UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________ to _______________
Commission File Number 001-35272
MIDLAND STATES BANCORP, INC.
(Exact name of registrant as specified in its charter)
ILLINOIS
37-1233196
(State of other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
1201 Network Centre Drive
Effingham, IL
62401
(Address of principal executive offices)
(Zip Code)
(217) 342-7321
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☒ Yes ☐ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer ☒
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☒
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ☐ Yes ☒ No
As of October 31, 2018, the Registrant had 23,704,643 shares of outstanding common stock, $0.01 par value.
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets at September 30, 2018 (Unaudited) and December 31, 2017
Consolidated Statements of Income (Unaudited) for the three and nine months ended September 30, 2018 and 2017
Consolidated Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2018 and 2017
Consolidated Statements of Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2018 and 2017
Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2018 and 2017
Notes to Consolidated Financial Statements (Unaudited)
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
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.
Exhibits
SIGNATURES
Table of Contents
PART I – FINANCIAL INFORMATION
ITEM 1 – FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
September 30,
December 31,
2018
2017
(unaudited)
Assets
Cash and due from banks
$
240,489
214,519
Federal funds sold
1,944
683
Cash and cash equivalents
242,433
215,202
Investment securities available for sale, at fair value
682,396
450,525
Equity securities, at fair value
3,357
—
Loans
4,156,282
3,226,678
Allowance for loan losses
(19,631)
(16,431)
Total loans, net
4,136,651
3,210,247
Loans held for sale, at fair value
35,246
50,089
Premises and equipment, net
95,062
76,162
Other real estate owned
3,684
5,708
Nonmarketable equity securities
44,931
34,796
Accrued interest receivable
17,500
11,715
Mortgage servicing rights, at lower of cost or fair value
51,626
56,352
Mortgage servicing rights held for sale
4,419
10,176
Intangible assets
39,228
16,932
Goodwill
164,044
98,624
Cash surrender value of life insurance policies
138,600
113,366
Accrued income taxes receivable
5,080
8,358
Deferred tax assets, net
10,165
12,024
Other assets
50,190
42,425
Total assets
5,724,612
4,412,701
Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Noninterest-bearing
991,311
724,443
Interest-bearing
3,151,895
2,406,646
Total deposits
4,143,206
3,131,089
Short-term borrowings
145,450
156,126
FHLB advances and other borrowings
652,253
496,436
Subordinated debt
94,093
93,972
Trust preferred debentures
47,676
47,330
Accrued interest payable
5,564
2,531
Other liabilities
42,224
35,672
Total liabilities
5,130,466
3,963,156
Shareholders’ Equity:
Preferred stock, Series H, $2 par value; $1,000 per share liquidation value; 2,636 shares authorized, issued and outstanding at September 30, 2018 and December 31, 2017
2,829
2,970
Common stock, $0.01 par value; 40,000,000 shares authorized; 23,694,637 and 19,122,049 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively
237
191
Capital surplus
473,057
330,148
Retained earnings
122,745
114,478
Accumulated other comprehensive (loss) income
(4,722)
1,758
Total shareholders’ equity
594,146
449,545
Total liabilities and shareholders’ equity
The accompanying notes are an integral part of the consolidated financial statements.
1
CONSOLIDATED STATEMENTS OF INCOME—(UNAUDITED)
Three Months Ended
Nine Months Ended
Interest income:
Loans:
Taxable
49,216
38,689
140,946
97,016
Tax exempt
1,006
313
2,275
953
Loans held for sale
512
438
1,235
1,926
Investment securities:
3,753
1,920
10,152
4,723
1,195
948
3,446
2,802
540
331
1,421
788
Federal funds sold and cash investments
765
607
2,300
1,405
Total interest income
56,987
43,246
161,775
109,613
Interest expense:
Deposits
6,151
3,377
15,273
8,570
213
100
453
262
3,211
1,494
7,664
2,901
1,514
873
4,542
2,619
817
637
2,291
1,635
Total interest expense
11,906
6,481
30,223
15,987
Net interest income
45,081
36,765
131,552
93,626
Provision for loan losses
2,103
1,489
5,963
3,480
Net interest income after provision for loan losses
42,978
35,276
125,589
90,146
Noninterest income:
Commercial FHA revenue
3,130
3,777
6,786
14,625
Residential mortgage banking revenue
1,154
2,317
4,688
7,563
Wealth management revenue
5,467
3,475
14,862
9,754
Service charges on deposit accounts
2,804
2,133
7,464
4,147
Interchange revenue
2,759
1,724
7,733
3,816
Gain (loss) on sales of investment securities, net
98
(5)
219
Gain on sales of other real estate owned
86
22
559
54
Other income
2,872
1,857
8,534
5,186
Total noninterest income
18,272
15,403
50,621
45,364
Noninterest expense:
Salaries and employee benefits
22,528
22,411
74,390
61,368
Occupancy and equipment
5,040
4,144
14,000
10,800
Data processing
10,817
5,786
20,402
11,531
FDIC insurance
549
565
1,636
1,403
Professional
2,632
4,151
9,559
10,285
Marketing
1,137
1,070
3,754
2,517
Communications
1,289
723
3,606
1,655
Loan expense
629
1,338
1,531
42
146
298
725
Amortization of intangible assets
1,853
1,187
5,104
Loss on mortgage servicing rights held for sale
270
3,617
458
Other expense
3,898
3,934
11,723
9,082
Total noninterest expense
50,317
48,363
146,268
116,805
Income before income taxes
10,933
2,316
29,942
18,705
Income taxes
2,436
280
6,857
4,640
Net income
8,497
2,036
23,085
14,065
Preferred stock dividends and premium amortization
35
27
107
46
Net income available to common shareholders
8,462
2,009
22,978
14,019
Per common share data:
Basic earnings per common share
0.35
0.10
1.00
0.81
Diluted earnings per common share
0.98
0.78
Weighted average common shares outstanding
23,855,805
19,265,409
22,868,256
17,274,746
Weighted average diluted common shares outstanding
24,325,743
19,704,217
23,327,140
17,797,235
2
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME—(UNAUDITED)
(dollars in thousands)
Other comprehensive (loss) income:
Investment securities available for sale:
Unrealized (losses) gains that occurred during the period
(3,330)
305
(8,919)
3,245
Reclassification adjustment for realized net (gains) losses on sales of investment securities included in net income
(98)
5
(219)
Income tax effect
915
(94)
2,434
(1,188)
Change in investment securities available for sale, net of tax
(2,415)
113
(6,480)
1,838
Investment securities held to maturity:
Amortization of unrealized gain on investment securities transferred from available-for-sale
(25)
(83)
9
31
Change in investment securities held to maturity, net of tax
(16)
(52)
Other comprehensive (loss) income, net of tax
97
1,786
Total comprehensive income
6,082
16,605
15,851
3
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY—(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017
Accumulated
other
Total
Preferred
Common
Capital
Retained
comprehensive
shareholders'
stock
surplus
earnings
(loss) income
equity
Balances, December 31, 2017
Compensation expense for stock option grants
263
Amortization of restricted stock awards
841
Preferred dividends declared
(248)
Preferred stock, premium amortization
(141)
141
Common dividends declared ($0.66 per share)
(14,711)
Acquisition of Alpine Bancorporation, Inc.
45
139,876
139,921
Issuance of common stock under employee benefit plans
1,929
1,930
Other comprehensive loss
Balances, September 30, 2018
Balances, December 31, 2016
155
209,712
112,513
(610)
321,770
413
599
(102)
(56)
56
Common dividends declared ($0.60 per share)
(10,159)
Acquisition of CedarPoint Investment Advisors, Inc.
3,350
3,351
Acquisition of Centrue Financial Corporation
3,071
32
112,480
115,583
3,380
3,383
Other comprehensive income
Balances, September 30, 2017
3,015
329,934
116,373
1,176
450,689
4
CONSOLIDATED STATEMENTS OF CASH FLOWS—(UNAUDITED)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation on premises and equipment
4,552
3,666
Increase in cash surrender value of life insurance
(2,656)
(2,016)
Investment securities amortization, net
2,846
1,358
Loss (gain) on sales of investment securities, net
(559)
(54)
Impairment of other real estate owned
126
171
Origination of loans held for sale
(399,109)
(630,601)
Proceeds from sales of loans held for sale
424,874
679,217
Gain on loans sold and held for sale
(8,649)
(20,844)
Loss on disposals of premises and equipment
395
102
Amortization of mortgage servicing rights
2,303
4,254
Impairment of mortgage servicing rights
931
1,830
Net change in operating assets and liabilities:
(1,371)
(1,095)
2,494
1,035
3,278
3,653
(1,757)
159
(2,341)
Net cash provided by operating activities
65,934
62,740
Cash flows from investing activities:
Purchases
(68,556)
(221,617)
Sales
16,805
11,250
Maturities and payments
98,838
192,791
(2,929)
Maturities
10,480
Equity securities:
(44)
7,789
Net increase in loans
(147,450)
(160,266)
Proceeds from sale of premises and equipment
Purchases of premises and equipment
(5,807)
(5,363)
Proceeds from sales of mortgage servicing rights held for sale
12,994
Purchases of nonmarketable equity securities
(20,637)
(16,575)
Sales of nonmarketable equity securities
12,540
9,837
Proceeds from sales of other real estate owned
3,676
4,525
Net cash acquired (paid) in acquisition
36,153
(18,519)
Net cash used in investing activities
(53,677)
(196,386)
Cash flows from financing activities:
Net decrease in deposits
(99,013)
(29,766)
Net (decrease) increase in short-term borrowings
(10,676)
7,452
Proceeds from FHLB borrowings
902,080
347,357
Payments made on FHLB borrowings
(761,531)
(229,857)
Proceeds from other borrowings
39,964
Payments made on other borrowings
(2,857)
(1,770)
Cash dividends paid on preferred stock
Cash dividends paid on common stock
Proceeds from issuance of common stock under employee benefit plans
Net cash provided by financing activities
14,974
126,502
Net increase (decrease) in cash and cash equivalents
27,231
(7,144)
Cash and cash equivalents:
Beginning of period
190,716
End of period
183,572
Supplemental disclosures of cash flow information:
Cash payments for:
Interest paid on deposits and borrowed funds
27,190
14,677
Income tax paid
575
Supplemental disclosures of noncash investing and financing activities:
Transfer of loans to other real estate owned
904
2,659
Transfer of premises and equipment to assets held for sale
2,858
Transfer of mortgage servicing rights at lower of cost or market to mortgage servicing rights held for sale
3,649
10,618
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(UNAUDITED)
Note 1 – Business Description
Midland States Bancorp, Inc. (the “Company,” “we,” “our,” or “us”) is a diversified financial holding company headquartered in Effingham, Illinois. Its wholly owned banking subsidiary, Midland States Bank (the “Bank”), has branches across Illinois and in Missouri and Colorado, and provides a broad array of traditional community banking and other complementary financial services, including commercial lending, residential mortgage origination, wealth management, merchant services and prime consumer lending. We also originate and service government sponsored mortgages for multifamily and healthcare facilities through our subsidiary, Love Funding Corporation (“Love Funding”), based in Washington, D.C. Our commercial equipment financing business, which operates on a nationwide basis, was brought directly into the Bank under the name Midland Equipment Finance beginning in January 2018.
On February 28, 2018, we completed the acquisition of Alpine Bancorporation, Inc. (“Alpine”) and its banking subsidiary, Alpine Bank & Trust Co. (“Alpine Bank”), as more fully described in Note 3 to the consolidated financial statements. Through the Alpine acquisition, we greatly expanded our commercial and retail banking presence in northern Illinois. After the acquisition, Alpine Bank operated as a subsidiary of the Company until its merger into the Bank in July 2018.
Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We have derived income principally from interest earned on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as: fees received in connection with various lending and deposit services; wealth management services; residential mortgage loan originations, sales and servicing; and, from time to time, gains on sales of assets. Our income sources also include Love Funding’s commercial Federal Housing Administration (“FHA”) loan origination and servicing income. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for loan losses and income tax expense.
Note 2 – Basis of Presentation and Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements of the Company are unaudited and should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission (the “SEC”) on March 6, 2018. The consolidated financial statements have been prepared in accordance with the accounting principles generally accepted in the United States of America (“GAAP”) and conform to predominant practices within the banking industry. Management of the Company has made a number of estimates and assumptions related to the reporting of assets and liabilities to prepare the consolidated financial statements in conformity with GAAP. Actual results may differ from those estimates. In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the results of operations for the interim periods presented herein, have been included. Certain reclassifications of 2017 amounts have been made to conform to the 2018 presentation. Management has evaluated subsequent events for potential recognition or disclosure. Operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018 or any other period.
Principles of Consolidation
The consolidated financial statements include the accounts of the parent company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Assets held for customers in a fiduciary or agency capacity, other than trust cash on deposit with the Bank, are not assets of the Company and, accordingly, are not included in the accompanying unaudited consolidated financial statements.
6
Impact of Recently Issued Accounting Standards
FASB Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers” – In May 2014, the Financial Accounting Standards Board (the “FASB”) amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. The Company adopted ASU 2014-09 and all subsequent amendments to the ASU (collectively referred to as Topic 606) on January 1, 2018. Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and investment securities. In addition, certain noninterest income streams such as commercial FHA revenue, residential mortgage banking revenue and gain on sales of investment securities, net are also not in scope of the new guidance. Topic 606 is applicable to noninterest income streams such as wealth management revenue, service charges on deposit accounts, interchange revenue, gain on sales of other real estate owned, and certain other noninterest income streams. The impact of applying this standard to the Company’s consolidated financial statements was determined to be immaterial because the Company’s revenue recognition pattern for revenue streams within the scope of ASU 2014-09 did not change significantly from prior practice. We elected to implement this standard using the modified retrospective approach, with the cumulative effect recorded as an adjustment to opening retained earnings at January 1, 2018. Since the impact of applying the standard was determined to be immaterial, the Company did not record a cumulative effect adjustment to beginning retained earnings on January 1, 2018. See “Note 17 – Revenue from Contracts with Customers” for further discussion on the Company’s policies for revenue sources within the scope of Topic 606.
FASB ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities.” – In January 2016, the FASB issued this standard, which is intended to improve the recognition and measurement of financial instruments. This standard, among other things: (i) requires equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (iii) eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (iv) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (v) requires an entity to present separately, in other comprehensive income, the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (vi) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and (vii) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities. The adoption of ASU No. 2016-01 on January 1, 2018 did not have a material impact on the Company’s consolidated financial statements. See “Note 14 – Fair Value of Financial Instruments” regarding the valuation of the loan portfolio.
FASB ASU 2016-02, “Leases (Topic 842)” – In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” This update revises the model to assess how a lease should be classified and provides guidance for lessees and lessors, when presenting right-of-use assets and lease liabilities on the balance sheet. Under the new guidance, lessees will be required to recognize the following for all leases, with the exception of short-term leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. This update is effective for us on January 1, 2019, with early adoption permitted. A modified retrospective transition approach is required for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the consolidated financial statements, with certain practical expedients available. In July 2018, the FASB issued supplementary ASU No. 2018-11, which provides for an additional transition method permitting application of the new leases standard at the beginning of the year of adoption. The Company developed and is currently executing on a project plan for implementing the provisions of the new lease standard. While we have not yet determined the overall impact of the new guidance on the Company’s consolidated financial statements, we expect to report increased assets and liabilities on our consolidated statement of financial condition as a result of recognizing right-of-use assets and lease liabilities related to non-cancelable operating lease agreements for office space, which currently are not on our consolidated statement of financial condition.
7
FASB ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” – In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The objective of this update is to improve financial reporting by providing timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will use forward-looking information to better understand their credit loss estimates. For public companies that are filers with the SEC, this update is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early application is permitted for any organization for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company has formed a cross functional committee that has overseen the enhancement of existing technology required to source and model data for the purposes of meeting this standard. The committee has finalized the contract with a vendor to assist in generating loan level cash flows and disclosures. The vendor has started the process of uploading loan level historical data into their system. While the Company generally expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, the Company cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the Company’s consolidated financial statements. The Company is continuing to evaluate the potential impact on the Company’s consolidated balance sheets.
FASB ASU 2017-02, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” – In August 2017, the FASB issued this standard, the objectives of which are to: (1) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities; and (2) reduce the complexity of and simplify the application of hedge accounting by preparers. This standard is effective for interim and annual reporting periods beginning after December 15, 2018; early adoption is permitted. The Company currently does not designate any derivative financial instruments as formal hedging relationships, and therefore, does not utilize hedge accounting. However, the Company is currently evaluating this standard to determine whether its provisions will enhance the Company’s ability to employ risk management strategies, while improving the transparency and understanding of those strategies for financial statement users.
FASB ASU 2018-02, “Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” – In February 2018, ASU 2018-02 was issued following the enactment of the Tax Cuts and Jobs Act, which changed the Company’s maximum federal income tax rate from 35% to 21% effective starting in 2018. This standard allows an entity to elect a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. The standard is effective for periods beginning after December 15, 2018 although early adoption is permitted. The impact of this ASU on the Company’s consolidated financial statements was not material.
Note 3 – Acquisitions
Alpine Bancorporation, Inc.
On February 28, 2018, the Company completed its acquisition of Alpine and its banking subsidiary, Alpine Bank, which operated 19 locations in northern Illinois. In the aggregate, the Company acquired Alpine for consideration valued at approximately $173.2 million, which consisted of approximately $33.3 million in cash and the issuance of 4,463,200 shares of the Company’s common stock. The acquisition was accounted for under the acquisition method of accounting. Accordingly, the Company recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values, while $22.0 million of transaction and integration costs associated with the acquisition have been expensed during 2017 and the first nine months of 2018, and remaining integration costs will be expensed in future periods as incurred.
Management’s preliminary valuation of the tangible and intangible assets acquired and liabilities assumed, which are based on assumptions that are subject to change, and the resulting allocation of the consideration paid for the allocation is reflected in the table below. Prior to the end of the one-year measurement period for finalizing the consideration paid allocation, if information becomes available which would indicate adjustments are required to the allocation, such adjustments will be included in the allocation in the reporting period in which the adjustment amounts are determined.
8
Centrue Financial Corporation
On June 9, 2017, the Company completed its acquisition of Centrue Financial Corporation (“Centrue”) and its banking subsidiary, Centrue Bank, which operated 20 full-service banking centers located principally in northern Illinois. In the aggregate, the Company acquired Centrue for consideration valued at approximately $176.6 million, which consisted of approximately $61.0 million in cash and the issuance of 3,219,238 shares of the Company’s common stock, 181 shares of Series G preferred stock and 2,635.5462 shares of Series H preferred stock. The acquisition was accounted for under the acquisition method of accounting. Accordingly, the Company recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values, while $17.8 million of transaction and integration costs associated with the acquisition have been expensed during 2017 and the first nine months of 2018.
As of June 30, 2018, the Company finalized its valuation of all assets acquired and liabilities assumed in its acquisition of Centrue, resulting in no material change to acquisition accounting adjustments. A summary of the fair value of the assets acquired, liabilities assumed and resulting goodwill are included in the table below.
Alpine
Centrue
Assets acquired:
69,459
42,461
Investment securities, at fair value
301,800
149,013
786,186
679,582
3,416
531
Premises and equipment
18,126
17,147
53
4,983
2,038
8,168
4,414
2,376
Mortgage servicing rights
1,933
3,942
27,400
11,070
22,578
36,349
34,339
4,770
2,256
Total assets acquired
1,244,182
990,208
Liabilities assumed:
1,111,130
739,867
14,434
18,127
95,332
7,565
539
275
Deferred tax liabilities, net
1,994
4,500
3,600
Total liabilities assumed
1,136,290
861,073
Net assets acquired
107,892
129,135
65,335
47,444
Total consideration paid
173,227
176,579
Intangible assets:
Core deposit intangible
21,100
Customer relationship intangible
6,300
Total intangible assets
Estimated useful lives:
13 years
8 years
N/A
Goodwill arising from the acquisitions consists largely of the synergies and economies of scale expected from combining the operations of Alpine and Centrue into the Company. The goodwill is assigned as part of the Company’s banking reporting unit. The portion of the consideration paid allocated to goodwill will not be deductible for tax purposes.
The identifiable assets acquired from Alpine and Centrue included core deposit intangibles and customer relationship intangibles, which are being amortized on an accelerated basis as shown above.
Acquired loan data for Alpine and Centrue can be found in the table below:
Best Estimate at
Acquisition Date of
Fair Value
Gross Contractual
Contractual Cash
of Acquired Loans
Amounts Receivable
Flows Not Expected
at Acquisition Date
to be Collected
Alpine:
Acquired receivables subject to ASC 310-30
34,993
50,342
9,254
Acquired receivables not subject to ASC 310-30
751,193
774,836
4,244
Centrue:
11,381
20,523
7,227
668,201
821,338
4,835
The unaudited pro-forma financial information below for the three and nine months ended September 30, 2018 and 2017 gives effect to the Alpine acquisition as if it had occurred on January 1, 2017, which combines the historical results of Alpine with the Company’s consolidated statements of income, adjusted for the impact of the application of the acquisition method of accounting including loan discount accretion, intangible assets amortization, and deposit premium accretion, net of taxes. The unaudited pro-forma financial information also gives effect to the Centrue acquisition that closed on June 9, 2017 as if that transaction became effective January 1, 2017. The unaudited pro-forma financial information has been prepared for comparative purposes only and is not necessarily indicative of the results of operations had the acquisition actually occurred on January 1, 2017. No assumptions have been applied regarding revenue enhancements, expense efficiencies or asset dispositions. Only the acquisition related expenses that have been incurred as of September 30, 2018 are included in net income in the table below. Acquisition related expenses associated with Alpine that were recognized and are included in the unaudited pro-forma net income for the three and nine months ended September 30, 2018 totaled $9.1 million and $21.1 million, respectively, on a pre-tax basis.
Revenue(1)
63,353
69,594
194,910
210,873
5,196
25,656
25,278
0.21
1.05
1.04
(1)
Net interest income plus noninterest income
Note 4 – Investment Securities
Investment securities as of September 30, 2018 and December 31, 2017 were as follows:
September 30, 2018
Gross
Amortized
unrealized
Fair
cost
gains
losses
value
Available for sale securities
U.S. Treasury securities
25,028
495
24,533
Government sponsored entity debt securities
76,841
18
1,486
75,373
Agency mortgage-backed securities
349,501
573
6,377
343,697
State and municipal securities
169,887
2,634
1,509
171,012
Corporate securities
67,652
910
781
67,781
Total available for sale securities
688,909
4,135
10,648
Equity securities(1)
10
December 31, 2017
28,005
287
27,718
25,445
41
25,211
233,606
882
2,101
232,387
99,449
3,632
514
102,567
58,904
1,087
179
59,812
2,715
140
25
2,830
448,124
5,782
3,381
As a result of accounting guidance adopted in the first quarter of 2018, equity securities are no longer presented within available for sale securities and are now presented within equity securities in the consolidated balance sheets for the current period. For further discussion of this guidance, see Note 2 to the consolidated financial statements.
Unrealized losses and fair values for investment securities available for sale as of September 30, 2018 and December 31, 2017, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are summarized as follows:
Less than 12 Months
12 Months or more
Unrealized
loss
5,020
19,513
493
59,562
777
15,010
709
74,572
217,907
3,612
60,798
2,765
278,705
82,326
891
15,619
618
97,945
28,831
443
4,214
338
33,045
393,646
5,725
115,154
4,923
508,800
19,758
251
7,960
36
24,168
124,192
1,500
19,530
601
143,722
29,338
5,889
183
35,227
5,917
85
3,463
94
9,380
2,603
205,976
2,467
36,842
914
242,818
For all of the above investment securities, the unrealized losses are generally due to changes in interest rates and unrealized losses are considered to be temporary as the fair value is expected to recover as the securities approach maturity date.
We evaluate securities for other-than-temporary impairment (“OTTI”) on a quarterly basis, at a minimum, and more frequently when economic or market concerns warrant such evaluation. In estimating OTTI losses, we consider the severity and duration of the impairment; the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; and the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value.
11
At September 30, 2018, 393 investment securities available for sale had unrealized losses with aggregate depreciation of 2.1% from their amortized cost basis. The unrealized losses relate principally to the fluctuations in the current interest rate environment. In analyzing an issuer’s financial condition, we consider whether the securities are issued by the federal government or its agencies and whether downgrades by bond rating agencies have occurred. The Company does not have the intent to sell and it is not more likely than not that it will be required to sell a security in an unrealized loss position prior to recovery in value; therefore, the Company does not consider these securities to be other than temporarily impaired at September 30, 2018.
For the three and nine months ended September 30, 2018 and 2017, the Company did not recognize OTTI losses on its investment securities.
The following is a summary of the amortized cost and fair value of the available-for-sale investment securities, by maturity, at September 30, 2018. The maturities of agency and non-agency mortgage-backed securities are based on expected maturities. Expected maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be prepaid without penalties. The maturities of all other available-for-sale investment securities are based on final contractual maturity.
Within one year
51,775
51,705
After one year through five years
419,588
414,879
After five years through ten years
177,434
175,784
After ten years
40,112
40,028
Proceeds from the sale of investment securities available for sale were $16.8 million for the nine months ended September 30, 2018. There were no sales of investment securities available for sale during the three months ended September 30, 2018. Gross realized gains from the sale of securities available for sale were $73,000 for the nine months ended September 30, 2018. There were $25,000 gross realized losses for the nine months ended September 30, 2018.
Proceeds from the sale of investment securities available for sale were $2.7 million and $11.3 million for the three and nine months ended September 30, 2017, respectively. Gross realized gains from the sale of securities available for sale were $98,000 and $219,000 for the three and nine months ended September 30, 2017, respectively. There were no gross realized losses for the three and nine months ended September 30, 2017.
Proceeds from the sale of equity securities were $7.8 million for the nine months ended September 30, 2018. There were no sales of equity securities during the three months ended September 30, 2018. Gross realized losses from the sale of equity securities were $53,000 for the nine months ended September 30, 2018. There were no gross realized gains for the nine months ended September 30, 2018. During the three months ended September 30, 2018, the Company recognized net unrealized losses of $67,000 and for the nine months ended September 30, 2018, the Company recognized net unrealized gains of $26,000, which was recorded in noninterest income in the consolidated statements of income.
12
Note 5 – Loans
The following table presents total loans outstanding by portfolio, which includes non-purchased credit impaired (“Non-PCI”) loans and purchased credit impaired (“PCI”) loans, as of September 30, 2018 and December 31, 2017:
Non-PCI
PCI
Loans(1)
Commercial
785,859
5,688
791,547
553,257
2,673
555,930
Commercial real estate
1,692,143
19,783
1,711,926
1,427,076
12,935
1,440,011
Construction and land development
230,913
8,567
239,480
199,853
734
200,587
Total commercial loans
2,708,915
34,038
2,742,953
2,180,186
16,342
2,196,528
Residential real estate
576,259
9,875
586,134
447,602
5,950
453,552
Consumer
582,161
2,035
584,196
371,286
169
371,455
Lease financing
242,999
205,143
Total loans
4,110,334
45,948
3,204,217
22,461
The unpaid principal balance for PCI loans totaled $60.7 million and $32.8 million as of September 30, 2018 and December 31, 2017, respectively.
Total loans include net deferred loan fees of $15.4 million and $10.1 million at September 30, 2018 and December 31, 2017, respectively, and unearned discounts of $25.4 million and $20.7 million within the lease financing portfolio at September 30, 2018 and December 31, 2017, respectively.
At September 30, 2018 and December 31, 2017, the Company had commercial and residential loans held for sale totaling $35.2 million and $50.1 million, respectively. During the three and nine months ended September 30, 2018, the Company sold commercial and residential real estate loans with proceeds totaling $155.0 million and $424.9 million, respectively, and sold commercial and residential real estate loans with proceeds totaling $206.2 million and $679.2 million for the comparable periods in 2017, respectively.
We have extended loans to certain of our directors, executive officers, principal shareholders and their affiliates. The aggregate loans outstanding to the directors, executive officers, principal shareholders and their affiliates totaled $25.6 million and $22.4 million at September 30, 2018 and December 31, 2017, respectively. During the three and nine months ended September 30, 2018, there were $6.9 million and $8.6 million, respectively, of new loans and other additions, while repayments and other reductions totaled $1.7 million and $5.4 million, respectively.
Credit Quality Monitoring
The Company maintains loan policies and credit underwriting standards as part of the process of managing credit risk. These standards include making loans generally within the Company’s four main regions, which include eastern, northern and southern Illinois and the St. Louis metropolitan area. Our equipment leasing business provides financing to business customers across the country.
The Company has a loan approval process involving underwriting and individual and group loan approval authorities to consider credit quality and loss exposure at loan origination. The loans in the Company’s commercial loan portfolio are risk rated at origination based on the grading system set forth below. All loan authority is based on the aggregate credit to a borrower and its related entities.
The Company’s consumer loan portfolio is primarily comprised of both secured and unsecured loans that are relatively small and are evaluated at origination on a centralized basis against standardized underwriting criteria. The ongoing measurement of credit quality of the consumer loan portfolio is largely done on an exception basis. If payments are made on schedule, as agreed, then no further monitoring is performed. However, if delinquency occurs, the delinquent loans are turned over to the Company’s Consumer Collections Group for resolution. Credit quality for the entire consumer loan portfolio is measured by the periodic delinquency rate, nonaccrual amounts and actual losses incurred.
Loans in the commercial loan portfolio tend to be larger and more complex than those in the other loan portfolio, and therefore, are subject to more intensive monitoring. All loans in the commercial loan portfolio have an
13
assigned relationship manager, and most borrowers provide periodic financial and operating information that allows the relationship managers to stay abreast of credit quality during the life of the loans. The risk ratings of loans in the commercial loan portfolio are reassessed at least annually, with loans below an acceptable risk rating reassessed more frequently and reviewed by various individuals within the Company at least quarterly.
The Company maintains a centralized independent loan review function that monitors the approval process and ongoing asset quality of the loan portfolio, including the accuracy of loan grades. The Company also maintains an independent appraisal review function that participates in the review of all appraisals obtained by the Company.
Credit Quality Indicators
The Company uses a ten grade risk rating system to monitor the ongoing credit quality of its commercial loan portfolio. These loan grades rank the credit quality of a borrower by measuring liquidity, debt capacity, and coverage and payment behavior as shown in the borrower’s financial statements. The risk grades also measure the quality of the borrower’s management and the repayment support offered by any guarantors.
The Company considers all loans with Risk Grades of 1 – 6 as acceptable credit risks and structures and manages such relationships accordingly. Periodic financial and operating data combined with regular loan officer interactions are deemed adequate to monitor borrower performance. Loans with Risk Grades of 7 are considered “watch credits” and the frequency of loan officer contact and receipt of financial data is increased to stay abreast of borrower performance. Loans with Risk Grades of 8 – 10 are considered problematic and require special care. Further, loans with Risk Grades of 7 – 10 are managed and monitored regularly through a number of processes, procedures and committees, including oversight by a loan administration committee comprised of executive and senior management of the Company, which includes highly structured reporting of financial and operating data, intensive loan officer intervention and strategies to exit, as well as potential management by the Company’s Special Assets Group. Loans not graded in the commercial loan portfolio are monitored by aging status and payment activity.
The following table presents the recorded investment of the commercial loan portfolio (excluding PCI loans) by risk category as of September 30, 2018 and December 31, 2017:
Construction
Real
and Land
Estate
Development
Acceptable credit quality
735,936
1,606,393
229,411
2,571,740
510,928
1,384,630
191,872
2,087,430
Special mention
22,686
35,310
44
58,040
12,290
11,497
23,787
Substandard
18,849
31,278
50,127
14,695
42,413
Substandard – nonaccrual
8,388
19,162
1,239
28,789
1,266
12,482
785
14,533
Doubtful
Not graded
1,055
3,772
7,196
12,023
Total (excluding PCI)
The Company evaluates the credit quality of its other loan portfolio based primarily on the aging status of the loan and payment activity. Accordingly, loans on nonaccrual status, loans past due 90 days or more and still accruing interest, and loans modified under troubled debt restructurings are considered to be impaired for purposes of credit quality evaluation. The following table presents the recorded investment of our other loan portfolio (excluding PCI loans) based on the credit risk profile of loans that are performing and loans that are impaired as of September 30, 2018 and December 31, 2017:
Residential
Lease
Real Estate
Financing
Performing
569,716
581,635
242,302
1,393,653
441,418
370,999
203,797
1,016,214
Impaired
6,543
526
697
7,766
6,184
1,346
7,817
1,401,419
1,024,031
14
Impaired Loans
Impaired loans include loans on nonaccrual status, loans past due 90 days or more and still accruing interest and loans modified under troubled debt restructurings. Impaired loans at September 30, 2018 and December 31, 2017 do not include $45.9 million and $22.5 million, respectively, of PCI loans. The risk of credit loss on acquired loans was recognized as part of the fair value adjustment at the acquisition date.
There was no interest income recognized on nonaccrual loans during the three and nine months ended September 30, 2018 and 2017 while the loans were in nonaccrual status. Additional interest income that would have been recorded on nonaccrual loans had they been current in accordance with their original terms was $421,000 and $1.3 million for the three and nine months ended September 30, 2018, respectively, and $124,000 and $532,000 for the three and nine months ended September 30, 2017, respectively. The Company recognized interest income on commercial and commercial real estate loans modified under troubled debt restructurings of $17,000 and $75,000 for the three and nine months ended September 30, 2018, respectively, and $40,000 and $59,000 for the comparable periods in 2017, respectively.
The following table presents impaired loans (excluding PCI loans) by portfolio and related valuation allowance as of September 30, 2018 and December 31, 2017:
Unpaid
Related
Recorded
Principal
Valuation
Investment
Balance
Allowance
Impaired loans with a valuation allowance:
2,994
3,066
2,401
3,237
3,297
6,939
13,179
576
2,297
3,508
329
103
3,875
4,506
589
4,028
4,705
566
513
532
58
266
279
29
698
296
1,064
345
Total impaired loans with a valuation allowance
15,197
22,160
3,938
10,995
12,955
1,805
Impaired loans with no related valuation allowance:
5,891
9,204
866
13,679
14,216
11,700
17,359
1,113
740
780
2,668
2,943
2,156
2,380
21
282
Total impaired loans with no related valuation allowance
23,364
27,490
15,765
26,604
Total impaired loans:
8,885
12,270
4,103
9,079
20,618
27,395
13,997
20,867
1,292
843
7,449
7,085
546
300
Total impaired loans (excluding PCI)
38,561
49,650
26,760
39,559
The difference between a loan’s recorded investment and the unpaid principal balance represents: (1) a partial charge-off resulting from a confirmed loss due to the value of the collateral securing the loan being below the loan’s principal balance and management’s assessment that the full collection of the loan balance is not likely and (2) payments received on nonaccrual loans that are fully applied to principal on the loan’s recorded investment as compared to being applied to principal and interest on the unpaid customer principal and interest balance. The difference between the recorded investment and the unpaid principal balance on loans was $11.0 million and $12.8 million at September 30, 2018 and December 31, 2017, respectively. Interest income recognized on impaired loans during the three and nine months ended September 30, 2018 and 2017 was immaterial.
15
The aging status of the recorded investment in loans by portfolio (excluding PCI loans) as of September 30, 2018 and December 31, 2017 were as follows:
Accruing Loans
30-59
60-89
Past Due
Days
90 Days
Nonaccrual
or More
Current
2,508
2,628
13,525
772,334
1,995
276
793
22,226
1,669,917
2,590
3,829
227,084
1,271
1,462
150
5,600
8,483
567,776
3,974
2,292
33
327
6,626
575,535
2,933
749
26
671
4,379
238,620
15,271
7,407
1,003
35,387
59,068
4,051,266
3,282
177
2,538
7,263
545,994
3,116
630
16,228
1,410,848
1,953
2,738
197,115
897
632
51
5,204
6,784
440,818
2,824
1,502
234
4,613
366,673
392
1,738
203,405
12,464
2,941
2,642
21,317
39,364
3,164,853
Troubled Debt Restructurings
Loans modified as TDRs for commercial and commercial real estate loans generally consist of allowing commercial borrowers to defer scheduled principal payments and make interest only payments for a specified period of time at the stated interest rate of the original loan agreement or lower payments due to a modification of the loans’ contractual terms. TDRs that continue to accrue interest and are greater than $50,000 are individually evaluated for impairment on a quarterly basis, and transferred to nonaccrual status when it is probable that any remaining principal and interest payments due on the loan will not be collected in accordance with the contractual terms of the loan. TDRs that subsequently default are individually evaluated for impairment at the time of default. The allowance for loan losses on TDRs totaled $455,000 and $240,000 as of September 30, 2018 and December 31, 2017, respectively. The Company had no unfunded commitments in connection with TDRs at September 30, 2018 and December 31, 2017.
The Company’s TDRs are identified on a case-by-case basis in connection with the ongoing loan collection processes. The following table presents TDRs by loan portfolio (excluding PCI loans) as of September 30, 2018 and December 31, 2017:
Accruing (1)
Non-accrual (2)
496
517
299
663
9,567
10,230
1,515
9,915
11,430
386
1,179
929
1,211
166
Total loans (excluding PCI)
2,171
9,974
12,145
2,801
10,197
12,998
These loans are still accruing interest.
(2)
These loans are included in non-accrual loans in the preceding tables.
16
The following table presents a summary of loans by portfolio that were restructured during the three and nine months ended September 30, 2018 and the loans by portfolio that were modified as TDRs within the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2018:
Commercial Loan Portfolio
Other Loan Portfolio
For the three months ended September 30, 2018:
Troubled debt restructurings:
Number of loans
Pre-modification outstanding balance
Post-modification outstanding balance
Troubled debt restructurings that subsequently defaulted
Recorded balance
For the nine months ended September 30, 2018:
23
212
19
254
207
248
17
The following table presents a summary of loans by portfolio that were restructured during the three and nine months ended September 30, 2017 and the loans by portfolio that were modified as TDRs within the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2017:
For the three months ended September 30, 2017:
91
90
For the nine months ended September 30, 2017:
362
475
837
339
474
813
The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion of the debt was forgiven. Loans modified as a TDR that were fully paid down, charged-off or foreclosed upon during the period ended are not reported.
Purchased Credit Impaired Loans
The Company has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.
Accretable yield of PCI loans, or income expected to be collected, was as follows:
Balance, at beginning of period
11,114
7,566
5,732
9,035
New loans purchased – Alpine acquisition
6,095
New loans purchased – Centrue acquisition
Accretion
(1,308)
(1,270)
(3,659)
(4,276)
Other adjustments (including maturities, charge-offs and impact of changes in timing of expected cash flows)
136
1,678
1,150
(1,558)
Reclassification from non-accretable
1,350
(1,325)
1,974
1,519
Balance, at end of period
11,292
6,649
Accretion recorded as loan interest income totaled $1.3 million and $3.7 million during the three and nine months ended September 30, 2018, respectively and $1.3 million and $4.3 million during the three and nine months ended September 30, 2017, respectively.
Allowance for Loan Losses
The Company’s loan portfolio is principally comprised of commercial, commercial real estate, construction and land development, residential real estate and consumer loans and lease financing receivables. The principal risks to each category of loans are as follows:
Commercial – The principal risk of commercial loans is that these loans are primarily made based on the identified cash flow of the borrower and secondarily on the collateral underlying the loans. Most often, this collateral consists of accounts receivable, inventory and equipment. Inventory and equipment may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. If the cash flow from business operations is reduced, the borrower’s ability to repay the loan may be impaired. As such, repayment of such loans is often more sensitive than other types of loans to adverse conditions in the general economy.
Commercial real estate – As with commercial loans, repayment of commercial real estate loans is often dependent on the borrower’s ability to make repayment from the cash flow of the commercial venture. While commercial real estate loans are collateralized by the borrower’s underlying real estate, foreclosure on such assets may be more difficult than with other types of collateralized loans because of the possible effect the foreclosure would have on the borrower’s business, and property values may tend to be partially based upon the value of the business situated on the property.
Construction and land development – Construction and land development lending involves additional risks not generally present in other types of lending because funds are advanced upon the estimated future value of the project, which is uncertain prior to its completion and at the time the loan is made, and costs may exceed realizable values in declining real estate markets. Moreover, if the estimate of the value of the completed project proves to be overstated or market values or rental rates decline, the collateral may prove to be inadequate security for the repayment of the loan. Additional funds may also be required to complete the project, and the project may have to be held for an unspecified period of time before a disposition can occur.
Residential real estate – The principal risk to residential real estate lending is associated with residential loans not sold into the secondary market. In such cases, the value of the underlying property may have deteriorated as a result of a change in the residential real estate market, and the borrower may have little incentive to repay the loan or continue living in the property. Additionally, in areas with high vacancy rates, reselling the property without substantial loss may be difficult.
Consumer – The repayment of consumer loans is typically dependent on the borrower remaining employed through the life of the loan, as well as the possibility that the collateral underlying the loan, if applicable, may not be adequately maintained by the borrower.
Lease financing – Our financing leases are primarily for business equipment leased to varying types of businesses, nationwide, for the purchase of business equipment and software. If the cash flow from business operations is reduced, the business’s ability to repay may become impaired.
The following table represents, by loan portfolio, a summary of changes in the allowance for loan losses for the three and nine months ended September 30, 2018 and 2017:
Changes in allowance for loan losses for the three months ended September 30, 2018:
Balance, beginning of period
6,203
5,377
505
2,742
1,629
1,790
18,246
1,117
(41)
(268)
727
666
Charge-offs
(69)
(453)
(816)
(1,338)
Recoveries
202
160
620
Balance, end of period
7,568
5,284
436
2,438
2,105
1,800
19,631
Changes in allowance for loan losses for the three months ended September 30, 2017:
5,381
3,996
147
1,385
1,138
15,424
(745)
55
(433)
(92)
(11)
(128)
(105)
(335)
47
81
283
4,690
6,767
215
2,863
1,269
1,057
16,861
Changes in allowance for loan losses for the nine months ended September 30, 2018:
5,256
5,044
518
2,750
1,344
16,431
2,908
(156)
(250)
1,554
1,752
(1,145)
(259)
(209)
(1,236)
(1,775)
(4,624)
344
74
304
1,861
Changes in allowance for loan losses for the nine months ended September 30, 2017:
5,920
3,225
2,929
930
1,513
(630)
3,577
(178)
678
(80)
(737)
(470)
(455)
(536)
(658)
(2,856)
137
435
48
197
1,375
20
The following table represents, by loan portfolio, details regarding the balance in the allowance for loan losses and the recorded investment in loans as of September 30, 2018 and December 31, 2017 by impairment evaluation method:
September 30, 2018:
Allowance for loan losses:
Loans individually evaluated for impairment
2,375
516
285
252
Loans collectively evaluated for impairment
60
492
Non-impaired loans collectively evaluated for impairment
4,599
4,285
418
1,339
1,898
1,504
14,043
Loans acquired with deteriorated credit quality (1)
568
423
510
149
1,650
Total allowance for loan losses
Recorded investment (loan balance):
Impaired loans individually evaluated for impairment
8,632
20,055
1,166
33,626
Impaired loans collectively evaluated for impairment
253
563
3,063
417
4,935
776,974
1,671,525
229,621
4,071,773
Total recorded investment (loan balance)
December 31, 2017:
221
281
302
261
264
84
735
4,230
504
1,644
1,174
13,097
500
336
1,529
1,285
13,554
797
3,700
19,908
2,818
2,484
778
6,852
549,154
1,413,079
199,010
3,177,457
Loans acquired with deteriorated credit quality were originally recorded at fair value at the acquisition date and the risk of credit loss was recognized at that date based on estimates of expected cash flows.
Note 6 – Premises and Equipment, Net
A summary of premises and equipment as of September 30, 2018 and December 31, 2017 is as follows:
Land
20,231
16,109
Buildings and improvements
75,507
63,837
Furniture and equipment
29,236
25,843
124,974
105,789
Accumulated depreciation
(29,912)
(29,627)
Depreciation expense was recorded at $1.5 million and $4.6 million for the three and nine months ended
September 30, 2018, respectively. Depreciation expense was recorded at $1.3 million and $3.7 million for the three and nine months ended September 30, 2017, respectively.
Note 7 – Mortgage Servicing Rights
The Company services both residential and commercial FHA mortgage loans for others. At September 30, 2018 and December 31, 2017, the Company serviced commercial FHA mortgage loans for others with unpaid principal balances of approximately $3.93 billion and $3.98 billion, respectively.
Changes in our commercial FHA mortgage servicing rights were as follows for the three and nine months ended September 30, 2018 and 2017:
Mortgage servicing rights:
56,268
54,315
55,714
52,006
Originated servicing
176
1,433
2,087
Amortization
(633)
(650)
(1,990)
(1,928)
55,811
55,098
Valuation allowances:
3,887
3,254
1,711
Impairment
104
1,143
4,185
2,854
Mortgage servicing rights, net
52,244
Fair value:
At beginning of period
52,381
51,565
52,460
50,355
At end of period
The following table is a summary of key assumptions, representing both general economic and other published information and the weighted average characteristics of the commercial and residential portfolios, used in the valuation of servicing rights at September 30, 2018 and December 31, 2017. Assumptions used in the prepayment rate consider many factors as appropriate, including lockouts, balloons, prepayment penalties, interest rate ranges, delinquencies and geographic location. The discount rate is based on an average pre‑tax internal rate of return utilized by market participants in pricing the servicing portfolios. Significant increases or decreases in any one of these assumptions would result in a significantly lower or higher fair value measurement.
Remaining
Servicing
Interest
Years to
Prepayment
Discount
Fee
Rate
Maturity
Cost
Commercial FHA mortgage loans
0.13
%
3.66
30.2
8.25
1,000
11.02
0.12
3.67
30.3
8.27
We recognize revenue from servicing commercial FHA and residential mortgages as earned based on the specific contractual terms. This revenue, along with amortization of and changes in impairment on servicing rights, is reported in commercial FHA revenue and residential mortgage banking revenue in the consolidated statements of income. Mortgage servicing rights do not trade in an active market with readily observable prices. The fair value of mortgage servicing rights and their sensitivity to changes in interest rates is influenced by the mix of the servicing portfolio and characteristics of each segment of the portfolio. The Company’s servicing portfolio consists of the distinct portfolios of government-insured residential and commercial mortgages and conventional residential mortgages. The fair value of our servicing rights is estimated by using a cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, cost to service, contractual servicing fee income, ancillary income, late fees, replacement reserves and other economic factors that are determined based on current market conditions.
At September 30, 2018 and December 31, 2017, the Company serviced residential mortgage loans for others with unpaid principal balances of approximately $1.35 billion and $1.99 billion, respectively. During the year ended
December 31, 2017, the Company recognized a $4.1 million loss to reflect certain residential mortgage servicing rights classified as held for sale at the lower of their carrying value or fair value less estimated costs to sell. On January 2, 2018, the Company sold its $10.2 million of residential mortgage servicing rights held for sale. Subsequent to this sale, the Company transferred all remaining residential mortgage servicing rights, net of valuation allowances, to mortgage servicing rights held for sale. At September 30, 2018, residential mortgage servicing rights total $4.4 million are reflected in the consolidated balance sheet as mortgage servicing rights held for sale.
Note 8 – Goodwill and Intangible Assets
At September 30, 2018 and December 31, 2017, goodwill totaled $164.0 million and $98.6 million, respectively, reflecting an increase of approximately $65.3 million as a result of the acquisition of Alpine on February 28, 2018, as further discussed in Note 3 to the consolidated financial statements.
The Company’s intangible assets, consisting of core deposit and customer relationship intangibles, as of September 30, 2018 and December 31, 2017 are summarized as follows:
Carrying
Amount
Core deposit intangibles
52,712
(23,262)
29,450
31,612
(18,943)
12,669
Customer relationship intangibles
13,771
(3,993)
9,778
7,471
(3,208)
4,263
66,483
(27,255)
39,083
(22,151)
In conjunction with the acquisition of Alpine on February 28, 2018, we recorded $21.1 million of core deposit intangibles and $6.3 million of customer relationship intangibles, which are both being amortized on an accelerated basis over an estimated useful life of 13 years, as further discussed in Note 3 to the consolidated financial statements.
Amortization of intangible assets was $1.9 million and $5.1 million for the three and nine months ended September 30, 2018, respectively, and $1.2 million and $2.3 million for the comparable periods in 2017, respectively.
Note 9 – Derivative Instruments
As part of the Company’s overall management of interest rate sensitivity, the Company utilizes derivative instruments to minimize significant, unanticipated earnings fluctuations caused by interest rate volatility, including interest rate lock commitments and forward commitments to sell mortgage-backed securities.
Interest Rate Lock Commitments / Forward Commitments to Sell Mortgage-Backed Securities
Derivative instruments issued by the Company consist of interest rate lock commitments to originate fixed-rate loans to be sold. Commitments to originate fixed-rate loans consist of commercial and residential real estate loans. The interest rate lock commitments and loans held for sale are hedged with forward contracts to sell mortgage-backed securities. The fair value of the interest rate lock commitments and forward contracts to sell mortgage-backed securities are included in other assets or other liabilities in the consolidated balance sheets. Changes in the fair value of derivative financial instruments are recognized in commercial FHA revenue and residential mortgage banking revenue in the consolidated statements of income.
The following table summarizes the interest rate lock commitments and forward commitments to sell mortgage-backed securities held by the Company, their notional amount, estimated fair values and the location in which the derivative instruments are reported in the consolidated balances sheets at September 30, 2018 and December 31, 2017:
Notional Amount
Fair Value Gain
Derivative Instruments (included in Other Assets):
Interest rate lock commitments
315,741
345,152
5,503
6,331
Forward commitments to sell mortgage-backed securities
316,300
372,824
632,041
717,976
6,362
Net gains of $1.2 million and net losses of $941,000 were recognized on derivative instruments for the three
and nine months ended September 30, 2018, respectively. Net losses of $1.1 million and net gains of $48,000 were recognized on derivative instruments for the three and nine months ended September 30, 2017, respectively. Net gains and losses on derivative instruments were recognized in commercial FHA revenue and residential mortgage banking revenue in the consolidated statements of income.
Interest Rate Swap Contracts
The Company entered into derivative instruments related to interest rate swap contracts sold to commercial customers who wish to modify their interest rate sensitivity. These swaps are offset by contracts simultaneously purchased by the Company from other financial dealer institutions with mirror-image terms. Because of the mirror-image terms of the offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in the fair value subsequent to initial recognition have a minimal effect on earnings. These derivative contracts do not qualify for hedge accounting.
The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $9.6 million at September 30, 2018 and $10.0 million at December 31, 2017. The fair value of the customer derivative instruments and the offsetting counterparty derivative instruments was $390,000 at September 30, 2018 and $17,000 at December 31, 2017, which are included in other assets and other liabilities, respectively, on the consolidated balance sheets.
Note 10 – Deposits
The following table summarizes the classification of deposits as of September 30, 2018 and December 31, 2017:
Noninterest-bearing demand
Interest-bearing:
Checking
1,047,914
785,934
Money market
836,151
646,426
Savings
445,640
281,212
Time
822,190
693,074
Note 11 – Short-Term Borrowings
The following table presents the distribution of short-term borrowings and related weighted average interest rates as of September 30, 2018 and December 31, 2017:
Repurchase Agreements
Outstanding at period-end
Average amount outstanding
136,203
163,461
Maximum amount outstanding at any month end
173,387
196,278
Weighted average interest rate:
During period
0.44
0.23
0.63
0.28
Securities sold under agreements to repurchase, which are classified as secured borrowings, 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, which represents the amount of the Bank’s obligation. The Bank may be required to provide additional collateral based on the fair value of the underlying securities. Investment securities with a carrying amount of $146.4 million and $157.2 million at September 30, 2018 and December 31, 2017, respectively, were pledged for securities sold under agreements to repurchase.
The Company had available lines of credit of $68.4 million and $32.5 million at September 30, 2018 and December 31, 2017, respectively, from the Federal Reserve Discount Window. The lines are collateralized by collateral
24
agreements totaling $78.9 million and $36.5 million at September 30, 2018 and December 31, 2017, respectively. There were no outstanding borrowings under these lines of credit at September 30, 2018 and December 31, 2017.
At September 30, 2018, the Company had available federal funds lines of credit totaling $55.0 million. The lines of credit were unused at September 30, 2018.
Note 12 – FHLB Advances and Other Borrowings
The following table summarizes our Federal Home Loan Bank (“FHLB”) advances and other borrowings as of September 30, 2018 and December 31, 2017:
Midland States Bancorp, Inc.
Term loan - variable interest rate equal to LIBOR plus 2.25%, which was 4.38% and 3.63% at September 30, 2018 and December 31, 2017, respectively, – maturing through May 25, 2020
37,113
Series G redeemable preferred stock - 181 shares at $1,000 per share
Midland States Bank
FHLB advances – fixed rate, fixed term of $122.8 million and $145.0 million, at rates averaging 2.22% and 1.35% at September 30, 2018 and December 31, 2017, respectively – maturing through February 2023 and putable fixed rate of $495.0 million and $305.0 million at rates averaging 1.99% and 1.29% at September 30, 2018 and December 31, 2017, respectively – maturing through August 2025 with call provisions through December 2020
617,806
450,137
FHLB advances – variable rate, fixed term, at rates averaging 1.20% at December 31, 2017 – matured in March 2018
9,000
Other
Total FHLB advances and other borrowings
In 2017, the Company entered into a loan agreement with another bank for a term loan in the original principal amount of $40.0 million. The term loan matures on May 25, 2020 and has a variable rate of interest equal to one-month LIBOR plus 2.25%. Beginning September 1, 2017, the Company was required to begin making quarterly principal and interest payments on the term loan of $1.4 million with the remaining principal and any unpaid interest due at maturity. The loan is unsecured with a negative pledge of shares of the Bank’s common stock. The loan agreement contains financial covenants that require the Company to maintain a minimum total capital to risk-weighted assets ratio, a minimum adjusted loan loss reserves to nonperforming loans ratio, a minimum fixed charge coverage ratio and a maximum percentage of nonperforming assets to tangible capital. At September 30, 2018, the Company was in compliance with each of these financial covenants.
The Bank’s advances from the FHLB are collateralized by a blanket collateral agreement of qualifying mortgage and home equity line of credit loans and certain commercial real estate loans totaling approximately $2.22 billion and $1.86 billion at September 30, 2018 and December 31, 2017, respectively.
Note 13 – Earnings Per Share
Earnings per share are calculated utilizing the two‑class method. Basic earnings per share are calculated by dividing the sum of distributed earnings to common shareholders and undistributed earnings allocated to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share are calculated by dividing the sum of distributed earnings to common shareholders and undistributed earnings allocated to common shareholders by the weighted average number of shares adjusted for the dilutive effect of common stock awards using the treasury stock method (outstanding stock options and unvested restricted stock) and common stock warrants.
Presented below are the calculations for basic and diluted earnings per common share for the three and nine months ended September 30, 2018 and 2017:
(82)
Net income available to common shareholders equity
Common shareholder dividends
(5,208)
(3,818)
(14,617)
(10,100)
Unvested restricted stock award dividends
(31)
(19)
(59)
Undistributed earnings to unvested restricted stock awards
(18)
(49)
(21)
Undistributed earnings to common shareholders
3,205
(1,828)
8,218
3,839
Basic
Distributed earnings to common shareholders
5,208
3,818
14,617
10,100
Total common shareholders earnings, basic
8,413
1,990
22,835
13,939
Diluted
Total common shareholders earnings
Add back:
Undistributed earnings reallocated from unvested restricted stock awards
Total common shareholders earnings, diluted
8,414
22,836
13,940
Weighted average common shares outstanding, basic
Options and warrants
469,938
438,808
458,884
522,489
Weighted average common shares outstanding, diluted
Note 14 – Fair Value of Financial Instruments
ASC 820, Fair Value Measurements, defines fair value, establishes a framework for measuring fair value including a three‑level valuation hierarchy, and expands disclosures about fair value measurements. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date reflecting assumptions that a market participant would use when pricing an asset or liability. The hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:
·
Level 1: Unadjusted quoted prices for identical assets or liabilities traded in active markets.
Level 2: Observable inputs other than Level 1, including quoted prices for similar assets and liabilities in active markets, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3: Inputs to a valuation methodology that is unobservable, supported by little or no market activity, and significant to the fair value measurement. These valuation methodologies generally include pricing models, discounted cash flow models, or a determination of fair value that requires significant management judgment or estimation. This category also includes observable inputs from a pricing service not corroborated by observable market data, such as pricing corporate securities.
Fair value is used on a recurring basis to account for securities available for sale and derivative instruments, and for financial assets for which the Company has elected the fair value option. For assets and liabilities measured at the lower of cost or fair value, the fair value measurement criteria may or may not be met during a reporting period and such measurements are therefore considered “nonrecurring” for purposes of disclosing our fair value measurements. Fair value is used on a nonrecurring basis to adjust carrying values for impaired loans and other real estate owned and also to record impairment on certain assets, such as mortgage servicing rights, goodwill, intangible assets and other long-lived assets.
Assets and liabilities measured and recorded at fair value, including financial assets for which the Company has elected the fair value option, on a recurring and nonrecurring basis as of September 30, 2018 and December 31, 2017, are summarized below:
Quoted prices
in active
Significant
markets
for identical
observable
unobservable
assets
inputs
(Level 1)
(Level 2)
(Level 3)
Assets and liabilities measured at fair value on a recurring basis:
62,361
5,420
Equity securities
Interest rate swap contracts
390
726,892
696,939
Liabilities
Assets measured at fair value on a non-recurring basis:
Impaired loans
9,922
9,426
Assets held for sale
1,687
28
(Level) 3
55,033
4,779
506,993
474,496
9,385
7,631
1,754
801
3,358
The following table presents losses recognized on assets measured on a non‑recurring basis for the three and nine months ended September 30, 2018 and 2017:
989
3,906
564
180
1,130
Total loss on assets measured on a nonrecurring basis
1,557
3,722
5,421
7,321
The following table presents activity for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2018:
Corporate
Securities
Three Months
Nine Months
Ended
5,357
Total realized in earnings (1)
67
187
Total unrealized in other comprehensive income
616
Net settlements (principal and interest)
(162)
Amounts included in interest income from investment securities taxable in the consolidated statements of income.
The following table presents activity for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2017:
Non-Agency
Mortgage-Backed
4,740
7,480
235
242
(45)
4,749
The following table presents quantitative information about significant unobservable inputs used in fair value measurements of non-recurring assets (Level 3) at September 30, 2018 (in thousands):
Non-recurring
Unobservable
fair value measurements
technique
input / assumptions
Range (weighted average)
Discounted cash flow
Prepayment speed
8.00% - 18.00% (8.25%)
Discount rate
10.00% - 12.00% (11.02%)
5.00% - 8.10% (7.14%)
Mortgage Servicing Rights. When mortgage loans are sold with servicing rights retained, servicing rights are initially recorded at fair value with the effect recorded in net gain on sales of loans in the consolidated statements of operations. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or, alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income.
The Company utilizes the amortization method to subsequently measure the carrying value of its servicing rights. In accordance with GAAP, the Company must record impairment charges on a non-recurring basis when the carrying value exceeds the estimated fair value. The fair value of our servicing rights is estimated by using a cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, servicing costs, replacement reserves and other economic factors which are estimated based on current market conditions. The determination of fair value of servicing rights relies upon Level 3 inputs. The fair value of mortgage servicing rights was $51.6 million and $56.4 million at September 30, 2018 and December 31, 2017, respectively.
Impaired loans. Impaired loans are measured and recorded at fair value on a non-recurring basis. All of our nonaccrual loans and restructured loans are considered impaired and are reviewed individually for the amount of impairment, if any. Most of our loans are collateral dependent and, accordingly, we measure impaired loans based on the estimated fair value of such collateral. The fair value of each loan’s collateral is generally based on estimated market prices from an independently prepared appraisal, which is then adjusted for the cost related to liquidating such collateral; such valuation inputs result in a nonrecurring fair value measurement that is categorized as a Level 2 measurement. When adjustments are made to an appraised value to reflect various factors such as the age of the appraisal or known changes in the market or the collateral, such valuation inputs are considered unobservable and the fair value measurement is categorized as a Level 3 measurement. The impaired loans categorized as Level 3 also include unsecured loans and other secured loans whose fair values are based significantly on unobservable inputs such as the strength of a guarantor, cash flows discounted at the effective loan rate, and management’s judgment.
ASC Topic 825, Financial Instruments, requires disclosure of the estimated fair value of certain financial instruments and the methods and significant assumptions used to estimate such fair values. Additionally, certain financial instruments and all nonfinancial instruments are excluded from the applicable disclosure requirements.
30
The Company has elected the fair value option for newly originated residential and commercial loans held for sale. These loans are intended for sale and are hedged with derivative instruments. We have elected the fair value option to mitigate accounting mismatches in cases where hedge accounting is complex and to achieve operational simplification.
The following table presents the difference between the aggregate fair value and the aggregate remaining principal balance for loans for which the fair value option has been elected as of September 30, 2018 and December 31, 2017:
Aggregate
Contractual
fair value
Difference
principal
Residential loans held for sale
17,259
784
16,475
12,243
375
11,868
Commercial loans held for sale
17,987
238
17,749
37,846
343
37,503
Total loans held for sale
1,022
34,224
718
49,371
The following table presents the amount of gains and losses from fair value changes included in income before income taxes for financial assets carried at fair value for the three and nine months ended September 30, 2018 and 2017:
172
(245)
232
(131)
89
(527)
127
(517)
The Company adopted ASU No. 2016-01, effective January 1, 2018. Adoption of the standard resulted in the use of an exit price rather than an entrance price to determine the fair value of securities, loans, excluding loans held for sale, time deposits, FHLB and other borrowings, subordinated debt, and trust preferred debentures as of September 30, 2018. Although the exit price notion represents the value that would be received to sell an asset or paid to transfer a liability, the actual prices received for a sale of assets or paid to transfer liabilities could be different from the exit price disclosed.
The following tables are a summary of the carrying values and fair value estimates of certain financial instruments as of September 30, 2018 and December 31, 2017:
Investment securities available for sale
652,443
Loans, net
4,065,938
4,134,381
FHLB and other borrowings
648,967
60,991
51,248
418,028
3,200,016
3,127,626
494,634
90,860
45,379
46,069
Note 15 – Commitments, Contingencies and Credit Risk
In the normal course of business, there are outstanding various contingent liabilities such as claims and legal actions, which are not reflected in the consolidated financial statements. No material losses are anticipated as a result of these actions or claims.
We are a party to financial instruments with off-balance‑sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments.
Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank used the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The commitments are principally tied to variable rates. Loan commitments as of September 30, 2018 and December 31, 2017 were as follows:
Commitments to extend credit
706,519
568,356
Financial guarantees – standby letters of credit
143,025
142,189
The Company sells residential mortgage loans to investors in the normal course of business. Residential mortgage loans sold to others are predominantly conventional residential first lien mortgages originated under our usual underwriting procedures, and are sold on a nonrecourse basis, primarily to government-sponsored enterprises (“GSEs”). The Company’s agreements to sell residential mortgage loans in the normal course of business usually require certain representations and warranties on the underlying loans sold, related to credit information, loan documentation, collateral, and insurability. Subsequent to being sold, if a material underwriting deficiency or documentation defect is discovered, the Company may be obligated to repurchase the loan or reimburse the GSEs for losses incurred. The make-whole requests and any related risk of loss under the representations and warranties are largely driven by borrower performance. The Company establishes a mortgage repurchase liability related to these events that reflect management’s estimate of losses on loans for which the Company could have a repurchase obligation based on a combination of factors. Such factors incorporate the volume of loans sold in 2018 and years prior, borrower default expectations, historical investor repurchase demand and appeals success rates, and estimated loss severity. Loans repurchased from investors are initially recorded at fair value, which becomes the Company’s new accounting basis. Any difference between the loan’s fair value and the outstanding principal amount is charged or credited to the mortgage repurchase liability, as appropriate. Subsequent to repurchase, such loans are carried in loans receivable. The Company incurred losses as a result of make-whole requests and loan repurchases totaling $11,000 for the nine months ended September 30, 2018 and $17,000 for both the three and nine months ended September 30, 2017. There were no losses incurred for the three months ended September 30, 2018. The liability for unresolved repurchase demands totaled $492,000 and $371,000 at September 30, 2018 and December 31, 2017, respectively.
Note 16 – Segment Information
Our business segments are defined as Banking, Commercial FHA Origination and Servicing, Wealth Management, and Other. The reportable business segments are consistent with the internal reporting and evaluation of the principle lines of business of the Company. The banking segment provides a wide range of financial products and services to consumers and businesses, including commercial, commercial real estate, mortgage and other consumer loan products; commercial equipment leasing; mortgage loan sales and servicing; letters of credit; various types of deposit products, including checking, savings and time deposit accounts; merchant services; and corporate treasury management services. The commercial FHA origination and servicing segment provides for the origination and servicing of government sponsored mortgages for multifamily and healthcare facilities. The wealth management segment consists of
trust and fiduciary services, brokerage and retirement planning services. The other segment includes the operating results of the parent company, our captive insurance business unit, and the elimination of intercompany transactions.
During 2018, the Company re-evaluated its business segments and changed the composition of its reportable segments to those described above and restated all prior period information.
Selected business segment financial information as of and for the three and nine months ended September 30, 2018 and 2017 were as follows:
Commercial FHA
Origination and
Wealth
Banking
Management
Three Months Ended September 30, 2018
Net interest income (expense)
47,887
(177)
(2,703)
Noninterest income
9,807
3,144
5,444
(123)
Noninterest expense
43,636
3,218
3,146
317
11,955
(251)
2,372
(3,143)
Income taxes (benefit)
2,246
(148)
(6)
Net income (loss)
9,709
(103)
2,028
(3,137)
5,689,585
113,463
17,528
(95,964)
Three Months Ended September 30, 2017
38,597
(79)
117
(1,870)
8,093
3,967
(132)
42,145
3,910
2,122
186
Income (loss) before income taxes (benefit)
3,056
(22)
1,470
(2,188)
730
(9)
482
(923)
2,326
(13)
988
(1,265)
4,307,639
121,514
15,391
(96,783)
4,347,761
Nine Months Ended September 30, 2018
139,497
(236)
(7,941)
29,041
7,112
14,832
(364)
127,220
11,474
8,281
(707)
35,355
(4,598)
6,783
(7,598)
8,089
(1,143)
1,373
(1,462)
27,266
(3,455)
5,410
(6,136)
Nine Months Ended September 30, 2017
97,579
325
(4,701)
20,800
15,189
9,753
(378)
98,589
11,639
6,509
68
16,310
3,667
(5,147)
4,136
1,550
1,178
(2,224)
12,174
2,325
2,489
(2,923)
34
Note 17 – Revenue From Contracts with Customers
On January 1, 2018, the Company adopted ASU No. 2014-09 “Revenue from Contracts with Customers” (Topic 606) and all subsequent ASUs that modified Topic 606. As stated in “Note 2 – Basis of Presentation and Summary of Significant Accounting Policies,” the implementation of the new standard did not have a material impact on the measurement or recognition of revenue. Since the impact of applying the standard was determined to be immaterial, the Company did not record a cumulative effect adjustment to beginning retained earnings on January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts were not adjusted and continue to be reported in accordance with previous GAAP.
Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and investment securities. In addition, certain noninterest income streams such as commercial FHA revenue, residential mortgage banking revenue and gain on sales of investment securities, net are also not in scope of the new guidance. Topic 606 is applicable to noninterest income streams such as wealth management revenue, service charges on deposit accounts, interchange revenue, gain on sales of other real estate owned, and certain other noninterest income streams. The recognition of revenue associated with these noninterest income streams did not change significantly from current practice upon adoption of Topic 606. The noninterest income streams considered in-scope by Topic 606 are discussed below.
Wealth Management Revenue
Wealth management revenue is primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company also earns investment advisory fees through its SEC registered investment advisory subsidiary. The Company’s performance obligation in both of these instances is generally satisfied over time and the resulting fees are recognized monthly, based upon the month-end market value of the assets under management and contractually determined fee schedules. Payment is generally received a few days after month end through a direct charge to each customer’s account. The Company does not earn performance-based incentives. Optional services such as real estate sales and tax return preparation services are also available to existing trust and asset management customers. The Company’s performance obligation for these transactional-based services is generally satisfied, and related revenue recognized, at a point in time (i.e., as incurred). Payment is received shortly after services are rendered. Fees generated from transactions executed by the Company’s third party broker dealer are remitted by them to the Company on a monthly basis for that month’s transactional activity.
Service Charges on Deposit Accounts
Service charges on deposit accounts consist of fees received under depository agreements with customers to provide access to deposited funds, serve as custodian of deposited funds, and when applicable, pay interest on deposits. These service charges primarily include non-sufficient fund fees and other account related service charges. Non-sufficient fund fees are earned when a depositor presents an item for payment in excess of available funds, and the Company, at its discretion, provides the necessary funds to complete the transaction. The Company generates other account related service charge revenue by providing depositors proper safeguard and remittance of funds as well as by delivering optional services for depositors, such as check imaging or treasury management, that are performed upon the depositor’s request. The Company’s performance obligation for the proper safeguard and remittance of funds, monthly account analysis and any other monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Payment for service charges on deposit accounts is typically received immediately or in the following month through a direct charge to a customer’s account.
Interchange Revenue
Interchange revenue includes debit / credit card income and ATM user fees. Card income is primarily comprised of interchange fees earned for standing ready to authorize and providing settlement on card transactions processed through the MasterCard interchange network. The levels and structure of interchange rates are set by MasterCard and can vary based on cardholder purchase volumes. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with completion of the Company’s performance obligation, the transaction processing services provided to the cardholder. Payment is typically received immediately or in the following month. ATM fees are primarily generated when a Company cardholder withdraws funds from a non-Company ATM or a non-Company cardholder withdraws funds from a Company ATM.
The Company satisfies its performance obligation for each transaction at the point in time when the ATM withdrawal is processed.
Gain on Sales of Other Real Estate Owned
The Company records a gain or loss from the sale of other real estate owned (“OREO”) when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the Company finances the sale of OREO to a buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain or loss on sale if a significant financing component is present.
Other Noninterest Income
The other noninterest income revenue streams within the scope of Topic 606 consist of merchant services revenue, safe deposit box rentals, wire transfer fees, paper statement fees, check printing commissions, and other noninterest related fees. Revenue from the Company’s merchant services business consists principally of transaction and account management fees charged to merchants for the electronic processing of transactions. These fees are net of interchange fees paid to the credit card issuing bank, card company assessments, and revenue sharing amounts. Account management fees are considered earned at the time the merchant’s transactions are processed or other services are performed. Fees related to the other components of other noninterest income within the scope of Topic 606 are largely transactional based, and therefore, the Company’s performance obligation is satisfied and related revenue recognized, at the point in time the customer uses the selected service to execute a transaction.
The following presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the three and nine months ended September 30, 2018 and 2017.
Noninterest income - in-scope of Topic 606
Wealth management revenue:
Trust management/administration fees
4,327
11,768
7,181
Investment advisory fees
451
1,491
896
Investment brokerage fees
820
1,031
228
783
646
Service charges on deposit accounts:
Nonsufficient fund fees
2,098
1,467
5,539
2,810
706
1,925
1,337
Interchange revenues
Other income:
Merchant services revenue
448
310
1,246
802
278
393
1,273
Noninterest income - out-of-scope of Topic 606
6,516
7,368
17,281
25,572
Contract Balances
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as asset management fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into long-term revenue contracts with customers, and therefore, does not experience significant contract balances. As of September 30, 2018 and December 31, 2017, the Company did not have any significant contract balances.
Contract Acquisition Costs
In connection with the adoption of Topic 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. Upon adoption of Topic 606, the Company did not capitalize any contract acquisition costs.
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Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion explains our financial condition and results of operations as of and for the three and nine months ended September 30, 2018. Annualized results for these interim periods may not be indicative of results for the full year or future periods. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented elsewhere in this report and our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on March 6, 2018.
In addition to the historical information contained herein, this Form 10-Q includes “forward-looking statements” within the meaning of such term in the Private Securities Litigation Reform Act of 1995. These statements are subject to many risks and uncertainties, including changes in interest rates and other general economic, business and political conditions, including changes in the financial markets; changes in business plans as circumstances warrant; risks related to mergers and acquisitions and the integration of acquired businesses; and other risks detailed from time to time in filings made by the Company with the SEC. Readers should note that the forward-looking statements included herein are not a guarantee of future events, and that actual events may differ materially from those made in or suggested by the forward-looking statements. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “will,” “propose,” “may,” “plan,” “seek,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” or “continue,” or similar terminology. Any forward-looking statements presented herein are made only as of the date of this document, and we do not undertake any obligation to update or revise any forward-looking statements to reflect changes in assumptions, the occurrence of unanticipated events, or otherwise.
Critical Accounting Policies
The preparation of our consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances. These estimates form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. The estimates and judgments that management believes have the most effect on the Company’s reported financial position and results of operations are set forth in “Note 1 – Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements, included in our Annual Report on Form 10-K for the year ended December 31, 2017. There have been no significant changes in critical accounting policies or the assumptions and judgments utilized in applying these policies since December 31, 2017.
Overview
Midland States Bancorp, Inc. is a diversified financial holding company headquartered in Effingham, Illinois. Its wholly owned banking subsidiary, Midland States Bank, has branches across Illinois and in Missouri and Colorado, and provides a broad array of traditional community banking and other complementary financial services, including commercial lending, residential mortgage origination, wealth management, merchant services and prime consumer lending. We also originate and service government sponsored mortgages for multifamily and healthcare facilities through our subsidiary, Love Funding Corporation, based in Washington, D.C. Our commercial equipment financing business, Midland Equipment Finance, operates on a nationwide basis. As of September 30, 2018, we had $5.7 billion in assets, $4.1 billion of deposits and $594.1 million of shareholders’ equity.
Our strategic plan is focused on building a diversified financial services company anchored by a strong community bank. In the past several years, we have grown organically and through a series of acquisitions, with an over‑arching focus on enhancing shareholder value and maintaining a platform for scalability. In June 2017, we completed the acquisition of Centrue and its subsidiary, Centrue Bank, a regional, full-service community bank headquartered in Ottawa, Illinois. At closing, Centrue had 20 bank branches located principally in northern Illinois and total assets of $990.2 million. Most recently, on February 28, 2018, the Company completed the acquisition of Alpine, and its subsidiary, Alpine Bank, a regional, full-service community bank headquartered in Belvidere, Illinois. At closing, Alpine had 19 bank branches located principally in and around the Rockford, Illinois area and had total assets of $1.2 billion.
Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We have derived income principally from interest charged on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest
38
sources, such as: fees received in connection with various lending and deposit services; wealth management services; commercial FHA mortgage loan originations, sales and servicing; residential mortgage loan originations, sales and servicing; and, from time to time, gains on sales of assets. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for loan losses and income tax expense.
Significant Transactions
Each item listed below materially affects the comparability of our results of operations for the three and nine months ended September 30, 2018 and 2017, and our financial condition as of September 30, 2018 and December 30, 2017, and may affect the comparability of financial information we report in future fiscal periods.
Recent Acquisitions. On February 28, 2018, the Company acquired Alpine for total consideration valued at approximately $173.2 million. Consideration transferred by the Company consisted of $33.3 million in cash and 4,463,200 shares of common stock. All identifiable assets acquired and liabilities assumed were adjusted to fair value as of February 28, 2018, and the results of Alpine’s operations have been included in the consolidated statements of income beginning on that date. The resultant purchase accounting adjustments have been reflected in the consolidated balance sheet as of September 30, 2018. Intangible assets recognized as a result of the transaction consisted of $65.3 million in goodwill, $6.3 million in customer relationship intangibles and $21.1 million in core deposit intangibles.
On June 9, 2017, the Company acquired Centrue for total consideration value of approximately $176.6 million. Consideration paid by the Company consisted of $61.0 million in cash, 3,219,238 shares of common stock, 181 shares of Series G preferred stock and 2,636 shares of Series H preferred stock. All identifiable assets acquired and liabilities assumed were adjusted to fair value as of June 9, 2017, and the results of Centrue’s operations have been included in the consolidated statements of income beginning on that date. Intangible assets recognized as a result of the transaction consisted of $47.4 million in goodwill and $11.1 million in core deposit intangibles.
Purchased Credit‑Impaired (“PCI”) Loans. Our net interest margin benefits from favorable changes in expected cash flows on our PCI loans and from accretion income associated with purchase accounting discounts established on the non-PCI loans included in our acquisitions. Our reported net interest margin for the three months ended September 30, 2018 and 2017 was 3.59% and 3.78%, respectively. Accretion income associated with accounting discounts established on loans acquired totaled $1.7 million and $3.0 million for the three months ended September 30, 2018 and 2017, respectively, increasing the reported net interest margin by 10 and 27 basis points for each respective period. The reported net interest margin for the nine months ended September 30, 2018 and 2017 was 3.73% and 3.78%, respectively. Accretion income associated with purchase accounting discounts established on loans acquired totaled $9.1 million and $6.9 million for the nine months ended September 30, 2018 and 2017, respectively, increasing the reported net interest margin by 22 and 25 basis points for each respective period.
Mortgage Servicing Rights. The Company sells residential and commercial mortgage loans in the secondary market and typically retains the right to service the loans sold. Mortgage servicing rights (“MSR”) are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. MSR are amortized in proportion to and over the period of estimated net servicing income and assessed for impairment at each reporting date.
In the third quarter of 2017, we committed to a plan to sell our Fannie Mae residential MSR and transferred $14.2 million of residential MSR, net of valuation allowances, to MSR held for sale. As a result of recognizing a $4.1 million loss in 2017, MSR held for sale had a net carrying value of $10.2 million at December 31, 2017. The Fannie Mae MSR held for sale was sold on January 2, 2018.
During the second quarter of 2018, the Company transferred the remaining $3.6 million of residential MSR to MSR held for sale. An additional loss of $0.3 million was identified on MSR held for sale during the three and nine months ended September 30, 2018
There were no impairment charges on the residential MSR during the three and nine months ended September 30, 2018 compared to no impairment charges and $0.7 million for the three and nine months ended September 30, 2017, respectively. For commercial FHA MSR, we recognized impairment charges of $0.3 million and $0.9 million during the three and nine months ended September 30, 2018, respectively, compared to $0.1 million and $1.1 million during the three and nine months ended September 30, 2017.
39
Results of Operations
Net Interest Income. Our primary source of revenue is net interest income, which is the difference between interest income from interest-earning assets (primarily loans and securities) and interest expense of funding sources (primarily interest‑bearing deposits and borrowings). Net interest income is impacted by the volume of interest‑earning assets and related funding sources, as well as changes in the levels of interest rates. Noninterest‑bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. The impact of the noninterest‑bearing sources of funds is captured in the net interest margin, which is calculated as net interest income divided by average interest-earning assets. The net interest margin is presented on a tax-equivalent basis, which means that tax‑free interest income has been adjusted to a pretax-equivalent income, assuming federal income tax rates of 21% for the three and nine months ended September 30, 2018 and 35% for the three and nine months ended September 30, 2017, respectively.
In the third quarter of 2018, net interest income (on a tax-equivalent basis) was $45.7 million, an increase of $8.2 million, or 22.0%, from $37.4 million of net interest income we generated for the comparative prior year quarter. The tax-equivalent net interest margin was 3.59% for the third quarter of 2018 compared to 3.78% in the third quarter of 2017.
For the nine months ended September 30, 2018, we generated $133.1 million of net interest income (on a tax-equivalent basis), which was an increase of $37.4 million, or 39.1%, from $95.6 million of net interest income we produced during the nine months ended September 30, 2017. The tax-equivalent net interest margin was 3.73% for the first nine months of 2018 compared to 3.78% for the first nine months of 2017.
Average Balance Sheet, Interest and Yield/Rate Analysis. The following tables present average balance sheet information, interest income, interest expense and the corresponding average yields earned and rates paid for the three and nine months ended September 30, 2018 and 2017. The average balances are principally daily averages and, for loans, include both performing and nonperforming balances. Interest income on loans includes the effects of discount accretion and net deferred loan origination costs accounted for as yield adjustments.
40
For the Three Months Ended September 30,
Average
Yield /
(tax-equivalent basis, dollars in thousands)
& Fees
EARNING ASSETS:
154,526
202,407
Taxable investment securities
528,518
359,370
Investment securities exempt from federal income tax (1)
171,500
1,512
114,846
1,458
Total securities
700,018
5,265
474,216
3,378
Loans (2)
3,996,643
3,126,325
Loans exempt from federal income tax (1)
109,724
1,274
46,702
4,106,367
50,490
3,173,027
39,171
48,715
46,441
42,770
31,224
Total earning assets
5,052,396
57,572
3,927,315
43,925
Noninterest-earning assets
639,323
498,364
5,691,719
4,425,679
INTEREST-BEARING LIABILITIES:
Checking and money market deposits
1,888,758
2,880
1,448,228
1,139
Savings deposits
452,219
286,199
92
Time deposits
642,093
2,044
511,761
1,094
Brokered deposits
189,352
1,051
281,302
1,052
Total interest-bearing deposits
3,172,422
2,527,490
139,215
182,015
608,153
434,860
94,075
54,570
47,601
47,152
Total interest-bearing liabilities
4,061,466
3,246,087
NONINTEREST-BEARING LIABILITIES
Noninterest-bearing deposits
989,142
688,986
Other noninterest-bearing liabilities
47,654
37,289
Total noninterest-bearing liabilities
1,036,796
726,275
Shareholders’ equity
593,457
453,317
Net interest income / net interest margin (3)
45,666
37,444
Interest income and average rates for tax‑exempt loans and securities are presented on a tax‑equivalent basis, assuming federal income tax rates of 21% and 35% for the three months ended September 30, 2018 and 2017, respectively. Tax-equivalent adjustments totaled $585,000 and $679,000 for the three months ended September 30, 2018 and 2017, respectively.
Average loan balances include nonaccrual loans. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs.
(3)
Net interest margin during the periods presented represents: (i) the difference between interest income on interest‑earning assets and the interest expense on interest‑bearing liabilities, divided by (ii) average interest‑earning assets for the period.
For the Nine Months Ended September 30,
173,493
186,539
500,632
281,156
159,659
4,362
107,831
4,310
660,291
14,514
388,987
9,033
3,765,761
2,674,770
92,288
46,719
3,858,049
143,826
2,721,489
98,483
40,288
60,590
38,873
24,547
4,770,994
163,296
3,382,152
111,635
605,689
402,889
5,376,683
3,785,041
INTEREST-BEARING LIABILITIES
1,765,546
6,456
1,254,706
2,565
421,113
527
217,753
224
622,477
5,329
446,025
2,928
194,877
2,961
264,035
2,853
3,004,013
2,182,519
157,388
557,376
325,120
94,035
54,544
47,488
42,382
3,839,115
2,761,953
932,964
598,874
45,241
43,657
978,205
642,531
559,363
380,557
133,073
95,648
Interest income and average rates for tax‑exempt loans and securities are presented on a tax‑equivalent basis, assuming federal income tax rates of 21% and 35% for the nine months ended September 30, 2018 and 2017, respectively. Tax-equivalent adjustments totaled $1.5 million and $2.0 million for the nine months ended September 30, 2018 and 2017, respectively.
Interest Rates and Operating Interest Differential. Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest‑earning assets and interest‑bearing liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned on our interest‑earning assets and the interest incurred on our interest‑bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume. Changes which are not due solely to volume or rate have been allocated proportionally to the change due to volume and the change due to rate.
Compared with
Change due to:
Volume
Variance
(190)
348
158
(136)
895
1,053
1,833
4,069
1,360
5,429
Investment securities exempt from federal income tax
609
(555)
1,744
(1,692)
52
1,662
225
1,887
5,813
(332)
5,481
10,744
(217)
10,527
40,202
3,728
43,930
Loans exempt from federal income tax
691
101
792
1,426
1,413
11,435
(116)
11,319
41,628
3,715
45,343
(634)
(57)
(691)
134
75
209
633
13,063
584
13,647
47,163
4,498
51,661
509
1,232
1,741
1,457
3,891
59
71
303
347
603
950
1,334
1,067
(427)
426
(899)
1,007
108
488
2,286
2,774
2,124
4,579
6,703
(53)
244
755
962
1,717
2,633
2,130
4,763
634
641
1,902
1,923
173
222
434
656
1,839
3,586
5,425
6,828
7,408
14,236
11,224
(3,002)
8,222
40,335
(2,910)
37,425
Interest Income. The $11.3 million, or 28.9%, increase in interest income on loans (on a tax-equivalent basis) for the third quarter of 2018 was primarily due to a 29.4% increase in the average balance of loans outstanding. The average balance increase was primarily driven by the addition of $786.2 million of loans from Alpine in February 2018. The decrease in the average yield on loans was mainly due to the impact of lower accretion income, offset in part by higher market interest rates. The reported yield on total loans for the three months ended September 30, 2018 and 2017 was 4.88% and 4.90%, respectively. Accretion income associated with accounting discounts established on loans acquired totaled $1.7 million and $3.0 million for the three months ended September 30, 2018 and 2017, respectively, generating an 11 and 33 basis point favorable impact to the reported yields for the respective periods.
For the nine months ended September 30, 2018, the $45.3 million, or 46.0%, increase in interest income on loans was primarily due to a 41.8% increase in the average balance of loans outstanding combined with a 14 basis point increase in the average yield. The average balance increase was primarily due to loans added from the Centrue and Alpine acquisitions. The increase in the average yield on loans was mainly due to a $2.2 million increase in accretion income from purchase accounting discounts on acquired loans combined with the impact of higher market interest rates. The reported yield on total loans for the nine months ended September 30, 2018 and 2017 was 4.98% and 4.84%, respectively. Accretion income associated with purchase accounting discounts established on loans acquired totaled $9.1 million and $6.9 million for the nine months ended September 30, 2018 and 2017, respectively, increasing the reported net yields by 26 and 30 basis points for each respective period.
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Interest income on our investment securities portfolio on a tax-equivalent basis increased $1.9 million and $5.5 million for the three and nine months ended September 30, 2018, respectively, compared to the prior year periods, mainly attributable to increases in the average balances of investment securities of 47.6% and 69.7% for the respective periods. The increase in the average balance for the quarter was primarily due to the addition of $301.8 million of investment securities from Alpine in February 2018. The increase in the average balance for the nine months ended September 30, 2018 was also impacted by investment securities added from the Centrue acquisition.
Interest income on short-term cash investments increased to $0.8 million and $2.3 million for the three and nine months ended September 30, 2018, respectively, compared to $0.6 million and $1.4 million for the corresponding periods in 2017. These increases were primarily attributable to an increase in short-term interest rates.
Interest Expense. Interest expense on deposits increased to $6.2 million and $15.3 million for the three and nine months ended September 30, 2018, respectively, as compared to $3.4 million and $8.6 million for the three and nine months ended September 30, 2017, respectively. The $2.8 million, or 82.1%, increase in interest expense on deposits for the third quarter of 2018 was primarily due to the average balance of interest-bearing deposits increasing 25.5% combined with a 24 basis point increase in the average rate paid. For the nine-month period, the $6.7 million, or 78.2%, increase in interest expense on deposits was mainly attributable to the average balance of deposits increasing 37.6% coupled with an 16 basis point increase in the average rate paid. The increase in the average balance of deposits for the three months ended September 30, 2018 primarily reflected the addition of $770.2 million of interest-bearing deposits from Alpine in February 2018. The average balance increase for the nine months ended September 30, 2018 was also impacted by interest-bearing deposits added from the Centrue acquisition. The increase in the average rates paid were primarily due to the impact of higher market interest rates.
Interest expense on borrowings increased to $5.8 million and $15.0 million for the three and nine months ended September 30, 2018, as compared to $3.1 million and $7.4 million for the three and nine months ended September 30, 2017. The $2.7 million and $7.5 million increases in interest expense on borrowings for the three and nine months ended September 30, 2018, respectively, were primarily due to expanded usage of FHLB advances as a short-term and long-term funding source, the addition of $18.1 million of FHLB advances assumed from Alpine, issuing $40.0 million of subordinated debt in October 2017 to assist with funding the acquisition of Alpine, and the impact of higher market interest rates on new FHLB advances and our variable rate trust preferred debentures. Interest expense on borrowings for the nine months ended September 30, 2018 was also impacted by the full effect of FHLB advances, trust preferred debentures and a term loan assumed as a result of the Centrue acquisition.
Provision for Loan Losses. The provision for loan losses totaled $2.1 million and $6.0 million for the three and nine months ended September 30, 2018 compared to $1.5 million and $3.5 million for the three and nine months ended September 30, 2017. The provision for loan losses recorded during the three months ended September 30, 2018 was primarily due to specific reserves established on a group of commercial loans to one borrower that were classified as nonaccrual during the third quarter of 2018.
The provision for loan losses in the first nine months of 2018 was also impacted by the increase in specific reserves of two commercial loans that were classified as nonaccrual during the first quarter of 2018 and then charged off in the second quarter of 2018. The remaining provision increase resulted from the growth of our loan portfolio and as a result, an increase in the required reserves.
Noninterest Income. The following table sets forth the major components of our noninterest income for the three and nine months ended September 30, 2018 and 2017:
For the Three Months Ended
Increase
(decrease)
(647)
(1,163)
1,992
Gain on sales of investment securities, net
64
1,015
2,869
For the Nine Months Ended
(7,839)
(2,875)
5,108
3,317
3,917
(Loss) gain on sales of investment securities, net
(224)
3,348
5,257
The $2.9 million increase in noninterest income for the three months ended September 30, 2018 was primarily due to the impact of the Alpine acquisition, which was a primary factor in wealth management revenue increasing $2.0 million and interchange revenue increasing $1.0 million between the quarters. Included in the Alpine acquisition were $1.1 billion of wealth management assets under administration. These increases were offset in part by a $1.2 million decrease in mortgage banking revenue primarily due to lower market demand. The increases in noninterest income were also offset by a $0.6 million decrease in commercial FHA revenue which resulted primarily from interest rate lock commitments declining from $112.5 million in the third quarter of 2017 to $82.8 million in the third quarter of 2018.
For the nine months ended September 30, 2018, the $5.3 million increase in noninterest income resulted mainly from the impact of the Alpine acquisition, which was a primary factor in wealth management revenue increasing $5.1 million. The increases in service charges on deposit accounts and interchange revenue resulted from the impact of the Alpine and Centrue acquisitions. These increases were offset in part by a $7.8 million decrease in commercial FHA revenue and a $2.9 million decrease in residential mortgage banking revenue. The decrease in commercial FHA revenue resulted primarily from interest rate lock commitments declining from $420.9 million during the nine months ended September 30, 2017 to $227.5 million for the nine months ended September 30, 2018. The decrease in residential mortgage banking revenue was primarily due to declines in closed production and interest rate lock commitments.
Noninterest Expense. The following tables set forth the major components of noninterest expense for the three and nine months ended September 30, 2018 and 2017:
5,031
(1,519)
(367)
(104)
(3,347)
(36)
1,954
13,022
3,200
8,871
233
(726)
1,237
1,951
(193)
2,813
(3,159)
2,641
29,463
The $2.0 million increase in noninterest expense for the three months ended September 30, 2018 was primarily due to the impact of the Alpine acquisition. Included in data processing expense for the three months ended September 30, 2018 was $2.8 million in contract terminations and $1.3 million in system conversion charges resulting from the acquisition of Alpine. The loss on mortgage servicing rights held for sale recorded in the third quarter of 2017 related to Fannie Mae residential MSR transferred to held for sale during that quarter.
For the nine months ended September 30, 2018, the $29.5 million increase in noninterest expense resulted primarily from the impact of the Alpine acquisition and the effect of the Centrue acquisition. Included in noninterest expense for the nine months ended September 30, 2018 was $23.5 million of integration and acquisition expenses associated primarily with Alpine.
Income Tax Expense. Income tax expense was $2.4 million and $6.9 million for the three and nine months ended September 30, 2018, respectively, compared to $0.3 million and $4.6 million for the three and nine months ended September 30, 2017. Effective tax rates were 22.3% and 22.9% for the three and nine months ended September 30, 2018, respectively, compared to 12.1% and 24.8% for the three and nine months ended September 30, 2017, respectively. The maximum federal corporate income tax rate decreased from 35% to 21% beginning in 2018.
Financial Condition
Assets. Total assets increased $1.3 billion to $5.7 billion at September 30, 2018 as compared to December 31, 2017. This increase primarily reflected the addition of $1.2 billion of assets from the Alpine acquisition.
Loans. The loan portfolio is the largest category of our assets. At September 30, 2018, total loans were $4.2 billion. The following table shows loans by non‑PCI and PCI loan category as of September 30, 2018 and December 31, 2017:
Loans increased $929.6 million to $4.2 billion at September 30, 2018 as compared to December 31, 2017. The increase in loans was primarily due to $786.2 million of loans added from the Alpine acquisition. The remaining increase reflected organic loan growth primarily from our commercial equipment financing business and consumer loans originated through home improvement specialty retailers. The $23.5 million increase in PCI loans at September 30, 2018 compared to December 31, 2017 reflected the addition of $29.0 million of PCI loans from the Alpine acquisition, partially offset by loan payoffs and repayments.
Outstanding loan balances increase due to new loan originations, advances on outstanding commitments and loans acquired as a result of acquisitions of other financial institutions, net of amounts received for loan payments and payoffs, charge‑offs of loans and transfers of loans to OREO. The following table shows the fair values of those loans acquired at acquisition date and the net growth for the periods presented.
For the Year Ended
Net
Growth
Acquired
(Attrition)
198,866
36,751
104,812
(6,709)
347,360
(75,445)
484,772
(14,376)
44,856
(5,963)
28,458
(5,196)
591,082
(44,657)
618,042
(26,281)
120,645
11,937
58,857
140,982
74,459
138,282
3,047
98,391
37,856
13,664
143,418
679,946
226,756
The principal categories of our loan portfolio are discussed below:
Commercial loans. We provide a mix of variable and fixed rate commercial loans. The loans are typically made to small‑ and medium‑sized manufacturing, wholesale, retail and service businesses for working capital needs, business expansions and farm operations. Commercial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with business operations as the primary source of repayment, but may also include collateralization by inventory, accounts receivable and equipment, and generally include personal guarantees.
Commercial real estate loans. Our commercial real estate loans consist of both real estate occupied by the borrower for ongoing operations and non-owner occupied real estate properties. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as owner occupied offices, warehouses and production facilities, office buildings, hotels, mixed-use residential and commercial facilities, retail centers, multifamily
properties and assisted living facilities. Our commercial real estate loan portfolio also includes farmland loans. Farmland loans are generally made to a borrower actively involved in farming rather than to passive investors.
Construction and land development loans. Our construction and land development loans are comprised of residential construction, commercial construction and land acquisition and development loans. Interest reserves are generally established on real estate construction loans.
Residential real estate loans. Our residential real estate loans consist of residential properties that generally do not qualify for secondary market sale.
Consumer loans. Our consumer loans include direct personal loans, indirect automobile loans, lines of credit and installment loans originated through home improvement specialty retailers and contractors. Personal loans are generally secured by automobiles, boats and other types of personal property and are made on an installment basis.
Lease financing. Our equipment leasing business provides financing leases to varying types of businesses, nationwide, for purchases of business equipment and software. The financing is secured by first priority interest in the financed asset and generally require monthly payments.
The following table shows the contractual maturities of our loan portfolio and the distribution between fixed and adjustable interest rate loans at September 30, 2018:
Within One Year
One Year to Five Years
After Five Years
Adjustable
Fixed Rate
43,498
295,441
206,302
90,511
116,384
39,411
178,222
87,694
871,361
233,186
83,477
257,986
13,549
71,154
44,759
92,640
240
17,138
235,269
454,289
1,122,422
416,337
200,101
314,535
2,999
11,953
27,368
45,828
198,622
299,364
3,550
2,573
554,464
21,444
2,037
128
7,008
224,867
11,124
248,826
468,815
1,929,121
483,609
411,884
614,027
Loan Quality
We use what we believe is a comprehensive methodology to monitor credit quality and prudently manage credit concentration within our loan portfolio. Our underwriting policies and practices govern the risk profile and credit and geographic concentration for our loan portfolio. We also have what we believe to be a comprehensive methodology to monitor these credit quality standards, including a risk classification system that identifies potential problem loans based on risk characteristics by loan type as well as the early identification of deterioration at the individual loan level. In addition to our allowance for loan losses, our purchase discounts on acquired loans provide additional protections against credit losses.
Discounts on PCI Loans. PCI loans are loans that have evidence of credit deterioration since origination and for which it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments. These loans are recorded at estimated fair value on their purchase date without a carryover of the related allowance for loan losses. At September 30, 2018 and December 31, 2017, we had PCI loans totaling $45.9 million and $22.5 million, respectively.
In determining the fair value of purchased credit‑impaired loans at acquisition, we first determine the contractually required payments due, which represent the total undiscounted amount of all uncollected principal and interest payments, adjusted for the effect of estimated prepayments. We then estimate the undiscounted cash flows we expect to collect. We incorporate several key assumptions to estimate cash flows expected to be collected, including probability of default rates, loss given default assumptions and the amount and timing of prepayments. We calculate fair value by discounting the estimated cash flows we expect to collect using an observable market rate of interest, when available, adjusted for factors that a market participant would consider in determining fair value. We have aggregated
certain credit‑impaired loans acquired in the same transaction into pools based on common risk characteristics. A pool is accounted for as one asset with a single composite interest rate and an aggregate fair value and expected cash flows.
The difference between contractually required payments due and the cash flows expected to be collected, considering the impact of prepayments, is referred to as the nonaccretable difference. The nonaccretable difference, which is neither accreted into income nor recorded on our consolidated balance sheet, reflects estimated future credit losses expected to be incurred over the life of the loans. The excess of cash flows expected to be collected over the estimated fair value of PCI loans is referred to as the accretable yield. This amount is not recorded on our consolidated balance sheet, but is accreted into interest income over the remaining life of the loans, or pool of loans, using the effective yield method. The outstanding customer balance for PCI loans totaled $60.7 million and $32.8 million as of September 30, 2018 and December 31, 2017, respectively.
Subsequent to acquisition, we periodically evaluate our estimates of cash flows expected to be collected. These evaluations, performed quarterly, require the continued use of key assumptions and estimates, similar to the initial estimate of fair value. Subsequent changes in the estimated cash flows expected to be collected may result in changes in the accretable yield and nonaccretable difference or reclassifications between accretable yield and the nonaccretable difference. Decreases in expected cash flows due to further credit deterioration will result in an impairment charge to the provision for loan losses, resulting in an increase to the allowance for loan losses and a reclassification from accretable yield to nonaccretable difference. Increases in expected cash flows due to credit improvements will result in an increase in the accretable yield through a reclassification from the nonaccretable difference or as a reduction in the allowance for loan losses to the extent established on specific pools subsequent to acquisition. The adjusted accretable yield is recognized in interest income over the remaining life of the loan, or pool of loans.
The following table shows changes in the accretable yield for PCI loans for the three and nine months ended September 30, 2018 and 2017:
New loans purchased - Alpine acquisition
New loans purchased - Centrue acquisition
Other adjustments (including maturities, charge-offs, and impact of changes in timing of expected cash flows)
As of September 30, 2018, the balance of accretable discounts on our PCI loan portfolio was $11.3 million compared to $5.7 million at December 31, 2017. We may not accrete the full amount of these discounts into interest income in future periods if the assets to which these discounts are applied do not perform according to our current expectations.
We have also recorded accretable discounts in purchase accounting for loans that are not considered PCI loans. Similar to the way in which we employ the fair value methodology for PCI loans, we consider expected prepayments and estimate the amount and timing of undiscounted cash flows in order to determine the accretable discount for non-PCI loans. Such discounts are accreted into income on a level yield basis.
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Analysis of the Allowance for Loan Losses. The following table allocates the allowance for loan losses, or the allowance, by loan category:
Book Value
% (1)
0.95
0.26
13,288
10,818
0.49
0.61
0.36
0.74
0.51
Represents the percentage of the allowance to total loans in the respective category.
The allowance and the balance of nonaccretable discounts represent our estimate of probable and reasonably estimable credit losses inherent in loans held for investment as of the respective balance sheet date. We assess the appropriateness of our allowance for non-PCI loans separately from our allowance for PCI loans.
The allowance for loan losses was $19.6 million at September 30, 2018 compared to $16.4 million at December 31, 2017. The increase in the allowance at September 30, 2018 compared to December 31, 2017 was mainly attributable to loan growth during first nine months of 2018 and a specific reserve established on a group of commercial loans to one borrower that were classified as nonaccrual during the third quarter of 2018.
Individual loans considered to be uncollectible are charged off against the allowance. Factors used in determining the amount and timing of charge-offs on loans include consideration of the loan type, length of delinquency, sufficiency of collateral value, lien priority and the overall financial condition of the borrower. Collateral value is determined using updated appraisals and/or other market comparable information. Charge-offs are generally taken on loans once the impairment is determined to be other-than-temporary. Recoveries on loans previously charged off are added to the allowance. Net charge-offs to average loans were 0.10% and 0.28% for the nine months ended September 30, 2018 and the year ended December 31, 2017, respectively.
Allowance for non‑PCI loans. Our methodology for assessing the appropriateness of the allowance for non-PCI loans includes a general allowance for performing loans, which are grouped based on similar characteristics, and a specific allowance for individual impaired loans or loans considered by management to be in a high risk category. General allowances are established based on a number of factors, including historical loss rates, an assessment of portfolio trends and conditions, accrual status and economic conditions.
For commercial and commercial real estate loans, a specific allowance may be assigned to individual loans based on an impairment analysis. Loans are considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. The amount of impairment is based on an analysis of the most probable source of repayment, including the present value of the loan's expected future cash flows and the estimated market value or the fair value of the underlying collateral. Interest income on impaired loans is accrued as earned, unless the loan is placed on nonaccrual status.
Allowance for PCI loans. PCI loans are recorded at their estimated fair value at the date of acquisition, with the estimated fair value including a component for estimated credit losses. An allowance related to PCI loans may be recorded subsequent to acquisition if a PCI loan pool experiences a decrease in expected cash flows as compared to the expected cash flows projected in the previous quarter. Loans considered to be uncollectible are initially charged off against the specific loan pool’s non‑accretable difference. When the pool’s non‑accretable difference has been fully utilized, uncollectible amounts are charged off against the corresponding allowance.
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The following table shows our allowance by loan portfolio and by non‑PCI and PCI loans as of September 30, 2018 and December 31, 2017:
7,000
4,756
4,861
4,708
12,297
991
9,978
840
1,928
2,210
1,956
17,981
14,902
Provision for Loan Losses. In determining the allowance and the related provision for loan losses, we consider three principal elements: (i) valuation allowances based upon probable losses identified during the review of impaired commercial, commercial real estate, and construction and land development loans, (ii) allocations, by loan classes, on loan portfolios based on historical loan loss experience and qualitative factors, and (iii) valuation allowances on PCI loan pools based on decreases in expected cash flows. Provisions for loan losses are charged to operations to adjust the total allowance to a level deemed appropriate by us.
The following table provides an analysis of the allowance for loan losses, provision for loan losses and net charge‑offs for the three and nine months ended September 30, 2018 and 2017:
As of and for the
Charge-offs:
1,145
737
259
470
69
455
105
1,236
536
816
1,775
658
Total charge-offs
335
4,624
2,856
Recoveries:
Total recoveries
Net charge-offs
2,763
1,481
Gross loans, end of period
3,157,972
Average loans
Net charge-offs to average loans
0.01
0.07
Allowance to total loans
0.47
0.53
Impaired Loans. The following table sets forth our nonperforming assets by asset categories as of the dates indicated. Impaired loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and loans modified under troubled debt restructurings. The balances of impaired loans reflect the net investment in these assets, including deductions for purchase discounts. PCI loans are excluded from nonperforming status because we expect to fully collect their new carrying values, which reflect significant purchase discounts. If our expectation of reasonably
estimable future cash flows from PCI loans deteriorates, the loans may be classified as nonaccrual loans and interest income will not be recognized until the timing and amount of future cash flows can be reasonably estimated.
Impaired loans:
Total impaired loans
Other real estate owned, non-guaranteed
3,077
4,134
Nonperforming assets
41,638
30,894
Impaired loans to total loans
0.93
0.83
Nonperforming assets to total assets
0.73
0.70
We did not recognize any interest income on nonaccrual loans during the nine months ended September 30, 2018 and the year ended December 31, 2017 while the loans were in nonaccrual status. Additional interest income that we would have recognized on these loans had they been current in accordance with their original terms was $1.3 million and $0.9 million during the nine months ended September 30, 2018 and year ended December 31, 2017, respectively. We recognized interest income on commercial and commercial real estate loans modified under troubled debt restructurings of $0.1 million and $0.1 million during the nine months ended September 30, 2018 and the year ended December 31, 2017, respectively.
We use a ten grade risk rating system to categorize and determine the credit risk of our loans. Potential problem loans include loans with a risk grade of 7, which are "special mention," and loans with a risk grade of 8, which are "substandard" loans that are not considered to be impaired. These loans generally require more frequent loan officer contact and receipt of financial data to closely monitor borrower performance. Potential problem loans are managed and monitored regularly through a number of processes, procedures and committees, including oversight by a loan administration committee comprised of executive officers and other members of the Bank's senior management team.
The following table presents the recorded investment of potential problem commercial loans (excluding PCI loans) by loan category at the dates indicated:
Construction &
Land Development
Risk Category
8 (1)
22,403
18,636
34,988
31,128
107,198
12,588
27,419
12,260
14,770
67,037
Includes only those 8‑rated loans that are not included in impaired loans.
Investment Securities. Our investment strategy aims to maximize earnings while maintaining liquidity in securities with minimal credit risk. The types and maturities of securities purchased are primarily based on our current and projected liquidity and interest rate sensitivity positions.
The following table sets forth the book value and percentage of each category of investment securities at September 30, 2018 and December 31, 2017. The book value for investment securities classified as available for sale and equity securities is equal to fair market value.
Book
% of
Value
3.6
6.1
11.0
5.6
50.1
51.6
24.9
22.8
9.9
13.3
Total investment securities, available for sale, at fair value
99.5
447,695
99.4
0.5
0.6
Total investment securities, at fair value
685,753
100.0
The following table sets forth the book value, maturities and weighted average yields for our investment portfolio at September 30, 2018. The book value for investment securities classified as available for sale is equal to fair market value.
% of Total
Weighted
Yield
Investment securities, available for sale
U.S. Treasury securities:
Maturing within one year
Maturing in one to five years
Maturing in five to ten years
Maturing after ten years
Total U.S. Treasury securities
Government sponsored entity debt securities:
7,119
52,984
14,786
484
Total government sponsored entity debt securities
Agency mortgage-backed securities:
17,742
283,962
37,550
4,443
Total agency mortgage-backed securities
State and municipal securities (1):
19,815
50,445
69,122
31,630
Total state and municipal securities
Corporate securities:
2,010
7,975
54,326
3,470
Total corporate securities
Total investment securities, available for sale
No stated maturity
Total investment securities and equity securities
Weighted average yield for tax‑exempt securities are presented on a tax‑equivalent basis assuming a federal income tax rate of 21%.
The table below presents the credit ratings at September 30, 2018 at fair value for our investment securities classified as available for sale.
Estimated
Average Credit Rating
AAA
AA+/−
A+/−
BBB+/−
<BBB−
Not Rated
3,175
340,522
31,576
106,921
12,638
5,787
13,355
15,666
49,139
2,976
34,751
547,349
28,304
54,926
16,331
Cash and Cash Equivalents. Cash and cash equivalents increased $27.2 million to $242.4 million as of September 30, 2018 compared to December 31, 2017. This increase was primarily due to cash flows from financing activities and operating activities totaling $15.0 million and $65.9 million, respectively. These increases were offset in part by cash flows used in investing activities of $53.7 million. Cash flows provided by financing activities primarily consisted of FHLB proceeds exceeding payments by $140.5 million, offset in part by a $99.0 million decrease in deposits, $14.7 million in payments made on common dividends and a $10.7 million decrease in short-term borrowings.
Cash provided by operating activities primarily reflected $23.1 million of net income, $25.8 million of proceeds received from sales of loans held for sale exceeding originations, and $13.0 million of proceeds from the sale of residential MSR held for sale. Cash used in investing activities primarily reflected loan growth exceeding net cash flows received from investment security transactions and net cash received from the Alpine acquisition.
Goodwill and Other Intangible Assets. Goodwill was $164.0 million at September 30, 2018 compared to $98.6 million at December 31, 2017. Goodwill represents the excess of consideration paid in an acquisition over the fair value of the net assets acquired. The $65.4 million increase during the first nine months of 2018 primarily resulted from goodwill associated with the Alpine acquisition.
Our other intangible assets, which consist of core deposit and customer relationship intangibles, were $39.2 million and $16.9 million at September 30, 2018 and December 31, 2017, respectively. The increase in other intangibles primarily reflected the impact of a $21.1 million core deposit intangible and a $6.3 million customer relationship intangible associated with the Alpine acquisition.
Liabilities. Total liabilities increased $1.2 billion to $5.1 billion at September 30, 2018 due primarily to the Alpine acquisition.
Deposits. We emphasize developing total client relationships with our customers in order to increase our retail and commercial core deposit bases, which are our primary funding sources. Our deposits consist of noninterest‑bearing and interest‑bearing demand, savings and time deposit accounts.
The following table summarizes our average deposit balances and weighted average rates for the three months ended September 30, 2018 and 2017:
September 30, 2017
1,022,010
0.45
833,684
0.17
866,748
0.79
614,544
0.50
452,220
0.15
Time, less than $250,000
560,810
1.23
449,308
0.82
Time, $250,000 and over
81,283
1.47
62,453
1.08
Time, brokered
189,351
2.20
281,301
1.48
Total interest-bearing
0.77
2,527,489
4,161,564
0.59
3,216,475
0.42
The following table sets forth the maturity of time deposits of $250,000 or more and brokered time deposits as of September 30, 2018:
Maturity Within:
Three
Three to Six
Six to 12
After 12
Months or Less
Months
9,119
12,616
32,808
21,549
76,092
26,539
55,491
72,241
34,265
188,536
35,658
68,107
105,049
55,814
264,628
Total deposits increased $1.0 billion to $4.1 billion at September 30, 2018 as compared to December 31, 2017. This increase primarily resulted from $1.1 billion of deposits added from the Alpine acquisition. At September 30, 2018, total deposits were comprised of 23.9% noninterest‑bearing demand accounts, 56.3% interest‑bearing transaction accounts and 19.8% of time deposits. At September 30, 2018, brokered time deposits totaled $188.5 million, or 4.6% of total deposits, compared to $190.3 million, or 6.1% of total deposits, at December 31, 2017.
Short‑Term Borrowings. In addition to deposits, we use short‑term borrowings, such as federal funds purchased and securities sold under agreements to repurchase, as a source of funds to meet the daily liquidity needs of our customers and fund growth in earning assets. Short‑term borrowings were $145.5 million at September 30, 2018 compared to $156.1 million at December 31, 2017. The weighted average interest rate on our short‑term borrowings was 0.63% and 0.28% at September 30, 2018 and December 31, 2017, respectively.
FHLB Advances and Other Borrowings. FHLB advances and other borrowings totaled $652.3 million and $496.4 million as of September 30, 2018 and December 31, 2017, respectively. During the first nine months of 2018, we increased FHLB advances at the Bank by $166.0 million and assumed FHLB advances totaling $18.1 million as a result of the Alpine acquisition.
Capital Resources and Liquidity Management
Capital Resources. Shareholders’ equity is influenced primarily by earnings, dividends, issuances and redemptions of common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized holding gains or losses, net of taxes, on available‑for‑sale investment securities.
Shareholders’ equity increased $144.6 million to $594.1 million at September 30, 2018 as compared to December 31, 2017. The increase in shareholders’ equity was due primarily to $139.9 million of common equity issued for the Alpine acquisition. During the first nine months of 2018, we generated net income of $23.1 million, and declared dividends to common shareholders of $14.7 million.
In conjunction with the acquisition of Alpine, the Company paid $33.3 million in cash and issued 4,463,200 shares of Midland common stock upon closing of the transaction on February 28, 2018. Additionally, the Company
issued $40.0 million aggregate principal amount of subordinated debentures in October 2017, the proceeds of which were used to fund the payment of the cash portion of the merger consideration.
Liquidity Management. Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short‑term and long‑term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders.
Integral to our liquidity management is the administration of short‑term borrowings. To the extent we are unable to obtain sufficient liquidity through core deposits, we seek to meet our liquidity needs through wholesale funding or other borrowings on either a short‑ or long‑term basis.
The Company had available lines of credit of $68.4 million and $32.5 million at September 30, 2018 and December 31, 2017, respectively, from the Federal Reserve Discount Window. The lines are collateralized by collateral agreements totaling $78.9 million and $36.5 million at September 30, 2018 and December 31, 2017, respectively. There were no outstanding borrowings under these lines of credit at September 30, 2018 and December 31, 2017.
The Company is a corporation separate and apart from the Bank and, therefore, must provide for its own liquidity. The Company’s main source of funding is dividends declared and paid to us by the Bank. There are statutory, regulatory and debt covenant limitations that affect the ability of the Bank to pay dividends to the Company. Management believes that these limitations will not impact our ability to meet our ongoing short‑term cash obligations.
Regulatory Capital Requirements
We are subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action”, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off‑balance sheet items as calculated under regulatory accounting policies.
The Dodd‑Frank Wall Street Reform and Consumer Protection Act and the Basel III regulatory capital reforms (the “Basel III Rule”) have established capital standards for banks and bank holding companies. The table below summarizes the minimum capital requirements applicable to us under the Basel III Rule.
Basel III
Well
Adequately
Ratio
Capitalized
Tier 1 leverage ratio
5.0
4.0
Common equity Tier 1 risk-based capital ratio
6.5
4.5
Tier 1 risk-based capital ratio
8.0
6.0
Total risk-based capital ratio
10.0
In addition to the minimum regulatory capital requirements set forth in the table above, the Basel III Rule implemented a “capital conservation buffer” that is added to the minimum requirements for capital adequacy purposes. A banking organization that fails to meet the required amount of the capital conservation buffer will be subject to limits
on capital distributions (e.g., dividends, stock buybacks, etc.) and certain discretionary bonus payments to executive officers. For community banks, the capital conservation buffer requirement is being phased in over a three-year period beginning on January 1, 2016. The capital conservation buffer in 2016 was 0.625%, was 1.25% in 2017, is 1.875% in 2018 and will be fully phased in at 2.5% on January 1, 2019.
At September 30, 2018, the Company was considered to be “well‑capitalized” with a Tier 1 leverage ratio of 8.24%, a common equity Tier 1 capital ratio of 8.37%, a Tier 1 capital ratio of 9.85% and a total capital ratio of 12.35%.
At September 30, 2018, Midland States Bank exceeded all regulatory capital requirements under the Basel III Rule and was considered to be “well‑capitalized” with a Tier 1 leverage ratio of 9.86%, a common equity Tier 1 capital ratio of 11.77%, a Tier 1 capital ratio of 11.77% and a total capital ratio of 12.22%.
Contractual Obligations
The following table contains supplemental information regarding our total contractual obligations at September 30, 2018:
Payments Due
Less than
One to
Three to
More than
One Year
Three Years
Five Years
Deposits without a stated maturity
3,321,015
562,666
216,159
43,300
65
Securities sold under repurchase agreements
106,670
39,592
395,991
110,000
Operating lease obligations
2,826
4,480
3,552
2,449
13,307
Total contractual obligations
4,138,627
260,231
442,843
254,283
5,095,984
We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate cash levels. We expect to maintain adequate cash levels through profitability, loan and securities repayment and maturity activity and continued deposit gathering activities. We have in place various borrowing mechanisms for both short‑term and long‑term liquidity needs.
Quantitative and Qualitative Disclosures About Market Risk
Market Risk. Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through exposures to market interest rates, equity prices, and credit spreads. We have identified two primary sources of market risk: interest rate risk and price risk.
Interest Rate Risk
Overview. Interest rate risk is the risk to earnings and value arising from changes in market interest rates. Interest rate risk arises from timing differences in the repricings and maturities of interest‑earning assets and interest‑bearing liabilities (reprice risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay residential mortgage loans at any time and depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S. Treasuries and LIBOR (basis risk).
Our board of directors’ Asset‑Liability Committee (“ALCO”) establishes broad policy limits with respect to interest rate risk. ALCO establishes specific operating guidelines within the parameters of the board of directors’ policies. In general, we seek to minimize the impact of changing interest rates on net interest income and the economic values of assets and liabilities. Our ALCO meets quarterly to monitor the level of interest rate risk sensitivity to ensure compliance with the board of directors’ approved risk limits.
Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective management of interest rate risk begins with
57
understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk posture given business forecasts, management objectives, market expectations, and policy constraints.
An asset sensitive position refers to a balance sheet position in which an increase in short‑term interest rates is expected to generate higher net interest income, as rates earned on our interest‑earning assets would reprice upward more quickly than rates paid on our interest‑bearing liabilities, thus expanding our net interest margin. Conversely, a liability sensitive position refers to a balance sheet position in which an increase in short‑term interest rates is expected to generate lower net interest income, as rates paid on our interest‑bearing liabilities would reprice upward more quickly than rates earned on our interest‑earning assets, thus compressing our net interest margin.
Income Simulation and Economic Value Analysis. Interest rate risk measurement is calculated and reported to the ALCO at least quarterly. The information reported includes period‑end results and identifies any policy limits exceeded, along with an assessment of the policy limit breach and the action plan and timeline for resolution, mitigation, or assumption of the risk.
We use two approaches to model interest rate risk: Net Interest Income at Risk (“NII at Risk”) and Economic Value of Equity (“EVE”). Under NII at Risk, net interest income is modeled utilizing various assumptions for assets, liabilities, and derivatives. EVE measures the period end market value of assets minus the market value of liabilities and the change in this value as rates change. EVE is a period end measurement.
The following table shows NII at Risk at the dates indicated:
Net Interest Income Sensitivity
Immediate Change in Rates
-100
+100
+200
Dollar change
(7,215)
Percent change
(3.8)
1.4
2.5
(7,943)
3,546
6,504
(5.8)
2.6
4.7
We report NII at Risk to isolate the change in income related solely to interest earning assets and interest‑bearing liabilities. The NII at Risk results included in the table above reflect the analysis used quarterly by management. It models immediate -100, +100 and +200 basis point parallel shifts in market interest rates.
We are within board policy limits for the +100 and +200 basis point scenarios. The NII at Risk reported at September 30, 2018, projects that our earnings exhibit decreased sensitivity to changes in interest rates compared to December 31, 2017.
The following table shows EVE at the dates indicated:
Economic Value of Equity Sensitivity
(53,407)
32,796
59,189
(8.5)
5.2
9.5
(47,892)
29,803
53,786
(10.7)
6.7
12.0
The EVE results included in the table above reflect the analysis used quarterly by management. It models immediate −100, +100 and +200 basis point parallel shifts in market interest rates.
We are within board policy limits for the +100 and +200 basis point scenarios. The EVE reported at September 30, 2018 projects that as interest rates increase, the economic value of equity position will increase, and as interest rates decrease, the economic value of equity position will decrease. When interest rates rise, fixed rate assets generally lose economic value; the longer the duration, the greater the value lost. The opposite is true when interest rates fall.
Price Risk. Price risk represents the risk of loss arising from adverse movements in the prices of financial instruments that are carried at fair value and subject to fair value accounting. We have price risk from equity investments and investments in securities backed by mortgage loans.
Item 3 – Quantitative and Qualitative Disclosures About Market Risk
The quantitative and qualitative disclosures about market risk are included under “Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Quantitative and Qualitative Disclosures About Market Risk,” appearing on pages 57 through 59 of this report.
Item 4 – Controls and Procedures
Evaluation of disclosure controls and procedures. The Company’s management, including our Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective as of that date to provide reasonable assurance that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its Chief Executive Officer and its Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in internal control over financial reporting. There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II – Other Information
Item 1 – Legal Proceedings
In the normal course of business, we are named or threatened to be named as a defendant in various lawsuits, none of which we expect to have a material effect on the Company. However, given the nature, scope and complexity of the extensive legal and regulatory landscape applicable to our business (including laws and regulations governing consumer protection, fair lending, fair labor, privacy, information security, anti-money laundering and anti-terrorism), we, like all banking organizations, are subject to heightened legal and regulatory compliance and litigation risk. There are no material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.
Item 1A – Risk Factors
There have been no material changes from the risk factors previously disclosed in the “Risk Factors” section included in our Annual Report on Form 10-K for the year ended December 31, 2017.
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
The following table sets forth information regarding the Company’s repurchase of shares of its outstanding common stock during the third quarter of 2018.
Maximum
Number of
Shares Purchased
Shares that May
Number
Price
as Part of Publicly
Yet Be Purchased
of Shares
Paid Per
Announced Plans
Under the Plans
Period
Purchased (1)
Share
or Programs
July 1 - 31, 2018
1,982
35.01
-
August 1 - 31, 2018
5,448
34.73
September 1 -30, 2018
33.93
7,663
34.78
__________________________________
Represents shares of the Company’s common stock repurchased under the employee stock purchase program and/or shares withheld to satisfy tax withholding obligations upon the vesting of awards of restricted stock. These shares were purchased pursuant to the terms of the applicable plan and not pursuant to a publicly announced repurchase plan or program.
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Item 6 – Exhibits
Exhibit No.
Description
10.1
Form of Restricted Stock Award Terms under the Midland States Bancorp, Inc. Second Amended and Restated 2010 Long-Term Incentive Plan (for awards on and after November 6, 2018)
31.1
Chief Executive Officer’s Certification required by Rule 13(a)-14(a) – filed herewith.
31.2
Chief Financial Officer’s Certification required by Rule 13(a)-14(a) – filed herewith.
32.1
Chief Executive Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.
32.2
Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.
Financial information from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018, formatted in XBRL interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Income; (iii) Consolidated Statements of Comprehensive Income; (iv) Consolidated Statements of Shareholders’ Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements – filed herewith.
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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.
Midland States Bancorp, INC.
Date: November 7, 2018
By:
/s/
Leon J. Holschbach
Chief Executive Officer
(Principal Executive Officer)
Stephen A. Erickson
Chief Financial Officer
(Principal Financial and Accounting Officer)
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