UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2013
or
For the transition period from to
Commission File Number: 0-18415
Isabella Bank Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
identification No.)
(989) 772-9471
(Registrant’s telephone number, including area code)
N/A
(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. x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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). x Yes ¨ 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 “accelerated filer”, “large accelerated filer”, and “smaller reporting company”, in Rule 12b-2 of the Exchange Act (Check One).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common Stock no par value, 7,696,617 as of April 29, 2013
ISABELLA BANK CORPORATION
QUARTERLY REPORT ON FORM 10-Q
Table of Contents
PART I FINANCIAL INFORMATION
Item 1 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 1A Risk Factors
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
Item 6 Exhibits
SIGNATURES
2
Forward Looking Statements
This report contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We intend such forward looking statements to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995, and is included in this statement for purposes of these safe harbor provisions. Forward looking statements, which are based on certain assumptions and describe future plans, strategies and expectations, are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar expressions. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the FRB, the quality or composition of the loan or investment portfolios, demand for loan products, fluctuation in the value of collateral securing our loan portfolio, deposit flows, competition, demand for financial services in our market area, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward looking statements and undue reliance should not be placed on such statements. Further information concerning Isabella Bank Corporation and its business, including additional factors that could materially affect our financial results, is included in our filings with the SEC.
The acronyms and abbreviations identified below may be used throughout this 10-Q, or in our other filings. You may find it helpful to refer back to this page while reading this report.
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PART I – FINANCIAL INFORMATION
Item 1 – Interim Condensed Consolidated Financial Statements (Unaudited)
INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
Cash and cash equivalents
Cash and demand deposits due from banks
Interest bearing balances due from banks
Total cash and cash equivalents
Certificates of deposit held in other financial institutions
Trading securities
AFS securities (amortized cost of $509,401 in 2013 and $490,420 in 2012)
Mortgage loans AFS
Loans
Commercial
Agricultural
Residential real estate
Consumer
Total loans
Less allowance for loan losses
Net loans
Premises and equipment
Corporate owned life insurance
Accrued interest receivable
Equity securities without readily determinable fair values
Goodwill and other intangible assets
Other assets
TOTAL ASSETS
Deposits
Noninterest bearing
NOW accounts
Certificates of deposit under $100 and other savings
Certificates of deposit over $100
Total deposits
Borrowed funds
Accrued interest payable and other liabilities
Total liabilities
Shareholders’ equity
Common stock — no par value 15,000,000 shares authorized; issued and outstanding 7,688,928 shares (including 2,800 shares held in the Rabbi Trust) in 2013 and 7,671,846 shares (including 5,130 shares held in the Rabbi Trust) in 2012
Shares to be issued for deferred compensation obligations
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See notes to interim condensed consolidated financial statements.
4
INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(Dollars in thousands except per share data)
Balance, January 1, 2012
Comprehensive income
Issuance of common stock
Common stock transferred from the Rabbi Trust to satisfy deferred compensation obligations
Share based payment awards under equity compensation plan
Common stock purchased for deferred compensation obligations
Common stock repurchased pursuant to publicly announced repurchase plan
Cash dividends ($0.20 per share)
Balance, March 31, 2012
Balance, January 1, 2013
Comprehensive income (loss)
Cash dividends ($0.21 per share)
Balance, March 31, 2013
5
INTERIM CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Interest income
Loans, including fees
AFS securities
Taxable
Nontaxable
Federal funds sold and other
Total interest income
Interest expense
Borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income
Service charges and fees
Gain on sale of mortgage loans
Earnings on corporate owned life insurance policies
Gain on sale of AFS securities
Other
Total noninterest income
Noninterest expenses
Compensation and benefits
Furniture and equipment
Occupancy
AFS security impairment loss
Total OTTI impairment loss
Portion of loss reported in other comprehensive income
Net AFS security impairment loss
Total noninterest expenses
Income before federal income tax expense
Federal income tax expense
NET INCOME
Earnings per share
Basic
Diluted
Cash dividends per basic share
6
INTERIM CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Net income
Unrealized gains on AFS securities:
Unrealized (losses) gains arising during the period
Reclassification adjustment for net realized gains included in net income
Reclassification adjustment for impairment loss included in net income
Net unrealized (losses) gains
Tax effect (1)
OCI, net of tax
7
INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
OPERATING ACTIVITIES
Reconciliation of net income to net cash provided by operations:
Impairment of foreclosed assets
Depreciation
Amortization and impairment of originated mortgage servicing rights
Amortization of acquisition intangibles
Net amortization of AFS securities
Net unrealized losses on trading securities
Net gain on sale of mortgage loans
Net unrealized gains on borrowings measured at fair value
Increase in cash value of corporate owned life insurance policies
Share-based payment awards under equity compensation plan
Origination of loans held for sale
Proceeds from loan sales
Net changes in operating assets and liabilities which provided (used) cash:
Net cash provided by operating activities
INVESTING ACTIVITIES
Net change in certificates of deposit held in other financial institutions
Activity in AFS securities
Sales
Maturities and calls
Purchases
Loan principal originations, net
Proceeds from sales of foreclosed assets
Purchases of premises and equipment
Proceeds from the redemption of corporate owned life insurance policies
Net cash used in investing activities
8
INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
FINANCING ACTIVITIES
Acceptances and withdrawals of deposits, net
Increase in other borrowed funds
Cash dividends paid on common stock
Proceeds from issuance of common stock
Common stock repurchased
Net cash provided by financing activities
DECREASE IN CASH AND CASH EQUIVALENTS
Cash and cash equivalents at beginning of period
CASH AND CASH EQUIVALENTS AT END OF PERIOD
SUPPLEMENTAL CASH FLOWS INFORMATION:
Interest paid
Federal income taxes paid
SUPPLEMENTAL NONCASH INVESTING AND FINANCING INFORMATION:
Transfers of loans to foreclosed assets
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NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
NOTE 1 – BASIS OF PRESENTATION
As used in these notes as well as in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, references to “Isabella,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Isabella Bank Corporation and its subsidiaries. Isabella Bank Corporation refers solely to the parent holding company, and Isabella Bank refers to Isabella Bank Corporation’s subsidiary, Isabella Bank.
The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In our opinion, all adjustments considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013. For further information, refer to the consolidated financial statements and footnotes thereto included in our annual report for the year ended December 31, 2012.
The accounting policies are materially the same as those discussed in Note 1 to the Consolidated Financial Statements included in our annual report for the year ended December 31, 2012.
NOTE 2 – COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued relate solely to outstanding shares in the Directors Plan.
Earnings per common share have been computed based on the following:
Average number of common shares outstanding for basic calculation
Average potential effect of shares in the Directors Plan (1)
Average number of common shares outstanding used to calculate diluted earnings per common share
NOTE 3 – RECENTLY ADOPTED ACCOUNTING STANDARDS UPDATE
ASU No. 2013-02: “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”
In February 2013, ASU No. 2013-02 amended ASC Topic 220, “Comprehensive Income” to require disclosures related to reclassifications out of AOCI in one place. The ASU also requires the disclosure of reclassifications out of AOCI by component. The new authoritative guidance was effective for interim and annual periods beginning after December 15, 2012 and did not have a financial impact, but increased the level of disclosures related to AOCI (see Note 13).
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NOTE 4 – TRADING SECURITIES
Trading securities, at fair value, consist of the following investments at:
States and political subdivisions
Included in the net trading losses of $10 during the first three months of 2013 were $10 of net unrealized trading losses on securities that were held in our trading portfolio as of March 31, 2013. Included in the net trading losses of $16 during the first three months of 2012 were $13 of net unrealized trading losses on securities that were held in the trading portfolio as of March 31, 2012.
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NOTE 5 – AVAILABLE-FOR-SALE SECURITIES
The amortized cost and fair value of AFS securities, with gross unrealized gains and losses, are as follows at:
Government sponsored enterprises
Auction rate money market preferred
Preferred stocks
Mortgage-backed securities
Collateralized mortgage obligations
Total
The amortized cost and fair value of AFS securities by contractual maturity at March 31, 2013 are as follows:
SecuritiesWith
VariableMonthly
Total amortized cost
Fair value
Expected maturities for government sponsored enterprises and states and political subdivisions may differ from contractual maturities because issuers may have the right to call or prepay obligations.
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As auction rate money market preferred and preferred stocks have continual call dates, they are not reported by a specific maturity group. Because of their variable monthly payments, mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group.
A summary of the activity related to sales of AFS securities was as follows for the three month periods ended:
Proceeds from sales of AFS securities
Gross realized gains
Applicable income tax expense
The cost basis used to determine the realized gains or losses of securities sold was the amortized cost of the individual investment security as of the trade date.
Information pertaining to AFS securities with gross unrealized losses at March 31, 2013 and December 31, 2012 aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
Number of securities in an unrealized loss position:
13
As of March 31, 2013 and December 31, 2012, we conducted an analysis to determine whether any securities currently in an unrealized loss position should be other-than-temporarily impaired. Such analyses considered, among other factors, the following criteria:
Has the value of the investment declined more than what is deemed to be reasonable based on a risk and maturity adjusted discount rate?
Is the investment credit rating below investment grade?
Is it probable the issuer will be unable to pay the amount when due?
Is it more likely than not that we will not have to sell the security before recovery of its cost basis?
Has the duration of the investment been extended?
During the three month period ended March 31, 2012, we had one state issued student loan auction rate AFS investment security (which is included in states and political subdivisions) that was downgraded by Moody’s from A3 to Caa3. As a result of this downgrade, we engaged the services of an independent investment valuation firm to estimate the amount of credit losses (if any) related to this particular issue as of March 31, 2012. The evaluation calculated a range of estimated credit losses utilizing two different bifurcation methods: 1) Estimated Cash Flow Method and 2) Credit Yield Analysis Method. The two methods were then weighted, with a higher weighting applied to the Estimated Cash Flow Method, to determine the estimated credit related impairment. As a result of this analysis we recognized an OTTI of $282 in earnings in the first quarter of 2012.
A summary of key valuation assumptions used in the aforementioned analysis as of March 31, 2012, follows:
Ratings
Fitch
Moody’s
S&P
Seniority
Discount rate
Credit discount rate
Average observed discounts based on closed transactions
To test for additional impairment of this security during the three months ended March 31, 2013, we obtained another investment valuation (from the same firm engaged to perform the initial valuation as of March 31, 2012) as of March 31, 2013. Based on the results of this valuation, no additional OTTI was indicated as of March 31, 2013.
The following table provides a roll-forward of credit related impairment recognized in earnings for the:
Balance at beginning of period
Additions to credit losses for which no previous OTTI was recognized
Balance at end of period
Based on our analysis using the above criteria, the fact that we have asserted that we do not have the intent to sell these securities in an unrealized loss position, and it is unlikely that we will have to sell the securities before recovery of their cost basis, we do not believe that the values of any other securities are other-than-temporarily impaired as of March 31, 2013 or December 31, 2012.
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NOTE 6 – LOANS AND ALLOWANCE FOR LOAN LOSSES
We grant commercial, agricultural, residential real estate, and consumer loans to customers situated primarily in Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The ability of the borrowers to honor their repayment obligations is often dependent upon the real estate, agricultural, light manufacturing, retail, gaming and tourism, higher education, and general economic conditions of this region. Substantially all of the consumer and residential real estate loans are secured by various items of property, while commercial loans are secured primarily by real estate, business assets, and personal guarantees; a portion of loans are unsecured.
Loans that we have the intent and ability to hold in our portfolio are reported at their outstanding principal balance adjusted for any charge-offs, the ALLL, and any deferred fees or costs. Interest income on loans is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the level yield method.
The accrual of interest on commercial, agricultural, and residential real estate loans is typically discontinued at the time the loan is 90 days or more past due unless the credit is well-secured and in the process of collection. Consumer loans are typically charged off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
For loans that are placed on nonaccrual status or charged off, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected, is charged against the allowance for loan losses. The interest on these loans is accounted for on the cash basis, until qualifying for return to accrual status. Loans are typically returned to accrual status after six months of continuous performance. For impaired loans not classified as nonaccrual, interest income continues to be accrued over the term of the loan based on the principal amount outstanding.
Commercial and agricultural loans include loans for commercial real estate, commercial operating loans, farmland and agricultural production, and states and political subdivisions. Repayment of these loans is often dependent upon the successful operation and management of a business; thus, these loans generally involve greater risk than other types of lending. We minimize our risk by limiting the amount of loans to any one borrower to $12,500. Borrowers with credit needs of more than $12,500 are serviced through the use of loan participations with other commercial banks. Commercial and agricultural real estate loans generally require loan-to-value limits of less than 80%. Depending upon the type of loan, past credit history, and current operating results, we may require the borrower to pledge accounts receivable, inventory, and property and equipment. Personal guarantees are generally required from the owners of closely held corporations, partnerships, and sole proprietorships. In addition, we require annual financial statements, prepare cash flow analyses, and review credit reports as deemed necessary.
We offer adjustable rate mortgages, fixed rate balloon mortgages, construction loans, and fixed rate mortgage loans which typically have amortization periods up to a maximum of 30 years. Fixed rate loans with an amortization of greater than 15 years are generally sold upon origination to Freddie Mac. Fixed rate residential real estate loans with an amortization of 15 years or less may be held in our portfolio, held for future sale, or sold upon origination. We consider the direction of interest rates, the sensitivity of our balance sheet to changes in interest rates, and overall loan demand to determine whether or not to sell these loans to Freddie Mac.
Our lending policies generally limit the maximum loan-to-value ratio on residential real estate loans to 95% of the lower of the appraised value of the property or the purchase price, with the condition that private mortgage insurance is required on loans with loan to value ratios in excess of 80%. Substantially all loans upon origination have a loan to value ratio of less than 80%. Underwriting criteria for residential real estate loans include: evaluation of the borrower’s ability to make monthly payments, the value of the property securing the loan, ensuring the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower’s gross income, all debt servicing does not exceed 36% of income, acceptable credit reports, verification of employment, income, and financial information. Appraisals are performed by independent appraisers and reviewed internally. All mortgage loan requests are reviewed by our mortgage loan committee or through a secondary market automated underwriting system; loans in excess of $400 require the approval of our Internal Loan Committee, the Board of Directors’ Loan Committee, or the Board of Directors.
Consumer loans include automobile loans, secured and unsecured personal loans, and overdraft protection related loans. Loans are amortized generally for a period of up to 6 years. The underwriting emphasis is on a borrower’s perceived intent and ability to pay rather than collateral value. No consumer loans are sold to the secondary market.
The ALLL is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the ALLL when we believe the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the ALLL.
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The ALLL is evaluated on a regular basis and is based upon a periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The primary factors behind the determination of the level of the ALLL are specific allocations for impaired loans, historical loss percentages, as well as unallocated components. Specific allocations for impaired loans are primarily determined based on the difference between the net realizable value of the loan’s underlying collateral or the net present value of the projected payment stream and our recorded investment. Historical loss allocations were calculated at the loan class and segment levels based on a migration analysis of the loan portfolio over the preceding four years. An unallocated component is maintained to cover uncertainties that we believe affect our estimate of probable losses based on qualitative factors. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A summary of changes in the ALLL and the recorded investment in loans by segments follows:
January 1, 2013
Loans charged-off
Recoveries
March 31, 2013
ALLL
Individually evaluated for impairment
Collectively evaluated for impairment
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January 1, 2012
March 31, 2012
The following table displays the credit quality indicators for commercial and agricultural credit exposures based on internally assigned credit ratings as of:
Rating
2 - High quality
3 - High satisfactory
4 - Low satisfactory
5 - Special mention
6 - Substandard
7 - Vulnerable
8 - Doubtful
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Internally assigned risk ratings are reviewed, at a minimum, when loans are renewed or when management has knowledge of improvements or deterioration of the credit quality of individual credits. Descriptions of the internally assigned risk ratings for commercial and agricultural loans are as follows:
Credit has strong financial condition and solid earnings history, characterized by:
Credit with sound financial condition and has a positive trend in earnings supplemented by:
Credit with satisfactory financial condition and further characterized by:
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4. LOW SATISFACTORY – Acceptable Risk
Credit with bankable risks, although some signs of weaknesses are shown:
Would include most start-up businesses.
Occasional instances of trade slowness or repayment delinquency – may have been 10-30 days slow within the past year.
Management’s abilities are apparent, yet unproven.
Weakness in primary source of repayment with adequate secondary source of repayment.
Loan structure generally in accordance with policy.
If secured, loan collateral coverage is marginal.
Adequate cash flow to service debt, but coverage is low.
To be classified as less than satisfactory, only one of the following criteria must be met.
5. SPECIAL MENTION – Criticized
Credit constitutes an undue and unwarranted credit risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an unwarranted risk in light of the circumstances surrounding a specific loan:
Downward trend in sales, profit levels, and margins.
Impaired working capital position.
Cash flow is strained in order to meet debt repayment.
Loan delinquency (30-60 days) and overdrafts may occur.
Shrinking equity cushion.
Diminishing primary source of repayment and questionable secondary source.
Management abilities are questionable.
Weak industry conditions.
Litigation pending against the borrower.
Collateral or guaranty offers limited protection.
Negative debt service coverage, however the credit is well collateralized and payments are current.
6. SUBSTANDARD – Classified
Credit where the borrower’s current net worth, paying capacity, and value of the collateral pledged is inadequate. There is a distinct possibility that we will implement collection procedures if the loan deficiencies are not corrected. In addition, the following characteristics may apply:
Sustained losses have severely eroded the equity and cash flow.
Deteriorating liquidity.
Serious management problems or internal fraud.
Original repayment terms liberalized.
Likelihood of bankruptcy.
Inability to access other funding sources.
Reliance on secondary source of repayment.
Litigation filed against borrower.
Collateral provides little or no value.
Requires excessive attention of the loan officer.
Borrower is uncooperative with loan officer.
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7. VULNERABLE – Classified
Credit is considered “Substandard” and warrants placing on nonaccrual. Risk of loss is being evaluated and exit strategy options are under review. Other characteristics that may apply:
Insufficient cash flow to service debt.
Minimal or no payments being received.
Limited options available to avoid the collection process.
Transition status, expect action will take place to collect loan without immediate progress being made.
8. DOUBTFUL – Workout
Credit has all the weaknesses inherent in a “Substandard” loan with the added characteristic that collection and/or liquidation is pending. The possibility of a loss is extremely high, but its classification as a loss is deferred until liquidation procedures are completed, or reasonably estimable. Other characteristics that may apply:
Normal operations are severely diminished or have ceased.
Seriously impaired cash flow.
Original repayment terms materially altered.
Secondary source of repayment is inadequate.
Survivability as a “going concern” is impossible.
Collection process has begun.
Bankruptcy petition has been filed.
Judgments have been filed.
Portion of the loan balance has been charged-off.
9. LOSS – Charge-off
Credits are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification is for charged-off loans but does not mean that the asset has absolutely no recovery or salvage value. These loans are further characterized by:
Liquidation or reorganization under bankruptcy, with poor prospects of collection.
Fraudulently overstated assets and/or earnings.
Collateral has marginal or no value.
Debtor cannot be located.
Over 120 days delinquent.
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Our primary credit quality indicators for residential real estate and consumer loans is the individual loan’s past due aging. The following tables summarize the past due and current loans as of:
Commercial real estate
Commercial other
Total commercial
Agricultural real estate
Agricultural other
Total agricultural
Senior liens
Junior liens
Home equity lines of credit
Total residential real estate
Secured
Unsecured
Total consumer
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Impaired Loans
Loans may be classified as impaired if they meet one or more of the following criteria:
Impairment is measured on a loan by loan basis for commercial and agricultural loans by comparing the loan’s outstanding balance to the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less cost to sell, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impairment is measured on a loan by loan basis for residential real estate and consumer loans by comparing the loan’s outstanding balance to the present value of expected future cash flows discounted at the loan’s effective interest rate.
We do not recognize interest income on impaired loans in nonaccrual status. For impaired loans not in nonaccrual status, interest income is recognized daily, as earned, according to the terms of the loan agreement. The following is a summary of information pertaining to impaired loans as of, and for the periods ended:
Impaired loans with a valuation allowance
Residential real estate senior liens
Residential real estate junior liens
Total impaired loans with a valuation allowance
Impaired loans without a valuation allowance
Consumer secured
Total impaired loans without a valuation allowance
Impaired loans
Total impaired loans
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As of March 31, 2013 and December 31, 2012, we had committed to advance $13 and $9, respectively, in connection with impaired loans, which include TDR’s.
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Troubled Debt Restructurings
Loan modifications are considered to be TDR’s when the modification includes terms outside of normal lending practices to a borrower who is experiencing financial difficulties.
Typical concessions granted include, but are not limited to:
To determine if a borrower is experiencing financial difficulties, we consider if:
The following is a summary of information pertaining to TDR’s granted in the periods ended:
We did not restructure any loans through the forbearance of principal or accrued interest in the three month periods ended March 31, 2013 or 2012.
Based on our historical loss experience, losses associated with TDR’s are not significantly different than other impaired loans within the same loan segment. As such, TDR’s, including TDR’s that have been modified in the past 12 months that subsequently defaulted, are analyzed in the same manner as other impaired loans within their respective loan segment.
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Following is a summary of loans that defaulted in the three month periods ended March 31, 2013 and 2012, which were modified within 12 months prior to the default date:
The following is a summary of TDR loan balances as of:
Troubled debt restructurings
NOTE 7 – EQUITY SECURITIES WITHOUT READILY DETERMINABLE FAIR VALUES
Included in equity securities without readily determinable fair values are restricted securities, which are carried at cost, and investments in nonconsolidated entities accounted for under the equity method of accounting.
Equity securities without readily determinable fair values consist of the following as of:
FHLB Stock
Investment in Corporate Settlement Solutions
FRB Stock
Investment in Valley Financial Corporation
NOTE 8 – BORROWED FUNDS
Borrowed funds consist of the following obligations as of:
FHLB advances
Securities sold under agreements to repurchase without stated maturity dates
Securities sold under agreements to repurchase with stated maturity dates
Federal funds purchased
25
The FHLB advances are collateralized by a blanket lien on all qualified 1-4 family residential real estate loans and certain mortgage-backed securities and collateralized mortgage obligations. Advances are also secured by our holdings of FHLB stock. As of March 31, 2013, we had the ability to borrow up to an additional $116,058, based on assets pledged as collateral. During the first quarter of 2013 and 2012, we reduced funding costs by modifying the term of $30,000 and $60,000, respectively, of FHLB advances.
The following table lists the maturity and weighted average interest rates of FHLB advances as of:
Fixed rate advances due 2014
Fixed rate advances due 2015
Fixed rate advances due 2016
Fixed rate advances due 2017
Fixed rate advances due 2018
Fixed rate advances due 2019
Fixed rate advances due 2020
Fixed rate advances due 2023
Securities sold under agreements to repurchase are classified as secured borrowings. Securities sold under agreements to repurchase without stated maturity dates generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. The securities underlying the agreements have a carrying value and a fair value of $132,414 and $143,322 at March 31, 2013 and December 31, 2012, respectively. Such securities remain under our control. We may be required to provide additional collateral based on the fair value of underlying securities.
The following table provides a summary of short term borrowings for the three month periods ended March 31:
We had pledged certificates of deposit held in other financial institutions, trading securities, AFS securities, and 1-4 family residential real estate loans in the following amounts at:
Pledged to secure borrowed funds
Pledged to secure repurchase agreements
Pledged for public deposits and for other purposes necessary or required by law
26
We had no investment securities that are restricted to be pledged for specific purposes.
NOTE 9 – OTHER NONINTEREST EXPENSES
A summary of expenses included in other noninterest expenses are as follows for the:
FDIC insurance premiums
Marketing and community relations
Directors fees
Audit fees
Education and travel
Postage and freight
Printing and supplies
Consulting fees
All other
Total other
NOTE 10 – FEDERAL INCOME TAXES
The reconciliation of the provision for federal income taxes and the amount computed at the federal statutory tax rate of 34% of income before federal income tax expense is as follows for the:
Income taxes at 34% statutory rate
Effect of nontaxable income
Interest income on tax exempt municipal securities
Total effect of nontaxable income
Effect of nondeductible expenses
Included in OCI for the three month periods ended March 31, 2013 and 2012 are changes in unrealized holding gains, related to auction rate money market preferred and preferred stocks. For federal income tax purposes, these securities are considered equity investments. As such, no deferred federal income taxes related to unrealized holding gains or losses are expected or recorded.
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A summary of OCI follows for the:
Unrealized gains arising during the period
Net unrealized gains (losses)
Tax effect
Unrealized gains (losses), net of tax
NOTE 11 – DEFINED BENEFIT PENSION PLAN
We maintain a noncontributory defined benefit pension plan, which was curtailed effective March 1, 2007. As a result of the curtailment, future salary increases are no longer considered and plan benefits are based on years of service and the individual employee’s five highest consecutive years of compensation out of the last ten years of service through March 1, 2007. We contributed $215 and $135 to the plan during the three month period ended March 31, 2013 and 2012, respectively. We do not anticipate any further contributions to the plan in 2013.
Following are the components of net periodic benefit cost for the three month periods ended March 31:
Interest cost on PBO
Expected return on plan assets
Amortization of unrecognized actuarial net loss
Net periodic benefit cost
NOTE 12 – FAIR VALUE
Following is a description of the valuation methodologies, key inputs, and an indication of the level of the fair value hierarchy in which the assets or liabilities are classified.
Cash and demand deposits due from banks: The carrying amounts of cash and short term investments, including Federal funds sold, approximate fair values. As such, we classify cash and demand deposits due from banks as Level 1.
Certificates of deposit held in other financial institutions: Interest bearing balances held in unaffiliated financial institutions include certificates of deposit and other short term interest bearing balances that mature within 3 years. Fair value is determined using prices for similar assets with similar characteristics. As such, we classify certificates of deposits held in other financial institutions as Level 2.
Investment securities: Investment securities are recorded at fair value on a recurring basis. Level 1 fair value measurement is based upon quoted prices for identical instruments. Level 2 fair value measurement is based upon quoted prices for similar instruments. If quoted prices are not available, fair values are measured using independent pricing models or other model based valuation techniques
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such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss and liquidity assumptions. The values for Level 1 and Level 2 investment securities are generally obtained from an independent third party. On a quarterly basis, we compare the values provided to alternative pricing sources.
Mortgage loans AFS: Mortgage loans AFS are carried at the lower of cost or fair value. The fair value of mortgage loans available-for-sale are based on what price secondary markets are currently offering for portfolios with similar characteristics. As such, we classify loans subject to nonrecurring fair value adjustments as Level 2.
Loans: For variable rate loans with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The resulting amounts are adjusted to estimate the effect of changes in the credit quality of borrowers since the loans were originated. As such, we classify loans as level 3 assets.
We do not record loans at fair value on a recurring basis. However, from time to time, loans are classified as impaired and a specific allowance for loan losses may be established. Loans for which it is probable that payment of interest and principal will be significantly different than the contractual terms of the original loan agreement are considered impaired. Once a loan is identified as impaired, we measure the estimated impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.
We review the net realizable values of the underlying collateral for collateral dependent impaired loans on at least a quarterly basis for all loan types. To determine the collateral value, management utilizes independent appraisals, broker price opinions, or internal evaluations. These valuations are reviewed to determine whether an additional discount should be applied given the age of market information that may have been considered as well as other factors such as costs to carry and sell an asset if it is determined that the collateral will be liquidated in connection with the ultimate settlement of the loan. We use these valuations to determine if any charge-offs or specific reserves are necessary. We may obtain new valuations in certain circumstances, including when there has been significant deterioration in the condition of the collateral, if the foreclosure process has begun, or if the existing valuation is deemed to be outdated.
Impaired loans where an allowance is established based on the net realizable value of collateral require classification in the fair value hierarchy. Due to the inherent level of estimation in the valuation process, we record impaired loans as nonrecurring Level 3.
The table below lists the quantitative information about impaired loans measured utilizing Level 3 fair value measurements as of:
Valuation Techniques
Unobservable Input
Discounted cash flow
Discount applied to
collateral appraisal:
Real Estate
Equipment
Discounted appraisal value
Cash crop inventory
Other inventory
Accounts receivable
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Accrued interest: The carrying amounts of accrued interest approximate fair value. As such, we classify accrued interest as Level 1.
Goodwill and other intangible assets: Acquisition intangibles and goodwill are evaluated for potential impairment on at least an annual basis. Acquisition intangibles and goodwill are typically qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired. If it is determined that the carrying balance of acquisition intangibles or goodwill is more likely than not to be impaired, we perform a cash flow valuation to determine the extent of the potential impairment. If the testing resulted in impairment, we would classify goodwill and other acquisition intangibles subjected to nonrecurring fair value adjustments as Level 3. During 2013 and 2012 there were no impairments recorded on goodwill and other acquisition intangibles.
Equity securities without readily determinable fair values: Included in equity securities without readily determinable fair values are FHLB Stock and FRB Stock as well as our ownership interests in Corporate Settlement Solutions and Valley Financial Corporation. The investment in Corporate Settlement Solutions, a title insurance company, was made in the 1st quarter 2007. The Corporation is not the managing entity of Corporate Settlement Solutions, LLC, and accounts for its investment in that entity under the equity method of accounting. Valley Financial Corporation is the parent company of 1st State Bank in Saginaw, Michigan, which is a de novo bank that opened in 2005. The Corporation made investments in Valley Financial Corporation in 2004 and in 2007.
The lack of an active market, or other independent sources to validate fair value estimates coupled with the impact of future capital calls and transfer restrictions, is an inherent limitation in the valuation process. As the fair values of these investments are not readily determinable, they are not disclosed under a specific fair value hierarchy; however, they are reviewed quarterly for impairment. If we were to record an impairment adjustment related to these securities, it would be classified as a nonrecurring Level 3 fair value adjustment. During 2013 and 2012, there were no impairments recorded on equity securities without readily determinable fair values.
Foreclosed assets: Upon transfer from the loan portfolio, foreclosed assets are adjusted to and subsequently carried at the lower of carrying value or fair value less costs to sell. Net realizable value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. Due to the inherent level of estimation in the valuation process, we record foreclosed assets as nonrecurring Level 3.
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The table below lists the quantitative information related to foreclosed assets measured utilizing Level 3 fair value measurements as of:
Valuation Technique
Originated mortgage servicing rights: OMSR is subject to impairment testing. A valuation model, which utilizes a discounted cash flow analysis using interest rates and prepayment speed assumptions currently quoted for comparable instruments and a discount rate determined by management, is used for impairment testing. If the valuation model reflects a value less than the carrying value, originated mortgage servicing rights are adjusted to fair value through a valuation allowance as determined by the model. As such, we classify loan servicing rights subject to nonrecurring fair value adjustments as Level 2.
Deposits: The fair value of demand, savings, and money market deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts), and are classified as Level 1. Fair values for variable rate certificates of deposit approximate their recorded carrying value. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. As such, certificates of deposit are classified as Level 2.
Borrowed funds: The carrying amounts of federal funds purchased, borrowings under overnight repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. The fair values of other borrowed funds are estimated using discounted cash flow analyses based on current incremental borrowing arrangements. As such, other borrowed funds are classified as Level 2.
Commitments to extend credit, standby letters of credit and undisbursed loans: Fair values for off balance sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the counterparties' credit standings. As we do not charge fees for lending commitments outstanding, it is not practicable to estimate the fair value of these instruments.
The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.
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Estimated Fair Values of Financial Instruments Not Recorded at Fair Value in their Entirety on a Recurring Basis
Disclosure of the estimated fair values of financial instruments, which differ from carrying values, often requires the use of estimates. In cases where quoted market values in an active market are not available, we use present value techniques and other valuation methods to estimate the fair values of our financial instruments. These valuation methods require considerable judgment and the resulting estimates of fair value can be significantly affected by the assumptions made and methods used.
The carrying amount and estimated fair value of financial instruments not recorded at fair value in their entirety on a recurring basis on our consolidated balance sheets are as follows as of:
ASSETS
Mortgage loans available-for-sale
Equity securities without readily determinable fair values (1)
Originated mortgage servicing rights
LIABILITIES
Deposits without stated maturities
Deposits with stated maturities
Accrued interest payable
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Financial Instruments Recorded at Fair Value
The table below presents the recorded amount of assets and liabilities measured at fair value on:
Description
Recurring items
AFS Securities
Government-sponsored enterprises
Total AFS Securities
Nonrecurring items
Impaired loans (net of the allowance for loan losses)
OMSR
Foreclosed assets
Percent of assets and liabilities measured at fair value
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The changes in fair value of assets and liabilities recorded at fair value through earnings on a recurring basis and changes in assets and liabilities recorded at fair value on a nonrecurring basis, for which an impairment, or reduction of an impairment, was recognized in the:
NOTE 13 – ACCUMULATED OTHER COMPREHENSIVE INCOME
The following table summarizes the changes in accumulated other comprehensive income by component for the three months ended:
OCI before reclassifications
Amounts reclassified from AOCI
Subtotal
Other comprehensive loss, net of tax
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The following table details reclassification adjustments and the related affected line items on our interim condensed consolidated statements of income for the three month periods ended March 31:
Details about AOCI components
Affected Line Item in the
Interim Condensed Consolidated
Statements of Income
Unrealized holding gains on AFS securities
NOTE 14 – PARENT COMPANY ONLY FINANCIAL INFORMATION
Cash on deposit at the Bank
Investments in subsidiaries
LIABILITIES AND SHAREHOLDERS’ EQUITY
Other liabilities
Income
Dividends from subsidiaries
Management fee and other
Total income
Expenses
Occupancy and equipment
Total expenses
Income before income tax benefit and equity in undistributed earnings of subsidiaries
Federal income tax benefit
Undistributed earnings of subsidiaries
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Adjustments to reconcile net income to cash provided by operations
Undistributed earnings of equity securities without readily determinable fair values
Share-based payment awards
Changes in operating assets and liabilities which used cash
Accrued interest and other liabilities
NET CASH PROVIDED BY OPERATING ACTIVITIES
Maturities, calls, and sales of AFS securities
Purchases of equipment and premises
Repayment of advances to subsidiaries
NET CASH PROVIDED BY INVESTING ACTIVITIES
Net increase (decrease) in other borrowed funds
Proceeds from the issuance of common stock
NET CASH USED IN FINANCING ACTIVITIES
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
Cash and cash equivalents at beginning of year
CASH AND CASH EQUIVALENTS AT END OF YEAR
NOTE 15 – OPERATING SEGMENTS
Our reportable segments are based on legal entities that account for at least 10% of net operating results. The operations of the Bank as of March 31, 2013 and 2012 and each of the three month periods then ended, represented 90% or more of our consolidated total assets and operating results. As such, no additional segment reporting is presented.
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Item 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations
ISABELLA BANK CORPORATION FINANCIAL REVIEW
(All dollars in thousands, except per share data)
This section reviews the financial condition and results of our operations for the three month periods ended March 31, 2013 and 2012. This analysis should be read in conjunction with our 2012 annual report and with the unaudited interim condensed consolidated financial statements and notes, beginning on page 4 of this report.
Executive Summary
Net income for the first quarter of 2013 declined by $147 when compared to the same period in 2012. The primary driver for this decline was the strategic restructuring of investment securities and borrowings in the first quarter of 2012 which led to a one-time increase in net income of $603.
Despite the uncertainty of the current economic environment and increased regulatory compliance costs, we continue to deliver consistent returns. While improvement in the financial landscape has resulted in decreases in net loans charged-off and corresponding reductions in the provision for loan losses, a large degree of economic uncertainty remains. Our continued success throughout these challenging times is a direct result of our unwavering focus on community banking principles, prudent underwriting standards, and long term sustainable growth. This focus has enabled us to continue to meet the needs of the communities we serve, which translates into increased shareholder value.
As we continue to provide superior customer service, we recently broke ground on a new branch in Big Rapids, Michigan, which is expected to open this fall. The new location will complement our existing Big Rapids office and provide additional shareholder value for years to come.
Recent Legislation
The Health Care and Education Act of 2010, the Patient Protection and Affordable Care Act, the Dodd-Frank Act, and the JOBS Act, have already had, and are expected to continue to have, a significant negative impact on our operating results. Of these three acts, the Dodd-Frank Act has had, and is likely to have, the most significant impact, along with its establishment of the CFPB. This particular act made sweeping changes in the regulation of financial institutions aimed at strengthening the oversight of the federal government over the operation of the financial services sector and increasing the protection of consumers within the financial services sector. As a result of the implementation of some of the provisions, we have had increases in compensation costs and this trend is expected to continue.
The CFPB has begun to issue substantial proposed and final rules regarding consumer lending, including residential mortgage lending. These rules will likely further increase our compensation and outside advisor costs to provide and ensure the compliance efforts required by the CFPB.
In August 2012, the FRB and other financial regulatory agencies proposed new capital requirements for all financial institutions. In general, the proposal adds a new capital standard of equity capital to assets and increases the minimum capital ratios to be considered well capitalized, all in partial compliance with the Basel III Accords. While these proposals are not yet final, as written the transition period for them to take effect begins in 2013. The proposals could significantly impact our capital requirements, which could impact our ability to increase, or even pay, dividends.
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RESULTS OF OPERATIONS
Selected Financial Data
The following table outlines our quarterly results of operations and provides certain performance measures for:
INCOME STATEMENT DATA
Net Income
PER SHARE
Basic earnings
Diluted earnings
Dividends
Market value*
Tangible book value*
BALANCE SHEET DATA
At end of period
Total assets
Average balance
PERFORMANCE RATIOS
Return on average total assets (annualized)
Return on average shareholders’ equity (annualized)
Return on average tangible equity (annualized)
Net interest margin yield (FTE annualized)
Loan to deposit*
Nonperforming loans to total loans*
Nonperforming assets to total assets*
ALLL to nonperforming loans*
CAPITAL RATIOS
Shareholders’ equity to assets*
Tier 1 capital to average assets*
Tier 1 risk-based capital*
Total risk-based capital*
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AVERAGE BALANCES, INTEREST RATE, AND NET INTEREST INCOME
The following schedules present the daily average amount outstanding for each major category of interest earning assets, nonearning assets, interest bearing liabilities, and noninterest bearing liabilities. This schedule also presents an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a 34% tax rate. Nonaccruing loans, for the purpose of the following computations, are included in the average loan amounts outstanding. FRB and FHLB restricted equity holdings are included in accrued income and other assets.
The following table displays the results for the three month periods ended March 31:
INTEREST EARNING ASSETS
Taxable investment securities
Nontaxable investment securities
Trading account securities
Total earning assets
NONEARNING ASSETS
Allowance for loan losses
Accrued income and other assets
INTEREST BEARING LIABILITIES
Interest bearing demand deposits
Savings deposits
Time deposits
Total interest bearing liabilities
NONINTEREST BEARING LIABILITIES
Demand deposits
Total liabilities and shareholders’ equity
Net interest income (FTE)
Net yield on interest earning assets (FTE)
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Net Interest Income
Net interest income is our primary source of income. Interest income includes loan fees of $821 and $647 for the three month periods ended March 31, 2013 and 2012, respectively. For analytical purposes, net interest income is adjusted to an FTE basis by adding the income tax savings from interest on tax exempt loans and securities, thus making year to year comparisons more meaningful.
VOLUME AND RATE VARIANCE ANALYSIS
The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:
Volume Variance—change in volume multiplied by the previous year’s rate.
Rate Variance—change in the FTE rate multiplied by the previous year’s volume.
The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
CHANGES IN INTEREST INCOME
Taxable AFS securities
Nontaxable AFS securities
Total changes in interest income
CHANGES IN INTEREST EXPENSE
Total changes in interest expense
Net change in interest margin (FTE)
As shown in the following table, we continue to experience downward pressure on our net yield on interest earning assets. This pressure is a direct result of FRB monetary policy which has reduced yields on interest earning assets more than rates on interest bearing liabilities. The persistent low interest rate environment coupled with an increase in the concentration of AFS securities and trading securities as a percentage of earnings assets has also placed downward pressure on net interest margin yield.
Given that the historically low interest rate environment is expected to continue for the foreseeable future, the net yield on interest earning assets is not likely to increase in the near future. We anticipate continued reduction in rates earned on loans without a proportionate decline in funding rate will continue to cause downward pressure in net interest margin yield. Any additional interest income will most likely be contingent upon increases in volume and likely at lower interest margins than current earning assets.
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Allowance for Loan Losses
The viability of any financial institution is ultimately determined by its management of credit risk. Loans outstanding represent our single largest concentration of risk. The ALLL is our estimation of probable losses inherent in the existing loan portfolio. We allocate the ALLL throughout the loan portfolio based on our assessment of the underlying risks associated with each loan segment. Our assessments include allocations based on specific impairment allocations, historical losses, internally assigned credit ratings, and past due and nonaccrual balances. A portion of the ALLL is not allocated to any one loan segment, but is instead a reflection of other qualitative risks within the loan portfolio.
The following tables summarize our charge-off and recovery activity for the three month periods ended March 31:
Allowance for loan losses - January 1
Loans charged off
Commercial and agricultural
Total loans charged off
Total recoveries
Allowance for loan losses - March 31
Net loans charged off
Year to date average loans outstanding
Net loans charged off to average loans outstanding
Total amount of loans outstanding - March 31
Allowance for loan losses as a% of loans
As shown in the preceding table, the level of net charge-offs continues to decline. This trend has allowed us to reduce our provision, which has led to a decline in the ALLL in both amount and as a percentage of loans. We do not expect any significant increases in net loans charged off throughout the remainder of 2013 and as such, we anticipate the provision for loan losses to approximate current levels. For further discussion of the allocation of the ALLL, see “Note 6 – Loans and Allowance for Loan Losses” of the interim condensed consolidated financial statements.
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Loans Past Due and Loans in Nonaccrual Status
Increases in past due and nonaccrual loans can have a significant impact on the ALLL. To determine the potential impact, and corresponding estimated losses, we analyze our historical loss trends on loans past due greater than 30 days and nonaccrual loans. We monitor all loans that are past due and in nonaccrual status for indicators of additional deterioration.
A summary of loans past due and in nonaccrual status, including the composition of the ending balance of nonaccrual loans by type, is included in “Note 6 – Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.
We have taken a proactive approach to avoid foreclosures on borrowers who are willing to work with us in modifying their loans, thus making them more affordable. While this approach has allowed certain borrowers to develop a payment structure that will allow them to continue making payments in lieu of foreclosure, it has contributed to a significant increase in the level of loans classified as TDR. The implementation of ASU No. 2011-02 “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring” has also contributed to the increased level of TDR’s. The modifications have been extremely successful for us and our customers as very few of the modified loans have resulted in foreclosures. At the time of the TDR, the loan is reviewed to determine whether or not to classify the loan as accrual or nonaccrual. The majority of new modifications result in terms that satisfy our criteria for continued interest accrual. TDR’s that have been placed in nonaccrual status may be placed back on accrual status after six months of continued performance.
We restructure debt with borrowers who due to temporary financial difficulties are unable to service their debt under the original terms. We may extend the amortization period, reduce interest rates, forgive principal, or a combination of these modifications. Typically, the modifications are for a period of five years or less. There were no TDR’s that were Government sponsored as of March 31, 2013 or December 31, 2012.
Losses associated with TDR’s, if any, are included in the estimation of the ALLL in the quarter in which a loan is identified as a TDR, and we review the ALLL estimation each reporting period to ensure its continued appropriateness.
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The following tables provide a roll-forward of TDR’s for the:
New modifications
Principal payments
Loans paid-off
Balances charged-off (1)
Transfers to OREO
Transfers to nonaccrual status
Balances charged-off
Transfers to accrual status
The following table summarizes our TDR’s as of:
Current
Past due 30-59 days
Past due 60-89 days
Past due 90 days or more
Total troubled debt restructurings
Additional disclosures about TDR’s are included in “Note 6 – Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.
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The following is a summary of information pertaining to impaired loans as of:
TDR’s
Total TDR’s
Other impaired loans
Total other impaired loans
Additional disclosure related to impaired loans is included in “Note 6 – Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.
Nonperforming Assets
The following table summarizes our nonperforming assets as of:
Nonaccrual loans
Accruing loans past due 90 days or more
Total nonperforming loans
OREO
Repossessed assets
Total nonperforming assets
Nonperforming loans as a % of total loans
Nonperforming assets as a % of total assets
Loans are placed in nonaccrual status when the foreclosure process has begun, generally after a loan is 90 days past due, unless they are well secured. Upon transferring the loans to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if any charge-offs are necessary. Loans may be placed back on accrual status after six months of continued performance.
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Included in the nonaccrual loan balances above were credits currently classified as TDR’s as of:
The following table lists individually significant commercial and agricultural loan relationships in nonaccrual status as of March 31, 2013 and December 31, 2012. To be classified as individually significant, the recorded investment in nonaccrual loans to each borrower must have exceeded $1,000 as of the end of either period.
Borrower 1
Others not individually significant
The reduction in the outstanding balance and specific allocation from December 31, 2012 to March 31, 2013 were the result of regular payments received from the customer. There were no other individually significant credits included in nonaccrual loans as of March 31, 2013 or December 31, 2012.
Additional disclosures about nonaccrual loans are included in “Note 6 – Loans and Allowance for Loan Losses” of our interim condensed consolidated financial statements.
We continue to devote considerable attention to identifying impaired loans and adjusting the net carrying value of these loans to their current net realizable values through the establishment of a specific reserve or the recording of a charge-off. We believe that all loans deemed to be impaired have been identified.
We believe that the level of the ALLL is appropriate as of March 31, 2013 and we will continue to closely monitor overall credit quality and our policies and procedures related to the analysis of the ALLL to ensure that the ALLL remains appropriate.
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NONINTEREST INCOME AND EXPENSES
Noninterest Income
Noninterest income consists of service charges and fee income, gains from the sale of mortgage loans, gains and losses on trading securities and borrowings measured at fair value, gains from the sale of investment securities, and other. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations:
NSF and overdraft fees
ATM and debit card fees
Trust fees
Freddie Mac servicing fee
Service charges on deposit accounts
Net OMSR income
Total service charges and fees
Brokerage and advisory fees
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Significant changes in noninterest income are detailed below:
We continuously analyze various fees related to deposit accounts including service charges and NSF and overdraft fees. Based on these analyses, we make any necessary adjustments to ensure that our fee structure is within the range of our competitors, while at the same time making sure that the fees remain fair to deposit customers. NSF and overdraft fees represent the largest single component of service charges and fees. While we have experienced significant increases in deposit accounts, NSF and overdraft fees have steadily declined. This decline has been the result of reduced overdraft activity by our customers as well as changes in banking regulations. We expect this trend to continue.
In recent periods, we have invested considerable efforts to increase our market share in trust and brokerage and advisory services. These efforts have translated into increases in trust fees and brokerage and advisory fees. We expect this trend to continue.
Historically low offering rates on residential real estate loans have contributed to increased mortgage refinancing. This increase in activity has resulted in substantial increases in the gain on sale of mortgage loans, while contributing to fluctuations in the value of our OMSR portfolio. While the gain on sale of mortgage loans has declined since last year, we expect refinancing demand to remain elevated for the remainder of 2013.
We are continually analyzing our AFS security portfolio for potential sale opportunities. These analyses identified three mortgage-backed securities pools in the first quarter of 2013 that made economic sense to sell. During the first quarter of 2012, we identified several pools of mortgage-backed securities with significant unrealized gains. As the interest rates of the underlying mortgages were significantly higher than the current offering rates for similar mortgages, we elected to realize these gains through the sales of such securities as the investments would have likely been paid off in the near term through refinancing activity. We do not anticipate any significant investment sales during the remainder of 2013.
The fluctuation in all other income is spread throughout various categories, none of which are individually significant. We do not anticipate any significant fluctuations from current levels for the remainder of 2013.
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Noninterest Expenses
Noninterest expenses include compensation and benefits, furniture and equipment, occupancy, net AFS security impairment loss, and other expenses. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations:
Employee salaries
Employee benefits
Total compensation and benefits
Service contracts
Total furniture and equipment
Outside services
Utilities
Property taxes
Total occupancy
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Significant changes in noninterest expenses are detailed below:
During the first quarter of 2012, we recorded a credit impairment on an AFS security through earnings due to a bond being downgraded below investment grades. We continuously monitor the AFS security portfolio for other potential other-than-temporary impairments. For further discussion, see “Note 5 – Available-For-Sale Securities” of our notes to interim condensed consolidated financial statements.
We have been a consistently strong supporter of the various communities, schools, and charities in the markets we serve. In the 1996, we established a foundation that is generally funded from non-recurring, or extraordinary, revenue sources. The foundation provides centralized oversight for donations to organizations that benefit our communities. Included in marketing and community relations were donations to the foundation of $0 and $250 for the three month periods ended March 31, 2013 and 2012, respectively.
During the first quarter of 2012, we incurred consulting fees to review our FHLB advances for potential restructuring options. They were also elevated in 2012 due to the engagement of consultants to review our loan prepayment and deposit decay assumptions as well as to review various information technology projects. Consulting fees are anticipated to approximate current levels for the remainder of 2013.
The fluctuations in all other expenses are spread throughout various categories, none of which are individually significant.
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ANALYSIS OF CHANGES IN FINANCIAL CONDITION
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
As shown above, total assets have remained essentially unchanged since December 31, 2012. While loans declined in the three months of 2013, we anticipate that loans will increase moderately throughout the year.
The following table outlines the changes in the loan portfolio:
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The following table outlines the changes in the deposit portfolio:
Noninterest bearing demand deposits
Certificates of deposit
Brokered certificates of deposit
Internet certificates of deposit
Capital
Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income. We are currently authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to theses authorizations, we issued 37,591 shares or $902 of common stock during the first three months of 2013, as compared to 25,998 shares or $609 of common stock during the same period in 2012. We also offer the Directors Plan which allows participants to purchase stock units, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $146 and $169 during the three month periods ended March 31, 2013 and 2012, respectively.
We have approved a publicly announced common stock repurchase plan. Pursuant to this plan, we repurchased 20,509 shares or $480 of common stock compared to 18,452 shares for $426 during the first three months of 2013 and 2012, respectively. As of March 31, 2013, we were authorized to repurchase up to an additional 64,901 shares of common stock.
There are no significant regulatory constraints placed on our capital. The FRB’s current recommended minimum primary capital to assets requirement is 6.0%. Our primary capital to adjusted average assets, which consists of shareholders' equity plus the allowance for loan losses less acquisition intangibles, was 8.28% as of March 31, 2013.
The FRB has established a minimum risk based capital standard. Under this standard, a framework has been established that assigns risk weights to each category of on and off balance sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital. The minimum standard is 8%, of which at least 4% must consist of equity capital net of goodwill. The following table sets forth the percentages required under the Risk Based Capital guidelines and our values as of:
Equity Capital
Secondary Capital
Total Capital
Secondary capital includes only the allowance for loan losses. The percentage for the secondary capital under the required column is the maximum amount allowed from all sources.
The FRB and FDIC also prescribe minimum capital requirements for Isabella Bank. At March 31, 2013, the Bank exceeded these minimum capital requirements. Recently passed legislation will likely increase the required level of capital for banks. This increase in capital levels may have an adverse impact on our ability to grow and pay dividends.
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Contractual Obligations and Loan Commitments
We are party to credit related financial instruments with off-balance-sheet risk. These financial instruments are entered into in the normal course of business to meet the financing needs of our customers. These financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement we have in a particular class of financial instrument.
The following table summarizes our credit related financial instruments with off-balance-sheet risk as of:
Unfunded commitments under lines of credit
Commercial and standby letters of credit
Commitments to grant loans
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These commitments may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements.
Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements, including commercial paper, bond financing, and similar transactions. These commitments to extend credit and letters of credit generally mature within one year. The credit risk involved in these transactions is essentially the same as that involved in extending loans to customers. We evaluate each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon the extension of credit, is based on a credit evaluation of the borrower. While we consider standby letters of credit to be guarantees, the amount of the liability related to such guarantees on the commitment date is not significant and a liability related to such guarantees is not recorded on the consolidated balance sheets.
Commitments to grant loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The amount of collateral obtained, if it is deemed necessary, is based on management’s credit evaluation of the customer. Commitments to grant loans include loans committed to be sold to the secondary market.
Our exposure to credit-related loss in the event of nonperformance by the counter parties to the financial instruments for commitments to extend credit and standby letters of credit could be up to the contractual notional amount of those instruments. We use the same credit policies as we do for extending loans to customers. No significant losses are anticipated as a result of these commitments.
Fair Value
We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. AFS securities, trading securities, and certain liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held-for-sale, foreclosed assets, OMSR, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write-downs of individual assets.
For further information regarding fair value measurements see “Note 12—Fair Value” of our notes to the interim condensed consolidated financial statements.
Liquidity
Liquidity is monitored regularly by our Market Risk Committee, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources.
Our primary sources of liquidity are cash and demand deposits due from banks, certificates of deposit held in other financial institutions, trading securities, and available-for-sale securities. These categories totaled $545,679 or 38.0% of assets as of March 31, 2013 as compared to $534,968 or 37.4% as of December 31, 2012. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Liquidity varies significantly daily, based on customer activity.
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Our primary source of funds is deposit accounts. We also have the ability to borrow from the FHLB, the FRB, and through various correspondent banks as federal funds purchased. These funding methods typically carry a higher interest rate than traditional market deposit accounts. Some borrowed funds, including FHLB Advances, FRB Discount Window Advances, and repurchase agreements, require us to pledge assets, typically in the form of certificates of deposits held in other financial institutions, investment securities, or loans as collateral. As of March 31, 2013, we had available lines of credit of $116,058.
The following table summarizes our sources and uses of cash for the three month periods ended March 31:
Decrease in cash and cash equivalents
Cash and cash equivalents January 1
Cash and cash equivalents March 31
Market Risk
Our primary market risks are interest rate risk and liquidity risk. We have no significant foreign exchange risk and do not utilize interest rate swaps or derivatives, except for interest rate locks and forward loan commitments, in the management of IRR. Any changes in foreign exchange rates or commodity prices would have an insignificant impact on our interest income and cash flows.
IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. IRR is the fundamental method by which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital.
The FRB has adopted a policy requiring us to effectively manage the various risks that can have a material impact on our safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures and internal controls for measuring and managing these risks. Specifically, the IRR policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long term assets, limiting the mismatch in repricing opportunity of assets and liabilities, and the frequency of measuring and reporting to our Board.
The primary technique to measure interest rate risk is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of yield curves, interest rate relationships, and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies.
Our interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of a constant balance sheet and constant market interest rates (base case). We then compare the results of various simulation analyses to the base case. At March 31, 2013, we projected the change in net interest income during the next twelve months assuming market interest rates were to immediately decrease by 100 basis points and increase by 100, 200, 300, and 400 basis points in a parallel fashion over the entire yield curve during the same time period. We did not project scenarios showing decreases in interest rates beyond 100 basis points as this is considered extremely unlikely given prevailing interest rate levels. These projections were based on our assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and real estate residential and consumer loans. While it is extremely unlikely that
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interest rates would immediately increase to these levels, we feel that these extreme scenarios help us identify potential gaps and mismatches in the repricing characteristics of assets and liabilities. We regularly monitor our forecasted net interest income sensitivity to ensure that it remains within established limits.
The following table summarizes our interest rate sensitivity as of:
Immediate basis point change asumption (short-term rates)
Percent change in net income vs. constant rates
The secondary method to measure interest rate risk is gap analysis. Gap analysis measures the cash flows and/or the earliest repricing of our interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the imbedded repricing options contained in assets and liabilities. Residential real estate and consumer loans allow the borrower to repay the balance prior to maturity without penalty, while commercial and agricultural loans have prepayment penalties. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current offering rates, the level of sales of used homes, and the overall availability of credit in the market place. Generally, a decrease in interest rates will result in an increase in cash flows from these assets. A significant portion of our securities are callable or have prepayment options. The call and prepayment options are more likely to be exercised in a period of decreasing interest rates. Savings and demand accounts may generally be withdrawn on request without prior notice. The timing of cash flows from these deposits is estimated based on historical experience. Time deposits have penalties that discourage early withdrawals.
The following tables provide information about assets and liabilities that are sensitive to changes in interest rates as of March 31, 2013 and December 31, 2012. The principal amounts of assets and time deposits maturing were calculated based on the contractual maturity dates. Savings and NOW accounts are based on management's estimate of their future cash flows. During the first quarter of 2012, we engaged the services of a third party to analyze our historical loan prepayment speeds and non-contractual deposit decay rates. We have reviewed the results of the analyses in detail and feel that it reasonably reflects the prepayment speeds and decay rates of our loan and deposit portfolios
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Rate sensitive assets
Other interest bearing assets
Average interest rates
Fixed interest rate loans (1)
Variable interest rate loans (1)
Rate sensitive liabilities
Savings and NOW accounts
Fixed interest rate time deposits
Variable interest rate time deposits
We do not believe that there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. As of the date of this report, we do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term. As of the date of this report, we do not expect to make material changes in those methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques.
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Item 3 – Quantitative and Qualitative Disclosures about Market Risk
The information presented in the “Market Risk” section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.
Item 4 – Controls and Procedures
DISCLOSURE CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision and with the participation of the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of March 31, 2013, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of March 31, 2013, were effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
During the most recent fiscal quarter, no change occurred in our internal control over financial reporting that materially affected, or is likely to materially effect, our internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 1 – Legal Proceedings
We are not involved in any material legal proceedings. We are involved in ordinary, routine litigation incidental to our business; however, no such routine proceedings are expected to result in any material adverse effect on operations, earnings, or financial condition.
Item 1A – Risk Factors
There have been no material changes to the risk factors disclosed in Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2012.
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
(C) Repurchases of Common Stock
We have adopted and publically announced a common stock repurchase plan. The plan was last amended on April 26, 2012, to allow for the repurchase of an additional 150,000 shares of common stock. These authorizations do not have expiration dates. As shares are repurchased under this plan, they are retired and revert back to the status of authorized, but unissued shares.
The following table provides information for the three month period ended March 31, 2013, with respect to this plan:
Balance, December 31, 2012
January 1 - 31, 2013
February 1 - 28, 2013
March 1 - 31, 2013
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Item 6 - Exhibits
31(a)
31(b)
101.1*
In accordance with Rule 406T of Regulations S-T, the XBRL related information shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Richard J. Barz
/s/ Dennis P. Angner
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