Banking, Consumer Banking and Risk Management and Shared Services.
The financial information of the Corporation’s segments was compiled utilizing the accounting policies described in Note 15 of the notes to consolidated financial statements. The management accounting policies and processes utilized in compiling segment financial information are highly subjective and unlike financial accounting, are not based on authoritative guidance similar to U.S. generally accepted accounting principles. As a result, reported segments and the financial information of the reported segments are not necessarily comparable with similar information reported by other financial institutions. Furthermore, changes in management structure or allocation methodologies and procedures may result in changes in previously reported segment financial data. During the first half of 2013, certain organization and methodology changes were made and, accordingly, 2012 results have been restated and presented on a comparable basis.
Year to Date Segment Review
The Commercial Banking segment consists of lending and deposit solutions to businesses, governments / municipalities, and financial institutions, and the support to deliver, fund and manage such banking solutions. The Commercial Banking segment had net income of $55 million for the first half of 2013, up $14 million compared to $41 million for the comparable period in 2012. The Corporation
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began providing resources in late 2011 to grow this segment, including investments to expand into new markets (Cincinnati, Indianapolis, and Michigan) and new industry lending segments (power, oil and gas). Primarily as a result of these investments, and lower other real estate owned losses and write-downs during the first half of 2013, segment revenue increased by $24 million to $204 million for the first half of 2013 compared to $180 million for the first half of 2012. The credit provision for loans increased $5 million to $27 million during the first half of 2013 due to the growth in the segment’s loan balances, partially offset by improvement in credit quality as compared to the first half of 2012. Total noninterest expense for the first half of 2013 was $92 million, down $3 million from $95 million in the comparable period in 2012 as slightly higher direct costs were more than offset by lower Corporate overhead charges. Average loan balances were $8.3 billion for the first half of 2013, up $1.2 billion from an average balance of $7.1 billion for the first half of 2012, and average deposit balances were $5.3 billion for the first half of 2013, up $1.1 billion from average deposits of $4.2 billion in the first half of 2012, reflecting our investments and strategy to expand and grow the Commercial Banking segment. Average allocated capital increased $48 million to $766 million for the first half of 2013 reflecting the increase in the segment’s loan balances offset by an improvement in credit quality as compared to the first half of 2012.
The Consumer Banking segment consists of lending and deposit solutions to individuals and small businesses and also provides a variety of investment and fiduciary products and services. The Consumer Banking segment had net income of $31 million in the first half of 2013, up $6 million compared to $25 million in the first half of 2012. Earnings increased as segment revenue grew $4 million to $268 million for the first half of 2013, primarily due to higher mortgage banking income. The credit provision for loans was level at $10 million for the first half of 2013 and 2012. Total noninterest expense decreased $5 million to $211 million for the first half of 2013, as slightly higher direct costs were more than offset by lower allocated occupancy costs, reflecting a reduction in our branch network from branch closures. Average loan balances were level at $7.3 billion for both the first half of 2013 and 2012. Average deposits were $9.6 billion for the first half of 2013, up $111 million from $9.5 billion in the first half of 2012. Average allocated capital decreased $17 million to $544 million for the first half of 2013.
Risk Management and Shared Services had net income of $9 million in the first half of 2013, down $11 million compared to $20 million for the comparable period in 2012. The primary components of the decrease were a $3 million higher credit provision, reflecting the higher provision for loan losses at the consolidated level and a $9 million increase in noninterest expense primarily due to higher unallocated occupancy costs for unused and vacant space as a result of retail branch closures. Average earning asset balances were $5.2 billion for the first half of 2013, up $266 million from an average balance of $5.0 billion during the first half of 2012, reflecting the growth in the Corporation’s investment portfolio.
Comparable Quarter Segment Review
The Commercial Banking segment had net income of $28 million for the second quarter of 2013, up $8 million compared to $20 million for the comparable quarter in 2012. The Corporation began providing resources to grow this segment in late 2011, including investments to expand into new markets (Cincinnati, Indianapolis, and Michigan) and new industry lending segments (power, oil and gas). Primarily as a result of these investments, segment revenue increased by $14 million to $103 million during the second quarter of 2013 compared to $89 million for the second quarter of 2012. The credit provision for loans increased $3 million to $15 million during the second quarter of 2013 due to the growth in the segment’s loan balances, partially offset by improvement in credit quality as compared to the second quarter of 2012. Total noninterest expense for the second quarter of 2013 was $46 million, down $2 million from $48 million in the comparable quarter in 2012 as higher direct costs were more than offset by lower Corporate overhead charges. Average loan balances were $8.5 billion for the second quarter of 2013, up $1.2 billion from an average balance of $7.3 billion for the second quarter of 2012, and average deposit balances were $5.2 billion for the second quarter of 2013, up $1 billion from average deposits of $4.2 billion in the second quarter of 2012, reflecting our investments and strategy to expand and grow the Commercial Banking segment. Average allocated capital increased $51 million to $777 million for the second quarter of 2013 reflecting the increase in the segment’s loan balances offset by an improvement in credit quality as compared to the second quarter of 2012.
The Consumer Banking segment had net income of $14 million in the second quarter of 2013, up $3 million compared to $11 million in the second quarter of 2012. Earnings increased as segment revenue grew $4 million to $135 million for the second quarter of 2013, primarily due to higher mortgage banking income. The credit provision for loans was level for the second quarter of 2013 and 2012 at $5 million. Total noninterest expense was down $1 million as increases in direct expenses were more than offset by a reduction in allocated occupancy costs due to the reduction in our branch network from branch closures Average loan balances were down $57 million to $7.2 billion for the second quarter of 2013 compared to $7.3 billion for the second quarter 2012. Average deposits were $9.7 billion for the second quarter of 2013, up $130 million from $9.5 billion in the second quarter of 2012. Average allocated capital decreased $16 million to $545 million for the second quarter of 2013.
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Risk Management and Shared Services had net income of $6 million in the second quarter of 2013, down $6 million compared to $12 million for the comparable quarter in 2012. Primary components of the decrease were $1 million higher credit provision and a $7 million increase in noninterest expense, largely due to higher unallocated occupancy costs for unused and vacant space as a result of retail branch closures. Average deposit balances were $2.2 billion for the second quarter of 2013, up $905 million from an average balance of $1.3 billion during the second quarter of 2012, primarily from funding loan growth. Average allocated capital increased $20 million to $559 million for the second quarter of 2013.
Results of Operations – Summary
The Corporation recorded net income of $95 million for the six months ended June 30, 2013, compared to net income of $86 million for the six months ended June 30, 2012. Net income available to common equity was $93 million for the six months ended June 30, 2013, or net income of $0.55 for both basic and diluted earnings per common share. Comparatively, net income available to common equity for the six months ended June 30, 2012, was $83 million, or net income of $0.48 for both basic and diluted earnings per common share. The net interest margin for the six months ended June 30, 2013 was 3.17% compared to 3.31% for the six months ended June 30, 2012.
TABLE 1
Summary Results of Operations: Trends
($ in Thousands, except per share data)
Net income (Quarter)
Net income (Year-to-date)
Net income available to common equity (Quarter)
Net income available to common equity (Year-to-date)
Earnings per common share – basic (Quarter)
Earnings per common share – basic (Year-to-date)
Earnings per common share – diluted (Quarter)
Earnings per common share – diluted (Year-to-date)
Return on average assets (Quarter)
Return on average assets (Year-to-date)
Return on average equity (Quarter)
Return on average equity (Year-to-date)
Return on average common equity (Quarter)
Return on average common equity (Year-to-date)
Return on average Tier 1 common equity (Quarter) (1)
Return on average Tier 1 common equity (Year-to-date) (1)
Efficiency ratio (Quarter) (2)
Efficiency ratio (Year-to-date)(2)
Efficiency ratio, fully taxable equivalent (Quarter)(2)
Efficiency ratio, fully taxable equivalent (Year-to-date) (2)
Net interest margin (Quarter)
Net interest margin (Year-to-date)
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TABLE 1A
Reconciliation of Non-GAAP Measure
Efficiency ratio (Quarter) (a)
Taxable equivalent adjustment (Quarter)
Asset gains (losses), net (Quarter)
Other intangible amortization (Quarter)
Efficiency ratio, fully taxable equivalent (Quarter) (b)
Efficiency ratio (Year-to-date)(a)
Taxable equivalent adjustment (Year-to-date)
Asset gains (losses), net (Year-to-date)
Other intangible amortization (Year-to-date)
Efficiency ratio, fully taxable equivalent (Year-to-date) (b)
Net Interest Income and Net Interest Margin
Net interest income on a taxable equivalent basis for the six months ended June 30, 2013, was $328 million, an increase of $8 million (3%) versus the first six months of 2012. The increase in taxable equivalent net interest income was attributable to favorable volume variances (as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $29 million), partially offset by unfavorable rate variances (as the impact of changes in the interest rate environment and product pricing reduced taxable equivalent net interest income by $21 million).
The net interest margin for the first half of 2013 was 3.17%, 14 bp lower than 3.31% for the same period in 2012. This comparable period decrease was comprised of a 9 bp decrease in interest rate spread (34 bp decrease in yield on earning assets offset by a decrease in the cost of interest-bearing liabilities of 25 bp) and a 5 bp lower contribution from net free funds.
The Federal Reserve left interest rates unchanged during 2012 and the first six months of 2013. For the remainder of 2013, the Corporation anticipates continued compression on the net interest margin.
The yield on earning assets was 3.49% for the first half of 2013, 34 bp lower than the comparable period last year. Loan yields were down 34 bp, (to 3.80%), due to the repricing of adjustable rate loans and competitive pricing pressures in a low interest rate environment. The yield on investment securities and other short-term investments decreased 33 bp (to 2.58%), and was also impacted by the low interest rate environment and prepayment speeds of mortgage-related securities purchased at a premium.
The rate on interest-bearing liabilities of 0.43% for the first half of 2013 was 25 bp lower than the same period in 2012. Rates on interest-bearing deposits were down 15 bp (to 0.25%, reflecting the low rate environment and a reduction of higher cost deposit products). The cost of short and long-term funding decreased 33 bp (to 1.21%), with the cost of long-term funding down 38 bp (due to the early redemption of higher costing junior subordinated debentures during 2012) while the cost of short-term funding decreased 14 bp.
Average earning assets were $20.8 billion for the first half of 2013, an increase of $1.4 billion (7%) from the comparable period last year. On average, loan balances increased $1.1 billion, including increases in commercial loans (up $1.2 billion) and residential mortgage loans (up $386 million), while retail loans decreased (down $473 million). Average investment securities and other short-term investments increased $306 million.
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Average interest-bearing liabilities of $15.9 billion for the first half of 2013 increased $933 million from the first half of 2012. On average, interest-bearing deposits grew $1.6 billion (primarily attributable to a $1.2 billion increase in money market accounts and a $714 million increase in interest-bearing demand deposits, partially offset by a $432 million decrease in time deposits), while noninterest-bearing demand deposits (a principal component of net free funds) were up $499 million. Average short and long-term funding decreased $667 million between the comparable six month periods, attributable to a $496 million decrease in securities sold under agreements to repurchase (“customer funding”) (driven by pricing strategies to shift funds away from customer funding and into more traditional deposit products) and a $213 million decrease in junior subordinated debentures.
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TABLE 2
Net Interest Income Analysis
($ in Thousands)
Earning assets:
Loans: (1)(2)(3)
Retail
Other short-term investments
Investments and other (1)
Total earning assets
Other assets, net
Interest-bearing liabilities:
Interest-bearing deposits:
Savings deposits
Interest-bearing demand deposits
Money market deposits
Time deposits
Total interest-bearing deposits
Total interest-bearing liabilities
Other liabilities
Total liabilities and equity
Interest rate spread
Net free funds
Net interest income, taxable equivalent, and net interest margin
Taxable equivalent adjustment
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Provision for Loan Losses
The provision for loan losses for the first half of 2013 was $8 million, compared to $0 for the first half of 2012 and $3 million for the full year of 2012. Net charge offs were $28 million for the first half of 2013, compared to $45 million for the first half of 2012 and $84 million for the full year of 2012. Annualized net charge offs as a percent of average loans for the first half of 2013 were 0.36%, compared to 0.63% for the first half of 2012 and 0.57% for the full year of 2012. At June 30, 2013, the allowance for loan losses was $277 million, down from $333 million at June 30, 2012 and $297 million at December 31, 2012. The ratio of the allowance for loan losses to total loans at June 30, 2013, was 1.76%, compared to 2.26% at June 30, 2012 and 1.93% at December 31, 2012. Nonaccrual loans at June 30, 2013 were $217 million, compared to $318 million at June 30, 2012, and $253 million at December 31, 2012. See Tables 7 and 8.
The provision for loan losses is predominantly a function of the Corporation’s reserving methodology and judgments as to other qualitative and quantitative factors used to determine the appropriate level of the allowance for loan losses which focuses on changes in the size and character of the loan portfolio, changes in levels of impaired and other nonaccrual loans, historical losses and delinquencies on each portfolio category, the level of loans sold or transferred to held for sale, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other factors which could affect potential credit losses. See additional discussion under sections “Allowance for Loan Losses,” and “Nonaccrual Loans, Potential Problem Loans, and Other Real Estate Owned.”
Noninterest Income
Noninterest income for the first half of 2013 was $166 million, up $12 million (8%) from the first half of 2012. For the remainder of 2013, the Corporation expects modest improvement in core fee-based revenues and lower mortgage banking revenues.
TABLE 3
Core fee-based revenue
Mortgage banking income
Mortgage servicing rights expense
Bank owned life insurance (“BOLI”) income
Subtotal
Investment securities gains, net
N/M – Not meaningful.
Trust service fees were $22 million for the first half of 2013, up $2 million (12%) from the comparable period in 2012. The market value of assets under management at June 30, 2013 and 2012 was $6.9 billion and $5.9 billion, respectively.
Service charges on deposit accounts were $34 million for the first half of 2013, down slightly, $1 million (2%) from the first half of 2012. The decrease was primarily attributable to lower nonsufficient funds / overdraft fees.
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Card-based and other nondeposit fees were $25 million for the first half of 2013, up $2 million (7%) from the first half of 2012, primarily attributable to higher commercial loan service charges due to year over year growth in commercial loan balances. Insurance commissions were $21 million, down $3 million (13%) from the first half of 2012, due to a $3 million reserve established in 2013 related to third party insurance products sold in prior years. Brokerage and annuity commissions were down $1 million (14%) for the comparable six month periods of 2013 and 2012, attributable to lower fixed and variable annuity commissions.
Net mortgage banking income was $37 million for the first half of 2013 and $34 million for the first half of 2012. Net mortgage banking consists of gross mortgage banking income less mortgage servicing rights expense. Gross mortgage banking income (which includes servicing fees and the gain or loss on sales of mortgage loans to the secondary market, related fees and fair value marks on derivatives (collectively “gains on sales and related income”)) was $33 million for the first half of 2013, a decrease of $15 million compared to the first half of 2012. This decrease was primarily attributable to lower gains on sales and related income (down $12 million) and a $4 million decrease due to the recognition of a repurchase reserve provision for losses related to repurchases and loss reimbursements on previously sold mortgage loans in the first half of 2013 versus none in the first half of 2012 (see Note 12, “Commitments, Off-Balance Sheet Arrangements and Contingent Liabilities” of the notes to consolidated financial statements for additional information concerning this repurchase reserve). Secondary mortgage production was $1.5 billion for the first half of 2013, compared to $1.3 billion for the first half of 2012.
Mortgage servicing rights expense includes both the amortization of the mortgage servicing rights asset and changes to the valuation allowance associated with the mortgage servicing rights asset. Mortgage servicing rights expense is affected by the size of the servicing portfolio, as well as the changes in the estimated fair value of the mortgage servicing rights asset. Mortgage servicing rights expense was $18 million lower than the comparable six month period in 2012, with a $15 million favorable change to the valuation reserve (comprised of a $13 million recovery to the valuation reserve for the first half of 2013 compared to a $2 million addition to the valuation reserve for the first half of 2012) and a $3 million reduction in amortization. As mortgage interest rates fall, prepayment speeds are usually faster and the value of the mortgage servicing rights asset generally decreases, requiring additional valuation reserve and higher amortization. Conversely, as mortgage interest rates rise, prepayment speeds are usually slower and the value of the mortgage servicing rights asset generally increases, requiring less valuation reserve and lower amortization. Mortgage servicing rights, net of any valuation allowance, are carried in other intangible assets, net, on the consolidated balance sheets at the lower of amortized cost or estimated fair value. At June 30, 2013, the mortgage servicing rights asset, net of its valuation allowance, was $61 million, representing 79 bp of the $7.8 billion servicing portfolio, compared to a net mortgage servicing rights asset of $47 million, representing 63 bp of the $7.5 billion servicing portfolio at June 30, 2012. Mortgage servicing rights are considered a critical accounting policy given that estimating their fair value involves a discounted cash flow model and assumptions that involve judgment, particularly of estimated prepayment speeds of the underlying mortgages serviced and the overall level of interest rates. See section “Critical Accounting Policies,” as well as Note 7 “Goodwill and Other Intangible Assets,” and Note 13, “Fair Value Measurements,” of the notes to consolidated financial statements for additional disclosure.
Capital market fees, net (which include fee income from foreign currency and interest rate risk related services provided to our customers) were $8 million for the first half of 2013, compared to $6 million for the first half of 2012 reflecting a $3 million favorable change in the credit risk of interest-rate related derivative instruments, partially offset by a $1 million decline in fees due to lower commercial lending volumes and related lower customer demand for interest rate swaps. Bank owned life insurance income was $6 million, down $1 million from the first half of 2012, primarily due to death benefits received during the first half of 2012, as well as the lower interest rates on the underlying assets of the BOLI investment. Other income was $5 million, an increase of $1 million versus the first half of 2012, primarily due to an increase in limited partnership income. Net asset gains of $1 million for the first half of 2013 were primarily attributable to the sale of miscellaneous assets, partially offset by losses on sales and other write-downs of other real estate owned. Net asset losses of $9 million for the first half of 2012 were primarily attributable to a $6 million write-down on software placed into production during the second quarter of 2012, $6 million of losses on sales and other write-downs on other real estate owned, and a $3 million impairment charge on certain limited partnership investments, partially offset by a $6 million gain on the sale of three retail branches in rural western Illinois.
Noninterest Expense
Noninterest expense was $337 million for the first half of 2013, up $1 million (less than 1%) from the comparable period in 2012. Personnel expense was up $9 million (5%), while nonpersonnel noninterest expenses were down $8 million (6%) on a combined basis. For the remainder of 2013, the Corporation expects flat year over year noninterest expense with reduced regulatory costs offset by continued investments in the franchise.
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TABLE 4
Personnel expense (which includes salary-related expenses and fringe benefit expenses) was $198 million for the first half of 2013, up $9 million (5%) versus the first half of 2012. Average full-time equivalent employees were 4,816 for the first six months of 2013, down 4% from 4,998 for the comparable six month period of 2012. Salary-related expenses increased $11 million (8%). This increase was primarily the result of higher compensation (up $5 million or 4%) and higher performance based incentives (up $4 million or 10%). Fringe benefit expenses were down $2 million (5%) versus the first half of 2012, primarily due to a decrease in health insurance costs.
Nonpersonnel noninterest expenses on a combined basis were $139 million, down $8 million (6%) compared to the first half of 2012. Occupancy, equipment and data processing were up $6 million (9%), due to strategic investments in our branch network, systems and infrastructure. Legal and professional fees for the first half of 2013 were $11 million, down $5 million (30%) from the comparable six month period in 2012 due to a decrease in consultant costs related to certain BSA compliance issues. Losses other than loans decreased $4 million from the first half of 2012 primarily due to a $4 million decrease in the provision for losses on unfunded commitments and a $2 million decrease in the provision for reinsurance losses, as well as the receipt of a $2.5 million settlement in 2012 with the Corporation’s insurance carrier towards the Overdraft litigation. Foreclosure / OREO expenses of $5 million decreased $3 million, primarily attributable to a decline in legal and collection expenses related to the improvement in credit quality. All remaining noninterest expense categories on a combined basis were down $2 million (4%) compared to the first half of 2012.
Income Taxes
Income tax expense recorded in the consolidated statements of income involves the interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Corporation undergoes examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. See Note 9, “Income Taxes,” of the notes to consolidated financial statements and section “Critical Accounting Policies.”
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Balance Sheet
At June 30, 2013, total assets were $23.6 billion, up $129 million from December 31, 2012. Loans of $15.7 billion at June 30, 2013 were up $336 million from December 31, 2012, with increases in commercial loans of $446 million and residential mortgage loans of $155 million, partially offset by a decrease of $233 million in home equity loans. See section “Credit Risk” for a detailed discussion of the changes in the loan portfolio and the related credit risk management for each loan type. Investment securities were $4.9 billion at June 30, 2013 down $36 million from year-end 2012.
At June 30, 2013, total deposits of $17.1 billion were up $193 million from December 31, 2012. Since December 31, 2012, money market deposits increased $522 million and interest- bearing demand deposits increased $248 million, while other time deposits were down $212 million. Noninterest-bearing demand deposits decreased $500 million to $4.3 billion and represented 25% of total deposits, down from 28% of total deposits at December 31, 2012. Short and long-term funding of $3.4 billion was up $37 million since year-end 2012, with an increase of $438 million in short-term funding offset by a decrease of $401 million in long-term funding.
Since June 30, 2012, loans increased $1.0 billion, with commercial loans up $1.1 billion and residential mortgage loans up $453 million, offset by a $443 million decline in home equity loans. Since June 30, 2012, deposits increased $2.0 billion, attributable to a $1.2 billion increase in money market deposits, a $724 million increase in interest bearing demand deposits, and a $385 million increase in noninterest-bearing demand deposits, partially offset by a $414 million decrease in other time deposits. Given the increase in deposit balances, short and long-term funding declined $425 million, including a $722 million decrease in customer funding and the repayment of $186 million of junior subordinated debentures, partially offset by a net increase of $250 million in FHLB advances and the issuance of $155 million of senior notes.
TABLE 5
Period End Loan Composition
Home equity revolving lines of credit
Home equity loans first liens
Home equity loans junior liens
Farmland
Multi-family
Non-owner occupied
1-4 family construction
All other construction
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Credit Risk
Total loans were $15.7 billion at June 30, 2013, an increase of $336 million or 2% from December 31, 2012. Commercial and business loans were $6.0 billion, up $197 million (3%) to represent 38% of total loans at June 30, 2013. Commercial real estate totaled $3.8 billion at June 30, 2013 and represented 24% of total loans, an increase of $249 million (7%) from December 31, 2012. Consumer loans were $6.0 billion, down $110 million (2%) from December 31, 2012, and represented 38% of total loans at June 30, 2013.
The Corporation has long-term guidelines relative to the proportion of Commercial and Business, Commercial Real Estate, and Consumer loans within the overall loan portfolio, with each targeted to represent 30-40% of the overall loan portfolio. The targeted long-term guidelines were unchanged during 2012 and the first half of 2013. Furthermore, certain sub-asset classes within the respective portfolios were further defined and dollar limitations were placed on these sub-portfolios. These guidelines and limits are reviewed quarterly and approved annually by the Enterprise Risk Committee of the Corporation’s Board of Directors. These guidelines and limits are designed to create balance and diversification within the loan portfolios.
The commercial and business lending portfolio, which consists of commercial and business loans and owner occupied commercial real estate loans, was $6.0 billion at June 30, 2013, up $197 million (3%) since year-end 2012. The commercial and business lending classification primarily includes commercial loans to middle market companies and small businesses. At June 30, 2013, the largest industry groups within the commercial and business loan category included the manufacturing sector which represented 8% of total loans and 20% of the total commercial and business loan portfolio. The next two largest industry groups within the commercial and business loan category included the finance and insurance sector, which represented 4% of total loans and 11% of the total commercial and business lending portfolio and the wholesale trade sector, which represented 4% of total loans and 10% of the total commercial and business loan portfolio at June 30, 2013. The remaining portfolio is spread over a diverse range of industries. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.
The commercial real estate lending portfolio, which consists of investor commercial real estate and construction loans, totaled $3.8 billion at June 30, 2013, up $249 million (7%) from December 31, 2012. Within the commercial real estate lending portfolio, commercial real estate lending to investors totaled $3.0 billion at June 30, 2013, an increase of $104 million (4%) from December 31, 2012. Commercial real estate primarily includes commercial-based loans to investors that are secured by commercial income properties or multifamily projects. Commercial real estate loans are typically intermediate to long-term financings. Loans of this type are mainly secured by commercial income properties or multifamily projects. Credit risk is managed in a similar manner to commercial and industrial loans and real estate construction by employing sound underwriting guidelines, lending primarily to borrowers in local markets and businesses, periodically evaluating the underlying collateral, and formally reviewing the borrower’s financial soundness and relationship on an ongoing basis. Real estate construction loans were $801 million, an increase of $145 million (22%) compared to December 31, 2012. Loans in this classification are primarily short-term or interim loans that provide financing for the acquisition or development of commercial income properties, multifamily projects or residential development, both single family and condominium. Real estate construction loans are made to developers and project managers who are generally well known to the Corporation, and have prior successful project experience. The credit risk associated with real estate construction loans is generally confined to specific geographic areas but is also influenced by general economic conditions. The Corporation controls the credit risk on these types of loans by making loans in familiar markets to developers, underwriting the loans to meet the requirements of institutional investors in the secondary market, reviewing the merits of individual projects, controlling loan structure, and monitoring project progress and construction advances.
The Corporation’s current lending standards for commercial real estate and real estate construction lending are determined by property type and specifically address many criteria, including: maximum loan amounts, maximum loan-to-value (“LTV”), requirements for pre-leasing and / or presales, minimum borrower equity, and maximum loan to cost. Currently, the maximum standard for LTV is 80%, with lower limits established for certain higher risk types, such as raw land which has a 50% LTV maximum. The Corporation’s LTV guidelines are in compliance with regulatory supervisory limits. In most cases, for real estate construction loans, the loan amounts include interest reserves, which are built into the loans and sized to fund loan payments through construction and lease up and / or sell out.
Consumer loans totaled $6.0 billion at June 30, 2013, down $110 million (2%) compared to December 31, 2012. Loans in this classification include residential mortgage, home equity and installment loans. Residential mortgage loans totaled $3.5 billion at June 30, 2013, up $155 million (5%) from December 31, 2012. Residential mortgage loans include conventional first lien home mortgages
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and the Corporation generally limits the maximum loan to 80% of collateral value without credit enhancement (e.g. PMI insurance). As part of management’s historical practice of originating and servicing residential mortgage loans, generally the Corporation’s 30-year, fixed-rate residential real estate mortgage loans are sold in the secondary market with servicing rights retained. The Corporation also retains a portion of its 15-year and under, fixed-rate residential real estate mortgages in its loan portfolio. At June 30, 2013, the residential mortgage portfolio was comprised of $1.3 billion of fixed-rate residential real estate mortgages and $2.2 billion of adjustable-rate residential real estate mortgages.
Home equity totaled $2.0 billion at June 30, 2013 down $233 million (11%) compared to December 31, 2012, and consists of home equity lines, as well as home equity loans, approximately half of which are first lien positions. Loans and lines in a junior position at June 30, 2013 included approximately 36% for which the Corporation also owned or serviced the related first lien loan and approximately 64% where the Corporation did not service the related first lien loan.
The Corporation’s credit risk monitoring guidelines for home equity is based on an ongoing review of loan delinquency status, as well as a semi-annual review of FICO score deterioration and property devaluation. The Corporation does not routinely obtain appraisals on performing loans to update LTV ratios after origination; however, the Corporation monitors the local housing markets by reviewing the various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring process. For second lien home equity loans, the Corporation is unable to track the performance of the first lien loan if it does not own or service the first lien loan. However, the Corporation obtains a refreshed FICO score on a semi-annual basis and monitors this as part of its assessment of the home equity portfolio.
The Corporation’s underwriting and risk-based pricing guidelines for home equity lines and loans consist of a combination of both borrower FICO and the original LTV of the property securing the loan. Currently, for home equity products, the maximum acceptable LTV is 90% for customers with FICO scores exceeding 760. Home equity loans generally have a 20 year term and are fixed rate with principal and interest payments required. As of June 30, 2013, approximately 40% of the home equity loan first liens have a remaining maturity of more than 10 years. Home equity lines are variable rate, interest only lines of credit which do not require the payment of principal during the initial revolving period, after which principal payments are required. Based upon outstanding balances at June 30, 2013, the following table presents the periods when home equity lines of credit revolving periods are scheduled to end.
Less than 1 year
1 - 3 years
3 - 5 years
5 - 10 years
Over 10 years
Total home equity revolving lines of credit
Installment loans totaled $434 million at June 30, 2013 down $32 million (7%) compared to December 31, 2012, and consist of educational loans, as well as short-term and other personal installment loans. The Corporation had $351 million and $374 million of education loans at June 30, 2013 and December 31, 2012, respectively, the majority of which are government guaranteed. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral. Risks of loss are generally on smaller average balances per loan spread over many borrowers. Once charged off, there is usually less opportunity for recovery on these smaller retail loans. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.
The Corporation’s underwriting and risk-based pricing guidelines for residential mortgage loans consist of a combination of both borrower FICO and the LTV of the property securing the loan. Residential mortgage products generally are underwritten using FHLMC and FNMA secondary marketing guidelines.
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An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. Credit risk is controlled by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers’ outstanding loans and commitments. Borrower relationships are formally reviewed and graded on an ongoing basis for early identification of potential problems. Further analyses by customer, industry, and geographic location are performed to monitor trends, financial performance, and concentrations.
The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas within our core footprint. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At June 30, 2013, no significant concentrations existed in the Corporation’s portfolio in excess of 10% of total loans.
TABLE 6
Period End Deposit and Customer Funding Composition
Noninterest-bearing demand
Savings
Interest-bearing demand
Money market
Brokered CDs
Other time
Customer repo sweeps
Customer repo term
Total customer funding
Total deposits and customer funding
Network transaction deposits included above in interest-bearing demand and money market
Total network transaction deposits and Brokered CDs
Total deposits and customer funding, excluding Brokered CDs and network transaction deposits
Allowance for Loan Losses
Credit risks within the loan portfolio are inherently different for each loan type. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and ongoing review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses. Credit risk management for each loan type is discussed briefly in the section entitled “Credit Risk.”
The level of the allowance for loan losses represents management’s estimate of an amount appropriate to provide for probable credit losses in the loan portfolio at the balance sheet date. In general, the change in the allowance for loan losses is a function of a number of factors, including but not limited to changes in the loan portfolio (see Table 5), net charge offs (see Table 7) and nonperforming assets (see Table 8). The Corporation’s process, designed to assess the appropriateness of the allowance for loan losses, includes an allocation methodology, as well as management’s ongoing review and grading of the loan portfolio into criticized and non-criticized
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categories. The allocation methodology focuses on evaluation of facts and issues related to specific loans, management’s ongoing review and grading of the loan portfolio, consideration of historical loan loss and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of potential problem loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Management considers the allowance for loan losses a critical accounting policy (see section “Critical Accounting Policies”), as assessing these numerous factors involves significant judgment.
The methodology used for the allocation of the allowance for loan losses at June 30, 2013 and December 31, 2012 was generally comparable, whereby the Corporation segregated its loss factors (used for both criticized and non-criticized loan categories) into a component primarily based on historical loss rates and a component primarily based on other qualitative factors that may affect loan collectability. Management allocates the allowance for loan losses by pools of risk within each loan portfolio. The allocation methodology consists of the following components: First, a valuation allowance estimate is established for specifically identified commercial and consumer loans determined by the Corporation to be impaired, using discounted cash flows, estimated fair value of underlying collateral, and / or other data available. Second, management allocates the allowance for loan losses with loss factors, for criticized loan pools by loan type as well as for non-criticized loan pools by loan type, primarily based on historical loss rates after considering loan type, historical loss and delinquency experience, and industry statistics. Loans that have been criticized are considered to have a higher risk of default than non-criticized loans, as circumstances were present to support the lower loan grade, warranting higher loss factors. The loss factors applied in the methodology are periodically re-evaluated and adjusted to reflect changes in historical loss levels or other risks. Lastly, management allocates the allowance for loan losses to absorb unrecognized losses that may not be provided for by the other components due to other factors evaluated by management, such as limitations within the credit risk grading process, known current economic or business conditions that may not yet show in trends, industry or other concentrations with current issues that impose higher inherent risks than are reflected in the loss factors, and other relevant considerations. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular category. The total allowance for loan losses is available to absorb losses from any segment of the loan portfolio.
At June 30, 2013, the allowance for loan losses was $277 million compared to $333 million at June 30, 2012, and $297 million at December 31, 2012. At June 30, 2013, the allowance for loan losses to total loans was 1.76% and covered 127% of nonaccrual loans, compared to 2.26% and 105%, respectively, at June 30, 2012, and 1.93% and 118%, respectively, at December 31, 2012. The provision for loan losses for the first half of 2013 was $8 million, compared to $0 for the first half of 2012, and $3 million for the full year 2012. Net charge offs were $28 million for the first half of 2013, $45 million for the comparable period ended June 30, 2012, and $84 million for the full year 2012. The ratio of net charge offs to average loans on an annualized basis was 0.36%, 0.63%, and 0.57% for the six months ended June 30, 2013, and 2012, and the full year 2012, respectively. Tables 7 and 8 provide additional information regarding activity in the allowance for loan losses, impaired loans, and nonperforming assets. See Note 6, “Loans, Allowance for Loan Losses, and Credit Quality,” of the notes to consolidated financial statements for additional allowance for loan losses disclosures.
Credit quality continued to improve during the first half of 2013. Nonaccrual loans declined to $217 million (representing 1.38% of total loans), down 32% from June 30, 2012 and down 14% from December 31, 2012, due to portfolio improvements, including a lower level of loans moving into the nonaccrual and potential problem loan categories. Loans past due 30-89 days totaled $59 million at June 30, 2013, an increase of 24% from June 30, 2012 and a decrease of 7% from December 31, 2012, while potential problem loans declined to $310 million, a reduction from both the first half of 2012 and year-end 2012. For the remainder of 2013, the Corporation expects modest improvement in credit trends and the provision for loan losses to increase based on quarterly loan growth.
Management believes the level of allowance for loan losses to be appropriate at June 30, 2013 and December 31, 2012.
Consolidated net income and stockholders’ equity could be affected if management’s estimate of the allowance for loan losses is subsequently materially different, requiring additional or less provision for loan losses to be recorded. Management carefully considers numerous detailed and general factors, its assumptions, and the likelihood of materially different conditions that could alter its assumptions. While management uses currently available information to recognize losses on loans, future adjustments to the allowance for loan losses may be necessary based on newly received appraisals, updated commercial customer financial statements, rapidly deteriorating customer cash flow, and changes in economic conditions that affect our customers. Additionally, larger credit relationships do not inherently create more risk, but can create wider fluctuations in net charge offs and credit quality. As an integral part of their examination process, various federal and state regulatory agencies also review the allowance for loan losses. These agencies may require additions to the allowance for loan losses or may require that certain loan balances be charged off or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination.
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TABLE 7
Allowance for Loan Losses:
Net loan charge offs:
Home equity loans 1st liens
Total net charge offs
CRE & Construction Net Charge Off Detail:
(A) – Annualized ratio of net charge offs to average loans by loan type in basis points.
N/M - Not meaningful.
Ratios:
Allowance for loan losses to total loans
Allowance for loan losses to net charge offs (annualized)
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TABLE 7 (continued)
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TABLE 8
Nonperforming Assets
Nonperforming assets:
Nonaccrual loans:
Commercial
Total nonaccrual loans (NALs)
Other real estate owned (OREO)
Total nonperforming assets (NPAs)
Accruing loans past due 90 days or more:
Total accruing loans past due 90 days or more
Restructured loans (accruing):
Total restructured loans (accruing)
Nonaccrual restructured loans (included in nonaccrual loans)
Nonaccrual loans to total loans
NPAs to total loans plus OREO
NPAs to total assets
Allowance for loan losses to NALs
Nonperforming assets by type:
Commercial real estate owned
Residential real estate owned
Bank properties real estate owned
Other real estate owned
Total nonperforming assets
Commercial real estate & Real estate construction NALs Detail:
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TABLE 8 (continued)
Loans 30-89 days past due by type:
Total loans past due 30-89 days
Commercial real estate & Real estate construction loans 30-89 days past due detail:
Potential problem loans by type:
Total potential problem loans
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Nonaccrual Loans, Potential Problem Loans, and Other Real Estate Owned
Management is committed to a proactive nonaccrual and problem loan identification philosophy. This philosophy is implemented through the ongoing monitoring and review of all pools of risk in the loan portfolio to ensure that problem loans are identified quickly and the risk of loss is minimized. Table 8 provides detailed information regarding nonperforming assets, which include nonaccrual loans and other real estate owned.
Nonaccrual Loans: Nonaccrual loans are considered one indicator of potential future loan losses. Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments, unless the loan is well secured and in the process of collection. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, amortization of related deferred loan fees or costs is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash and a determination has been made that the principal balance of the loan is collectible. If collectability of the principal and interest is in doubt, payments received are applied to loan principal.
Nonaccrual loans were $217 million at June 30, 2013, compared to $318 million at June 30, 2012 and $253 million at December 31, 2012. As shown in Table 8, total nonaccrual loans were down $100 million (32%) since June 30, 2012, with commercial nonaccrual loans down $76 million while consumer-related nonaccrual loans were down $24 million. Since December 31, 2012, total nonaccrual loans decreased $35 million (14%), with commercial nonaccrual loans down $16 million and consumer nonaccrual loans down $19 million. The ratio of nonaccrual loans to total loans was 1.38% at June 30, 2013, compared to 2.16% at June 30, 2012 and 1.64% at December 31, 2012. The Corporation’s allowance for loan losses to nonaccrual loans was 127% at June 30, 2013, up from 105% at June 30, 2012 and 118% at December 31, 2012, respectively.
Accruing Loans Past Due 90 Days or More: Loans past due 90 days or more but still accruing interest are classified as such where the underlying loans are both well secured (the collateral value is sufficient to cover principal and accrued interest) and are in the process of collection. At June 30, 2013, accruing loans 90 days or more past due totaled $2 million compared to $5 million at June 30, 2012 and $2 million at December 31, 2012, respectively.
Troubled Debt Restructurings (“Restructured Loans”): Loans are considered restructured loans if concessions have been granted to borrowers that are experiencing financial difficulty. The concessions granted generally involve the modification of terms of the loan, such as changes in payment structure or interest rate, which generally would not otherwise be considered. Restructured loans can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accrual status, depending on the individual facts and circumstances of the borrower. Nonaccrual restructured loans are included and treated with all other nonaccrual loans. In addition, all accruing restructured loans are reported as troubled debt restructurings, which are considered and accounted for as impaired loans. Generally, restructured loans remain on nonaccrual until the customer has attained a sustained period of repayment performance under the modified loan terms (generally a minimum of six months). However, performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and whether the loan should be returned to or maintained on accrual status. If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains on nonaccrual status.
At June 30, 2013, the Corporation had total restructured loans of $189 million (including $70 million classified as nonaccrual and $119 million performing in accordance with the modified terms), compared to $209 million at June 30, 2012 (including $87 million classified as nonaccrual and $122 million performing in accordance with the modified terms) and $202 million at December 31, 2012 (including $81 million classified as nonaccrual and $121 million performing in accordance with the modified terms).
Potential Problem Loans: The level of potential problem loans is another predominant factor in determining the relative level of risk in the loan portfolio and in determining the appropriate level of the allowance for loan losses. Potential problem loans are generally defined by management to include loans rated as substandard by management but that are not considered impaired (i.e., nonaccrual loans and accruing troubled debt restructurings); however, there are circumstances present to create doubt as to the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that the Corporation expects losses to occur, but that management recognizes a higher degree of risk associated with these loans. The loans that have been reported as potential problem loans are predominantly commercial loans covering a diverse range of businesses and real estate property types. At June 30, 2013, potential problem loans totaled $310 million, compared to $410 million at June 30, 2012 and $361 million at December 31, 2012, respectively.
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Other Real Estate Owned: Other real estate owned was $27 million at June 30, 2013, compared to $40 million at June 30, 2012 and $35 million at December 31, 2012, respectively. Write-downs on other real estate owned were $2 million and $5 million for the first half of 2013 and 2012, respectively, and $8 million for the full year 2012. Management actively seeks to ensure properties held are monitored to minimize the Corporation’s risk of loss.
Liquidity
The objective of liquidity management is to ensure that the Corporation has the ability to generate sufficient cash or cash equivalents in a timely and cost-effective manner to satisfy the cash flow requirements of depositors and borrowers and to meet its other commitments as they fall due, including the ability to pay dividends to shareholders, service debt, invest in subsidiaries or acquisitions, and satisfy other operating requirements. In addition to satisfying cash flow requirements in the ordinary course of business, the Corporation actively monitors and manages its liquidity position to ensure sufficient resources are available to meet cash flow requirements in adverse situations.
The Corporation’s internal liquidity management framework includes measurement of several key elements, such as deposit funding as a percent of total assets and liquid asset levels. Strong capital ratios, credit quality, and core earnings are essential to maintaining cost-effective access to wholesale funding markets. A downgrade or loss in credit ratings could have an impact on the Corporation’s ability to access wholesale funding at favorable interest rates. In addition to static liquidity measures, the Corporation performs dynamic scenario analysis in accordance with industry best practices. Measures have been established to ensure the Corporation has sufficient high quality short-term liquidity to meet cash flow requirements under stressed scenarios. At June 30, 2013 the Corporation was in compliance with its internal liquidity objectives.
While core deposits and loan and investment securities repayments are principal sources of liquidity, funding diversification is another key element of liquidity management. Diversity is achieved by strategically varying depositor type, term, funding market, and instrument. The Parent Company and its subsidiary bank are rated by Moody’s, Standard and Poor’s (“S&P”), Fitch Investors (“Fitch”), and Dominion Bond Rating Service (“DBRS”). Credit ratings by these nationally recognized statistical rating agencies are an important component of the Corporation’s liquidity profile. Credit ratings relate to the Corporation’s ability to issue debt securities and the cost to borrow money, and should not be viewed as an indication of future stock performance or a recommendation to buy, sell, or hold securities. Among other factors, the credit ratings are based on financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core deposits, and the Corporation’s ability to access a broad array of wholesale funding sources. Adverse changes in these factors could result in a negative change in credit ratings and impact not only the ability to raise funds in the capital markets but also the cost of these funds. Ratings are subject to revision or withdrawal at any time and each rating should be evaluated independently. The senior credit ratings of the Parent Company and its subsidiary bank are displayed below.
Bank short-term
Bank long-term
Corporation short-term
Corporation long-term
Outlook
The Corporation also has multiple funding sources that could be used to increase liquidity and provide additional financial flexibility. The Parent Company filed a “shelf” registration in January 2012, under which the Parent Company may offer any combination of the following securities, either separately or in units: debt securities, preferred stock, depositary shares, common stock, and warrants. In September 2012, the Corporation issued $155 million of senior notes due in March 2014 which bear a 1.875% fixed coupon. The Parent Company also has a $200 million commercial paper program, of which, $69 million was outstanding at June 30, 2013.
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While dividends and service fees from subsidiaries and proceeds from issuance of capital are primary funding sources for the Parent Company, these sources could be limited or costly (such as by regulation or subject to the capital needs of its subsidiaries or by market appetite for bank holding company stock). The Parent Company received dividends of $246 million during the first half of 2013 from subsidiaries.
The Bank has established federal funds lines with counterparty banks and the ability to borrow from the Federal Home Loan Bank ($2.2 billion of Federal Home Loan Bank advances were outstanding at June 30, 2013). The Bank also has significant excess loan and investment securities collateral which could be pledged to secure additional deposits or to counterparty banks, the Federal Home Loan Bank or other parties as necessary. Associated Bank may also issue institutional certificates of deposit, network transaction deposits, and brokered certificates of deposit.
Investment securities are an important tool to the Corporation’s liquidity objective. As of June 30, 2013, the majority of investment securities are classified as available for sale, with a very small portion of municipal securities (approximately 2% of the total investment securities portfolio) classified as held to maturity. Of the $4.9 billion investment securities portfolio at June 30, 2013, a portion of these securities were pledged to secure $2.1 billion of collateralized deposits and $490 million of repurchase agreements and for other purposes as required or permitted by law. The majority of the remaining investment securities of $2.0 billion could be pledged or sold to enhance liquidity, if necessary.
For the six months ended June 30, 2013, net cash provided by operating activities and financing activities was $193 million and $137 million, respectively, while net cash used in investing activities was $513 million, for a net decrease in cash and cash equivalents of $183 million since year-end 2012. During the first half of 2013, loans increased $336 million and investment securities decreased $36 million. On the funding side, deposits increased $193 million and short-term funding increased $438 million, while long-term funding decreased $401 million.
For the six months ended June 30, 2012, net cash provided by operating and financing activities was $236 million and $84 million, respectively, while net cash used in investing activities was $338 million, for a net decrease in cash and cash equivalents of $18 million since year-end 2011. During the first half of 2012, loans increased $668 million and investment securities decreased $416 million, as run-off from the investment securities portfolio was utilized to fund loan growth. On the funding side, short-term funding decreased $139 million while deposits and long-term funding were relatively unchanged.
Quantitative and Qualitative Disclosures about Market Risk
Market risk and interest rate risk are managed centrally. Market risk is the potential for loss arising from adverse changes in the fair value of fixed income securities, equity securities, other earning assets and derivative financial instruments as a result of changes in interest rates or other factors. Interest rate risk is the potential for reduced net interest income resulting from adverse changes in the level of interest rates. As a financial institution that engages in transactions involving an array of financial products, the Corporation is exposed to both market risk and interest rate risk. In addition to market risk, interest rate risk is measured and managed through a number of methods. The Corporation uses financial modeling simulation techniques that measure the sensitivity of future earnings due to changing rate environments to measure interest rate risk.
Policies established by the Corporation’s Asset / Liability Committee (“ALCO”) and approved by the Board of Directors are intended to limit these risks. The Board has delegated day-to-day responsibility for managing market and interest rate risk to ALCO. The primary objectives of market risk management is to minimize any adverse effect that changes in market risk factors may have on net interest income and to offset the risk of price changes for certain assets recorded at fair value.
Interest Rate Risk
In order to measure earnings sensitivity to changing market interest rates, the Corporation uses a simulation model to measure the impact of various interest rate shocks and other yield curve scenarios on earnings and the fair value of the financial assets and liabilities of the Corporation. The Corporation compares earnings between a static balance sheet scenario and balance sheets with projected growth scenarios to quantify potential impacts on such earnings of various balance sheet management and business strategies.
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Simulation of earnings: Determining the sensitivity of short-term future earnings is accomplished through the use of simulation modeling. Assumptions involving projected balance sheet growth, market spreads, prepayments of rate-sensitive instruments, and the cash flows from maturing assets and liabilities are incorporated in these simulation analyses. These analyses are designed to project net interest income based on various interest rate scenarios, compared to a baseline scenario. The Corporation runs numerous scenarios including instantaneous and gradual changes to market interest rates as well as yield curve slope changes. It then compares such scenarios to the baseline scenario to quantify its earnings sensitivity.
The resulting simulations for June 30, 2013, and December 31, 2012 projected that net interest income would increase by approximately 1.2% and 3.4%, respectively, if rates rose by a 100 bp shock. As of June 30, 2013, the simulations of earnings results were within the Corporation’s interest rate risk policy.
Market value of equity: The Corporation uses the market value of equity as a measure to quantify market risk from the impact of interest rates. The market value of equity is the fair value of assets, liabilities, and off-balance sheet financial instruments derived from the present value of the future cash flows. While the net interest income simulation model highlights exposures over a short time horizon, the market value of equity incorporates all cash flows over all of the balance sheet and derivative positions.
These results are based on multiple path simulations using an interest rate simulation model calibrated to market traded instruments. Sensitivities are measured assuming several factors including immediate and sustained parallel and non-parallel changes in market rates, yield curves and rate indexes. These factors quantify yield curve risk, basis risk, options risk, repricing mismatch risk, and market spread risk. The results are considered to be conservative estimates due to the fact that no management action to mitigate potential income variances is included within the simulation assumption set. These potentially mitigating factors include future balance sheet growth, changes in yield curve relationships, and changing product spreads. As of June 30, 2013, the projected changes for the market value of equity were within the Corporation’s interest rate risk policy.
Contractual Obligations, Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities
The Corporation utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers and to manage its own exposure to fluctuations in interest rates. These financial instruments include lending-related commitments and derivative instruments. A discussion of the Corporation’s derivative instruments at June 30, 2013, is included in Note 10, “Derivative and Hedging Activities,” of the notes to consolidated financial statements. A discussion of the Corporation’s lending-related commitments is included in Note 12, “Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities,” of the notes to consolidated financial statements. See also Note 8, “Short and Long-Term Funding,” of the notes to consolidated financial statements for additional information on the Corporation’s short-term and long-term funding.
Table 9 summarizes significant contractual obligations and other commitments at June 30, 2013, at those amounts contractually due to the recipient, including any premiums or discounts, hedge basis adjustments, or other similar carrying value adjustments.
TABLE 9: Contractual Obligations and Other Commitments
Operating leases
Commitments to extend credit
Capital
Stockholders’ equity at June 30, 2013 was $2.9 billion, down slightly ($59 million) from December 31, 2012. At June 30, 2013, stockholders’ equity included $25 million of accumulated other comprehensive loss compared to $49 million of accumulated other comprehensive income at December 31, 2012. Cash dividends of $0.16 per share were paid in the first half of 2013 and $0.10 per share were paid in the first half of 2012. The ratio of total stockholders’ equity to assets was 12.18% and 12.50% at June 30, 2013 and December 31, 2012, respectively.
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On November 13, 2012, the Board of Directors approved the repurchase of up to an aggregate amount of $125 million of common stock to be made available for reissuance in connection with the Corporation’s employee incentive plans and / or for other corporate purposes, of which $35 million remained authorized for repurchase at June 30, 2013. On July 23, 2013, the Board of Directors approved the repurchase of up $120 million of common stock. The July 2013 repurchase authorization is in addition to the $35 million remaining under the November 2012 authorization. See Section, “Recent Developments,” for additional information on the July 2013 common stock repurchase authorization. During the first half of 2013, 4.1 million shares were repurchased for $60 million (or an average cost per common share of $14.69), while during 2012, 4.7 million shares were repurchased for $60 million (or an average cost per common share of $12.77). The Corporation also repurchased shares for minimum tax withholding settlements on equity compensation during 2012 and the first half of 2013. See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds,” for additional information on the shares repurchased during the second quarter of 2013. The repurchase of shares will be based on market and investment opportunities, capital levels, growth prospects, and regulatory constraints. Such repurchases may occur from time to time in open market purchases, block transactions, private transactions, accelerated share repurchase programs, or similar facilities.
Basel III Capital Rules. In July 2013, the Federal Reserve and the OCC, the primary federal regulators for the Corporation and the Bank, respectively, published final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Corporation and the Bank, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach, which was derived from Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee’s 2004 “Basel II” capital accords. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. The Basel III Capital Rules are effective for the Corporation and the Bank on January 1, 2015 (subject to a phase-in period).
The Basel III Capital Rules, among other things, (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consist of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions / adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions / adjustments from capital as compared to existing regulations.
When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Corporation and the Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk).
Management believes that, as of June 30, 2013, the Corporation and the Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis if such requirements were currently effective.
Management actively reviews capital strategies for the Corporation and each of its subsidiaries in light of perceived business risks, future growth opportunities, industry standards, and compliance with regulatory requirements. The assessment of overall capital adequacy depends on a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic condition in markets served, and strength of management. The capital ratios of the Corporation and its banking affiliate were in excess of regulatory minimum requirements. The Corporation’s capital ratios are summarized in Table 10.
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TABLE 10
Capital Ratios
(In Thousands, except per share data)
Tangible stockholders’ equity(1)
Tier 1 capital(2)
Tier 1 common equity(3)
Tangible common equity(1)
Total risk-based capital(2)
Tangible assets(1)
Risk weighted assets(2)
Market capitalization
Book value per common share
Tangible book value per common share
Cash dividend per common share
Stock price at end of period
Low closing price for the period
High closing price for the period
Total stockholders’ equity / assets
Tangible common equity / tangible assets (1)
Tangible stockholders’ equity / tangible assets (1)
Tier 1 common equity / risk-weighted assets (3)
Tier 1 leverage ratio(2)
Tier 1 risk-based capital ratio(2)
Total risk-based capital ratio(2)
Common shares outstanding (period end)
Basic common shares outstanding (average)
Diluted common shares outstanding (average)
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Comparable Second Quarter Results
The Corporation recorded net income of $48 million for the three months ended June 30, 2013, compared to net income of $43 million for the three months ended June 30, 2012. Net income available to common equity was $47 million for the three months ended June 30, 2013, or net income of $0.28 for both basic and diluted earnings per common share. Comparatively, net income available to common equity for the three months ended June 30, 2012, was $42 million, or net income of $0.24 for both basic and diluted earnings per common share (see Table 1).
Taxable equivalent net interest income for the second quarter of 2013 was $165 million, $6 million higher than the second quarter of 2012 (see Table 2). Changes in the balance sheet volume and mix increased taxable equivalent net interest income by $15 million, while changes in the rate environment and product pricing lowered net interest income by $9 million. The Federal funds target rate was unchanged for both the second quarter of 2013 and the second quarter of 2012. The net interest margin between the comparable quarters was down 14 bp, to 3.16% in the second quarter of 2013. Average earning assets increased $1.6 billion to $21.0 billion in the second quarter of 2013, with average loans up $1.1 billion (predominantly in commercial loans) and investments up $440 million. On the funding side, average interest-bearing deposits were up $1.6 billion and average demand deposits increased $497 million, while average short and long-term funding was down $492 million (primarily attributable to a $454 million decrease in repurchase agreements).
Credit quality continued to improve with nonaccrual loans declining to $217 million (1.38% of total loans) at June 30, 2013, compared to $318 million (2.16% of total loans) at June 30, 2012 (see Table 8). Compared to the second quarter of 2012, potential problem loans were down 24% to $310 million. The provision for loan losses for the second quarter of 2013 was $4 million (or $10 million less than net charge offs), compared to $0 (or $24 million less than net charge offs) in the second quarter of 2012 (see Table 7). Annualized net charge offs represented 0.35% of average loans for the second quarter of 2013 compared to 0.65% for the second quarter of 2012. The allowance for loan losses to loans at June 30, 2013 was 1.76%, compared to 2.26% at June 30, 2012. See discussion under sections, “Provision for Loan Losses,” “Allowance for Loan Losses,” and “Nonaccrual Loans, Potential Problem Loans, and Other Real Estate Owned.”
Noninterest income for the second quarter of 2013 increased $8 million (11%) to $84 million versus the second quarter of 2012. Core fee-based revenue was down $1 million (2%) from the second quarter of 2012 as improvements in most fee categories were more than offset by a $3 million decline in insurance commissions due to a $3 million reserve established in the second quarter of 2013 related to third party insurance products sold in prior years. Net mortgage banking increased $3 million from the second quarter of 2012, predominantly due to a $12 million favorable change in the valuation allowance (from an addition of $4 million in the second quarter of 2012 to a recovery of $8 million in second quarter of 2013), partially offset by $11 million lower gains on sales. Capital market fees, net increased $2 million primarily due to a favorable change in the credit risk of interest related derivative instruments. Net asset losses for the second quarter of 2013 were primarily attributable to a $2 million write-down on real estate as the Corporation continues to identify cost efficiency opportunities within its footprint, partially offset by gains from the sale of miscellaneous assets. Net asset losses of $5 million for the second quarter of 2012 were primarily attributable to a $6 million write-down on software placed into production during the second quarter of 2012, $3 million of losses on sales and other write-downs on other real estate owned, and a $3 million impairment charge on certain limited partnership investments, partially offset by a $6 million gain on the sale of three retail branches in rural western Illinois.
On a comparable quarter basis, noninterest expense increased $4 million (2%) to $170 million in the second quarter of 2013. Personnel expense increased $6 million (6%) from the second quarter of 2012, primarily in salary-related expenses (reflecting an increase in performance based incentives and merit increases between the years). Equipment and data processing combined were up $2 million (12%) from the second quarter of 2012, primarily attributable to strategic investments in our branch network, systems and infrastructure. During the second quarter of 2013 foreclosure / OREO expense decreased $2 million, due to a decline in legal and collection expenses related to the overall improvement in credit quality. All remaining noninterest expense categories on a combined basis were down $2 million (4%).
For the second quarter of 2013, the Corporation recognized income tax expense of $23 million, compared to income tax expense of $21 million for the second quarter of 2012. The effective tax rate was 32.07% and 32.52% for the second quarter of 2013 and the second quarter of 2012, respectively.
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TABLE 11
Selected Quarterly Information
Summary of Operations:
Total core fee-based revenue
BOLI income
Other intangible amortization
Taxable equivalent net interest income
Net interest margin
Effective tax rate
Average Balances:
Assets
Earning assets
Interest-bearing liabilities
Deposits
Short and long-term funding
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Sequential Quarter Results
The Corporation recorded net income of $48 million for the three months ended June 30, 2013, compared to net income of $47 million for the three months ended March 31, 2013. Net income available to common equity was $47 million for the second quarter of 2013, or net income of $0.28 for both basic and diluted earnings per common share. Comparatively, net income available to common equity for the first quarter of 2013, was $46 million, or net income of $0.27 for both basic and diluted earnings per common share (see Table 1).
Taxable equivalent net interest income for the second quarter of 2013 was $165 million, $2 million higher than the first quarter of 2013. Changes in the balance sheet volume and mix increased the taxable equivalent net interest income by $1 million and one extra day in the second quarter increased net interest income by $1 million, while changes in the rate environment and product pricing were relatively level. The Federal funds target rate was unchanged for both quarters. The net interest margin between the sequential quarters was down 1 bp, to 3.16% in the second quarter of 2013. Average earning assets increased $270 million to $21.0 billion in the second quarter of 2013, with average loans up $280 million (predominantly in commercial loans) and average investments and other short-term investments down $10 million. On the funding side, average short and long-term funding was up $316 million and average interest-bearing deposits were down $47 million (primarily money market and time deposits).
The Corporation reported another quarter of improving credit quality with nonaccrual loans of $217 million (1.38% of total loans) at June 30, 2013, down from $225 million (1.45% of total loans) at March 31, 2013 (see Table 8). Potential problem loans declined to $310 million, down $34 million from the first quarter of 2013. Annualized net charge offs represented 0.35% of average loans for the second quarter of 2013, compared to 0.38% for the first quarter of 2013. The allowance for loan losses to loans at June 30, 2013 was 1.76%, compared to 1.84% at March 31, 2013 (see Table 7). See discussion under sections, “Provision for Loan Losses,” “Allowance for Loan Losses,” and “Nonaccrual Loans, Potential Problem Loans, and Other Real Estate Owned.”
Noninterest income for the second quarter of 2013 increased $2 million (3%) to $84 million versus the first quarter of 2013. Core fee-based revenue was flat to the prior quarter as improvements in trust service fees, service charges on deposits accounts, card-based and other nondeposit fees, and brokerage and annuity commissions were offset by a decline in insurance commissions due to a $3 million reserve established in the second quarter of 2013 related to third party insurance products sold in prior years. Net mortgage banking income was $19 million, up from net mortgage banking income of $18 million in the first quarter 2013, predominantly due to a $3 million favorable change in the valuation allowance (from a recovery of $5 million in the first quarter of 2013 to an $8 million recovery in the second quarter of 2013), partially offset by $2 million lower gains on sales. Net capital market fees increased $2 million primarily due to a favorable change in the credit risk of interest related derivative instruments. The $1 million decline in asset gains / losses, net was primarily related to a $2 million real estate write-down during the second quarter of 2013 as the Corporation continues to identify cost efficiency opportunities within its footprint.
On a sequential quarter basis, noninterest expense increased by $3 million (2%) to $170 million in the second quarter of 2013. Personnel expense increased $2 million. Salary-related expenses increased $5 million, reflecting an increase in performance based incentives and severance payments, while fringe benefit expenses were down $3 million, reflecting a decrease in unemployment taxes and lower health insurance costs. Losses other than loans were up $2 million, primarily due to an increase in the provision for losses on unfunded commitments. All remaining noninterest expense categories on a combined basis were down $1 million (1%).
For the second quarter of 2013, the Corporation recognized income tax expense of $23 million, compared to income tax expense of $21 million for the first quarter of 2013. The effective tax rate was 32.07% and 31.06% for the second quarter of 2013 and the first quarter of 2013, respectively.
Future Accounting Pronouncements
New accounting policies adopted by the Corporation are discussed in Note 2, “New Accounting Pronouncements Adopted,” of the notes to consolidated financial statements. The expected impact of accounting pronouncements recently issued or proposed but not yet required to be adopted are discussed below. To the extent the adoption of new accounting standards materially affects the Corporation’s financial condition, results of operations, or liquidity, the impacts are discussed in the applicable sections of this financial review and the notes to the consolidated financial statements.
In July 2013, the FASB issued an amendment to permit an entity to designate the Fed Funds Effective Swap Rate, also referred to as the overnight index swap rate (“OIS”), as a benchmark interest rate. The OIS will be included as a U.S. benchmark interest rate for hedge accounting purposes. Prior to this amendment, only interest rates on direct treasury obligations of the U.S. government and the London Interbank Offered Rate (“LIBOR”) swap rate were considered benchmark interest rates. In addition, the amendment removes the restriction on using different benchmark rates for similar hedges. This amendment is effective immediately, and can be applied on a prospective basis for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013.
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Recent Developments
On July 23, 2013, the Board of Directors declared a regular quarterly cash dividend of $0.08 per common share, payable on September 16, 2013, to shareholders of record at the close of business on September 3, 2013. The Board of Directors also declared a regular quarterly cash dividend of $0.50 per depositary share on Associated Banc-Corp’s 8.00% Series B Perpetual Preferred Stock, payable on September 16, 2013, to shareholders of record at the close of business on September 3, 2013. These cash dividends have not been reflected in the accompanying consolidated financial statements.
The Board of Directors also authorized the repurchase of up to $120 million of Associated Banc-Corp common stock. This repurchase authorization is in addition to the $35 million remaining under the previously authorized common stock repurchase program announced on November 13, 2012. Repurchases under such programs are subject to regulatory approval and may occur from time to time in open market purchases, block transactions, private transactions, accelerated share repurchase programs or similar facilities.
The Board of Directors also authorized the following, subject to regulatory approval where applicable:
the redemption of all of Associated Banc-Corp’s 9.25% Subordinated Notes due 2018 at the first redemption date; and
the purchase of up to $10 million of Associated Banc-Corp’s 8.0% Perpetual Preferred Stock, Series B.
On August 1, 2013, the Bank’s settlement agreement relating to In re: Checking Account Overdraft Litigation MDL No. 2036 in the United States District Court for the Southern District of Florida received final approval from the court. See Item 1. Legal Proceedings.
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
Information required by this item is set forth in Item 2 under the captions “Quantitative and Qualitative Disclosures about Market Risk” and “Interest Rate Risk.”
ITEM 4. Controls and Procedures
The Corporation maintains disclosure controls and procedures as required under Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Corporation’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As of June 30, 2013, the Corporation’s management carried out an evaluation, under the supervision and with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures. Based on the foregoing, its Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of June 30, 2013. No changes were made to the Corporation’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act of 1934) during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
PART II – OTHER INFORMATION
ITEM 1. Legal Proceedings
The following is a description of the Corporation’s material pending legal proceedings.
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A lawsuit, R.J. ZAYED v. Associated Bank, N.A., was filed in the United States District Court for the District of Minnesota on January 29, 2013. The lawsuit relates to a Ponzi scheme perpetrated by Oxford Global Partners and related entities (“Oxford”) and individuals and was brought by the receiver for Oxford. Oxford was a depository customer of the Bank. The lawsuit claims that the Bank is liable for failing to uncover the Oxford Ponzi scheme, and specifically alleges the Bank aided and abetted (1) the fraudulent scheme; (2) a breach of fiduciary duty; (3) conversion; and (4) false representations and omissions. The lawsuit seeks unspecified consequential and punitive damages. At this early stage of the lawsuit, it is not possible for management to assess the probability of a material adverse outcome or reasonably estimate the amount of any potential loss at this time. The Bank intends to vigorously defend this lawsuit. A lawsuit by investors in the same Ponzi scheme, Herman Grad, et al v. Associated Bank, N.A., brought in Brown County, Wisconsin in October 2009 was dismissed by the circuit court, and the dismissal was affirmed by the Wisconsin Court of Appeals in June 2011 in an unpublished opinion.
The Bank is currently subject to a Consent Order with the OCC relating to its BSA compliance. The OCC has issued a written notice to the Bank related to the Bank’s past BSA deficiencies. After the OCC’s review of the Bank’s response, the OCC may impose a civil money penalty related to these deficiencies. The Corporation is currently not able to estimate a reasonable range of losses relating to that possibility.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
Following are the Corporation’s monthly common stock purchases during the second quarter of 2013. For a discussion of the common stock repurchase authorizations and repurchases during the period, see section “Capital” included under Part I Item 2 of this document.
Period
April 1, 2013 -April 30, 2013
May 1, 2013 - May 31, 2013
June 1, 2013 - June 30, 2013
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ITEM 6. Exhibits
Exhibit (11), Statement regarding computation of per-share earnings. See Note 3 of the notes to consolidated financial statements in Part I Item 1.
Exhibit (31.1), Certification Under Section 302 of Sarbanes-Oxley by Philip B. Flynn, Chief Executive Officer, is attached hereto.
Exhibit (31.2), Certification Under Section 302 of Sarbanes-Oxley by Christopher Del Moral-Niles, Chief Financial Officer, is attached hereto.
Exhibit (32), Certification by the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley, is attached hereto.
Exhibit (101), Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Unaudited Consolidated Balance Sheets, (ii) Unaudited Consolidated Statements of Income, (iii) Unaudited Consolidated Statements of Comprehensive Income, (iv) Unaudited Consolidated Statements of Changes in Stockholders’ Equity, (v) Unaudited Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements. *
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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 hereunto duly authorized.
/s/ Philip B. Flynn
/s/ Christopher Del Moral-Niles
/s/ Bryan R. McKeag
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