UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
[ ] 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 0-22208
QCR HOLDINGS, INC.
(Exact name of Registrant as specified in its charter)
Delaware
42-1397595
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
3551 7th Street, Moline, Illinois 61265
(Address of principal executive offices, including zip code)
(309) 736-3580
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [ X ] No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer [ ] Accelerated filer [ X ] 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 Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: As of November 2, 2017, the Registrant had outstanding 13,888,923 shares of common stock, $1.00 par value per share.
QCR HOLDINGS, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
Page Number(s)
Part I
FINANCIAL INFORMATION
Item 1
Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets
3
As of September 30, 2017 and December 31, 2016
Consolidated Statements of Income
For the Three Months Ended September 30, 2017 and 2016
4
For the Nine Months Ended September 30, 2017 and 2016
5
Consolidated Statements of Comprehensive Income
For the Three and Nine Months Ended September 30, 2017 and 2016
6
Consolidated Statements of Changes in Stockholders' Equity
7
Consolidated Statements of Cash Flows
9
Notes to Consolidated Financial Statements
Note 1. Summary of Significant Accounting Policies
11
Note 2. Investment Securities
13
Note 3. Loans/Leases Receivable
18
Note 4. Earnings Per Share
28
Note 5. Fair Value
Note 6. Business Segment Information
32
Note 7. Regulatory Capital Requirements
33
Note 8. Subsequent Event - Acquisition of Guaranty Bank and Trust Company
35
Item 2
Management's Discussion and Analysis of Financial Condition and Results of Operations
Introduction
36
General
Executive Overview
37
Long-Term Financial Goals
39
Strategic Developments
40
GAAP to Non-GAAP Reconciliations
41
Net Interest Income (Tax Equivalent Basis)
43
Critical Accounting Policies
49
Results of Operations
Interest Income
50
Interest Expense
Provision for Loan/Lease Losses
51
Noninterest Income
52
Noninterest Expense
55
Income Taxes
57
Financial Condition
Investment Securities
58
Loans/Leases
59
Allowance for Estimated Losses on Loans/Leases
62
Nonperforming Assets
64
Deposits
65
Borrowings
Stockholders' Equity
67
Liquidity and Capital Resources
68
Special Note Concerning Forward-Looking Statements
70
Item 3
Quantitative and Qualitative Disclosures About Market Risk
71
Item 4
Controls and Procedures
73
Part II
OTHER INFORMATION
Legal Proceedings
74
Item 1A
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults upon Senior Securities
Mine Safety Disclosures
Item 5
Other Information
Item 6
Exhibits
75
Signatures
76
Throughout the Notes to the Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations, we use certain acronyms and abbreviations, as defined in Note 1.
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
September 30,
December 31,
2017
2016
ASSETS
Cash and due from banks
Federal funds sold
Interest-bearing deposits at financial institutions
Securities held to maturity, at amortized cost
Securities available for sale, at fair value
Total securities
Loans receivable held for sale
Loans/leases receivable held for investment
Gross loans/leases receivable
Less allowance for estimated losses on loans/leases
Net loans/leases receivable
Bank-owned life insurance
Premises and equipment, net
Restricted investment securities
Other real estate owned, net
Goodwill
Core deposit intangible
Other assets
Total assets
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Short-term borrowings
Federal Home Loan Bank advances
Other borrowings
Junior subordinated debentures
Other liabilities
Total liabilities
STOCKHOLDERS' EQUITY
Preferred stock, $1 par value; shares authorized 250,000 September 2017 and December 2016 - No shares issued or outstanding
Common stock, $1 par value; shares authorized 20,000,000 September 2017 - 13,201,959 shares issued and outstanding December 2016 - 13,106,845 shares issued and outstanding
Additional paid-in capital
Retained earnings
Accumulated other comprehensive (loss):
Securities available for sale
Interest rate cap derivatives
Total stockholders' equity
Total liabilities and stockholders' equity
See Notes to Consolidated Financial Statements (Unaudited)
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Three Months Ended September 30,
Interest and dividend income:
Loans/leases, including fees
Securities:
Taxable
Nontaxable
Total interest and dividend income
Interest expense:
Total interest expense
Net interest income
Provision for loan/lease losses
Net interest income after provision for loan/lease losses
Noninterest income:
Trust department fees
Investment advisory and management fees
Deposit service fees
Gains on sales of residential real estate loans, net
Gains on sales of government guaranteed portions of loans, net
Swap fee income
Securities gains (losses), net
Earnings on bank-owned life insurance
Debit card fees
Correspondent banking fees
Other
Total noninterest income
Noninterest expense:
Salaries and employee benefits
Occupancy and equipment expense
Professional and data processing fees
Acquisition costs
Post-acquisition transition and integration costs
FDIC insurance, other insurance and regulatory fees
Loan/lease expense
Net cost of (income from) operations of other real estate
Advertising and marketing
Bank service charges
Losses on debt extinguishment, net
Correspondent banking expense
Total noninterest expense
Net income before income taxes
Federal and state income tax expense
Net income
Basic earnings per common share
Diluted earnings per common share
Weighted average common shares outstanding
Weighted average common and common equivalent shares outstanding
Cash dividends declared per common share
Nine Months Ended September 30,
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
Three and Nine Months Ended September 30, 2017 and 2016
Other comprehensive income (loss):
Unrealized gains (losses) on securities available for sale:
Unrealized holding gains arising during the period before tax
Less reclassification adjustment for gains (losses) included in net income before tax
Unrealized gains (losses) on interest rate cap derivatives:
Unrealized holding losses arising during the period before tax
Less reclassification adjustment for ineffectiveness and caplet amortization before tax
Other comprehensive income (loss), before tax
Tax expense (benefit)
Other comprehensive income (loss), net of tax
Comprehensive income
Other comprehensive income:
Other comprehensive income, before tax
Tax expense
Other comprehensive income, net of tax
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
Accumulated
Additional
Common
Paid-In
Retained
Comprehensive
Stock
Capital
Earnings
Income (Loss)
Total
Balance December 31, 2016
Common cash dividends declared, $0.05 per share
Proceeds from issuance of 3,573 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 44,284 shares of common stock as a result of stock options exercised
Stock compensation expense
Restricted stock awards - 13,289 shares of common stock
Exchange of 6,772 shares of common stock in connection with stock options exercised and restricted stock vested
Balance March 31, 2017
Proceeds from issuance of 4,582 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 8,027 shares of common stock as a result of stock options exercised
Restricted stock awards - 2,000 shares of common stock
Exchange of 594 shares of common stock in connection with stock options exercised
Balance June 30, 2017
Other comprehensive loss, net of tax
Proceeds from issuance of 2,319 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 19,906 shares of common stock as a result of stock options exercised
Restricted stock awards - 4,500 shares of common stock
Balance September 30, 2017
(Continued)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED) - continued
Balance December 31, 2015
Common cash dividends declared, $0.04 per share
Proceeds from issuance of 5,054 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 46,020 shares of common stock as a result of stock options exercised
Tax benefit of nonqualified stock options exercised
Restricted stock awards - 22,382 shares of common stock
Exchange of 19,628 shares of common stock in connection with restricted stock vested, net
Balance March 31, 2016
Proceeds from issuance of 1,215,000 shares of common stock, net of issuance costs
Proceeds from issuance of 6,982 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 20,975 shares of common stock as a result of stock options exercised
Tax basis adjustment related to the acquisition of noncontrolling interest in m2 Lease Funds
Restricted stock awards - 500 shares of common stock
Balance June 30, 2016
Proceeds from issuance of 4,085 shares of common stock as a result of stock purchased under the Employee Stock Purchase Plan
Proceeds from issuance of 14,692 shares of common stock as a result of stock options exercised
Exchange of 838 shares of common stock in connection with stock options exercised
Balance September 30, 2016
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended September 30, 2017 and 2016
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Stock-based compensation expense
Deferred compensation expense accrued
Losses (gains) on other real estate owned, net
Amortization of premiums on securities, net
Securities losses (gains), net
Loans originated for sale
Proceeds on sales of loans
Gains on sales of residential real estate loans
Gains on sales of government guaranteed portions of loans
Amortization of core deposit intangible
Accretion of acquisition fair value adjustments, net
Increase in cash value of bank-owned life insurance
Decrease (increase) in other assets
Increase (decrease) in other liabilities
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Net decrease (increase) in federal funds sold
Net decrease (increase) in interest-bearing deposits at financial institutions
Proceeds from sales of other real estate owned
Activity in securities portfolio:
Purchases
Calls, maturities and redemptions
Paydowns
Sales
Activity in restricted investment securities:
Redemptions
Net increase in loans/leases originated and held for investment
Purchase of premises and equipment
Net cash paid for Community State Bank acquisition
Cash prepaid for Guaranty Bank acquisition
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposit accounts
Net decrease in short-term borrowings
Activity in Federal Home Loan Bank advances:
Term advances
Calls and maturities
Net change in short-term and overnight advances
Prepayments
Activity in other borrowings:
Proceeds from other borrowings
Calls, maturities and scheduled principal payments
Retirement of junior subordinated debentures
Payment of cash dividends on common stock
Net proceeds from the common stock offering, 1,215,000 shares issued
Proceeds from issuance of common stock, net
Net cash provided by financing activities
Net increase (decrease) in cash and due from banks
Cash and due from banks, beginning
Cash and due from banks, ending
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - continued
Supplemental disclosure of cash flow information, cash payments for:
Interest
Income/franchise taxes
Supplemental schedule of noncash investing activities:
Change in accumulated other comprehensive income, unrealized gains on securities available for sale and derivative instruments, net
Exchange of shares of common stock in connection with payroll taxes for restricted stock and in connection with stock options exercised
Transfers of loans to other real estate owned
Due from broker for sales of securities
Due to broker for purchases of securities
Due to counterparties for prepayment of FHLB advances and other borrowings
Dividends payable
Increase in the fair value of interest rate swap assets and liabilities
Supplemental disclosure of cash flow information for Community State Bank acquisition:
Fair value of assets acquired:
Cash and due from banks *
Securities
Loans/leases receivable held for investment, net
Other real estate owned
Total assets acquired
Fair value of liabilities assumed:
FHLB advances
Total liabilities assumed
Net assets acquired
Consideration paid:
Cash paid *
Total consideration paid
* Net cash paid at closing totaled $69,905,355
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2017
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of presentation: The interim unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and accompanying notes to the consolidated financial statements for the fiscal year ended December 31, 2016, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 10, 2017. Accordingly, footnote disclosures, which would substantially duplicate the disclosures contained in the audited consolidated financial statements, have been omitted.
The financial information of the Company included herein has been prepared in accordance with GAAP for interim financial reporting and has been prepared pursuant to the rules and regulations for reporting on Form 10-Q and Rule 10-01 of Regulation S-X. Such information reflects all adjustments (consisting of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods presented. Any differences appearing between the numbers presented in financial statements and management’s discussion and analysis are due to rounding. The results of the interim period ended September 30, 2017, are not necessarily indicative of the results expected for the year ending December 31, 2017, or for any other period.
The acronyms and abbreviations identified below are used throughout this Quarterly Report on Form 10-Q. It may be helpful to refer back to this page as you read this report.
Allowance: Allowance for estimated losses on loans/leases
Guaranty Bank: Guaranty Bank and Trust Company
AOCI: Accumulated other comprehensive income (loss)
HTM: Held to maturity
AFS: Available for sale
m2: m2 Lease Funds, LLC
ASC: Accounting Standards Codification
NIM: Net interest margin
ASU: Accounting Standards Update
NPA: Nonperforming asset
BOLI: Bank-owned life insurance
NPL: Nonperforming loan
Caps: Interest rate cap derivatives
OREO: Other real estate owned
Community National: Community National Bancorporation
OTTI: Other-than-temporary impairment
CRBT: Cedar Rapids Bank & Trust Company
PCI: Purchased credit impaired
CRE: Commercial real estate
Provision: Provision for loan/lease losses
CSB: Community State Bank
QCBT: Quad City Bank & Trust Company
C&I: Commercial and industrial
RB&T: Rockford Bank & Trust Company
Dodd-Frank Act: Dodd-Frank Wall Street Reform and
ROAA: Return on Average Assets
Consumer Protection Act
SBA: U.S. Small Business Administration
EPS: Earnings per share
SEC: Securities and Exchange Commission
Exchange Act: Securities Exchange Act of 1934, as amended
TA: Tangible assets
FASB: Financial Accounting Standards Board
TCE: Tangible common equity
FDIC: Federal Deposit Insurance Corporation
TDRs: Troubled debt restructurings
FHLB: Federal Home Loan Bank
TEY: Tax equivalent yield
FRB: Federal Reserve Bank of Chicago
The Company: QCR Holdings, Inc.
GAAP: Generally Accepted Accounting Principles
USDA: U.S. Department of Agriculture
Guaranty: Guaranty Bankshares, Ltd.
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries which include four commercial banks: QCBT, CRBT, CSB and RB&T. All are state-chartered commercial banks and all are members of the Federal Reserve system. The Company also engages in direct financing lease contracts through m2, a wholly-owned subsidiary of QCBT. All material intercompany transactions and balances have been eliminated in consolidation.
The acquisition of CSB occurred on August 31, 2016; therefore, the financial results of CSB for the periods since acquisition are included in this report.
On October 2, 2017, the Company announced the completion of its previously announced acquisition of Guaranty Bank, headquartered in Cedar Rapids, Iowa, from Guaranty. The financial results of Guaranty Bank are not included in this report because the closing was effective October 1, 2017. See Note 8 to the Consolidated Financial Statements for additional information about the acquisition.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)-continued
Recent accounting developments: In May 2014, FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 was originally effective for the Company on January 1, 2017; however, FASB issued ASU 2015-14 which defers the effective date in order to provide additional time for both public and private entities to evaluate the impact. ASU 2014-09 will now be effective for the Company on January 1, 2018 and it is not expected to have a significant impact on the Company’s consolidated financial statements.
In January 2016, FASB issued ASU 2016-01, Financial Instruments–Overall. ASU 2016-01 makes targeted adjustments to GAAP by eliminating the AFS classification for equity securities and requiring equity investments to be measured at fair value with changes in fair value recognized in net income. The standard also requires public business entities to use the exit price notion when measuring fair value of financial instruments for disclosure purposes. The standard clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to AFS securities in combination with the entity’s other deferred tax assets. It also requires an entity to present separately (within 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. Additionally, the standard 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. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and it is not expected to have a significant impact on the Company’s consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases. Under ASU 2016-02, lessees will be required to recognize a lease liability measured on a discounted basis and a right-of-use asset for all leases (with the exception of short-term leases). Lessor accounting is largely unchanged under ASU 2016-02. However, the definition of initial direct costs was updated to include only initial direct costs that are considered incremental. This change in definition will change the manner in which the Company recognizes the costs associated with originating leases. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted for all entities. The Company is in the process of analyzing the impact of adoption on the Company’s consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses. Under the standard, assets measured at amortized costs (including loans, leases and AFS securities) will be presented at the net amount expected to be collected. Rather than the “incurred” model that is currently being utilized, the standard will require the use of a forward-looking approach to recognizing all expected credit losses at the beginning of an asset’s life. For public companies, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Companies may choose to early adopt for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is in the process of analyzing the impact of adoption on the Company’s consolidated financial statements.
Effective January 1, 2017, the Company adopted ASU 2016-09, Compensation – Stock Compensation. Under the standard, the excess tax benefit (deficiency) related to stock options exercised and restricted stock awards vested is recorded as an adjustment to income tax expense. In the past, this tax benefit (deficiency) was recorded directly to equity. This change in accounting resulted in $191 thousand of reduced income tax in the third quarter of 2017 and $814 thousand of reduced income tax expense in the first nine months of 2017.
NOTE 2 – INVESTMENT SECURITIES
The amortized cost and fair value of investment securities as of September 30, 2017 and December 31, 2016 are summarized as follows:
Gross
Amortized
Unrealized
Fair
Cost
Gains
(Losses)
Value
September 30, 2017:
Securities HTM:
Municipal securities
Other securities
Securities AFS:
U.S. govt. sponsored agency securities
Residential mortgage-backed and related securities
December 31, 2016:
The Company’s HTM municipal securities consist largely of private issues of municipal debt. The large majority of the municipalities are located within the Midwest. The municipal debt investments are underwritten using specific guidelines with ongoing monitoring.
The Company’s residential mortgage-backed and related securities portfolio consists entirely of government sponsored or government guaranteed securities. The Company has not invested in private mortgage-backed securities or pooled trust preferred securities.
Gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of September 30, 2017 and December 31, 2016, are summarized as follows:
Less than 12 Months
12 Months or More
Losses
At September 30, 2017, the investment portfolio included 567 securities. Of this number, 203 securities were in an unrealized loss position. The aggregate losses of these securities totaled approximately 0.8% of the total amortized cost of the portfolio. Of these 203 securities, 80 securities had an unrealized loss for twelve months or more. All of the debt securities in unrealized loss positions are considered acceptable credit risks. Based upon an evaluation of the available evidence, including the recent changes in market rates, credit rating information and information obtained from regulatory filings, management believes the declines in fair value for these debt securities are temporary. In addition, the Company lacks the intent to sell these securities and it is not more-likely-than-not that the Company will be required to sell these debt securities before their anticipated recovery. At September 30, 2017 and December 31, 2016, equity securities represented less than 1% of the total portfolio.
The Company did not recognize OTTI on any debt or equity securities for the three or nine months ended September 30, 2017 and 2016.
All sales of securities for the three and nine months ended September 30, 2017 and 2016 were from securities identified as AFS. Information on proceeds received, as well as pre-tax gross gains and losses from sales on those securities are as follows:
Three Months Ended
Nine Months Ended
September 30, 2016
Proceeds from sales of securities*
Pre-tax gross gains from sales of securities
Pre-tax gross losses from sales of securities
Proceeds from sales of securities for the nine months ended September 30, 2016 includes $32.1 million receivable from the broker for the sale of securities
The amortized cost and fair value of securities as of September 30, 2017 by contractual maturity are shown below. Expected maturities of residential mortgage-backed and related securities may differ from contractual maturities because the residential mortgages underlying the residential mortgage-backed and related securities may be prepaid without any penalties. Therefore, these securities are not included in the maturity categories in the following table. “Other securities” AFS are excluded from the maturity categories as there is no fixed maturity date for those securities.
Amortized Cost
Fair Value
Due in one year or less
Due after one year through five years
Due after five years
Portions of the U.S. government sponsored agency securities and municipal securities contain call options, at the discretion of the issuer, to terminate the security at par and at predetermined dates prior to the stated maturity. These callable securities are summarized as follows:
As of September 30, 2017, the Company’s municipal securities portfolios were comprised of general obligation bonds issued by 119 issuers with fair values totaling $100.4 million and revenue bonds issued by 132 issuers, primarily consisting of states, counties, towns, villages and school districts with fair values totaling $278.7 million. The Company held investments in general obligation bonds in 21 states, including six states in which the aggregate fair value exceeded $5.0 million. The Company held investments in revenue bonds in 14 states, including six states in which the aggregate fair value exceeded $5.0 million.
As of December 31, 2016, the Company’s municipal securities portfolios were comprised of general obligation bonds issued by 116 issuers with fair values totaling $116.5 million and revenue bonds issued by 120 issuers, primarily consisting of states, counties, towns, villages and school districts with fair values totaling $255.5 million. The Company held investments in general obligation bonds in 21 states, including five states in which the aggregate fair value exceeded $5.0 million. The Company held investments in revenue bonds in 12 states, including six states in which the aggregate fair value exceeded $5.0 million.
The amortized cost and fair values of the Company’s portfolio of general obligation bonds are summarized in the following tables by the issuer’s state:
U.S. State:
Number of
Issuers
Average
Exposure Per
Issuer(Fair Value)
North Dakota
Illinois
Iowa
Missouri
Ohio
Texas
Total general obligation bonds
Exposure
Per Issuer(Fair Value)
The amortized cost and fair values of the Company’s portfolio of revenue bonds are summarized in the following tables by the issuer’s state:
Indiana
Kansas
Total revenue bonds
Both general obligation and revenue bonds are diversified across many issuers. As of September 30, 2017 and December 31, 2016, the Company did not hold general obligation or revenue bonds of any single issuer, the aggregate book or market value of which exceeded 5% of the Company’s stockholders’ equity. Of the general obligation and revenue bonds in the Company’s portfolio, the majority are unrated bonds that represent small, private issuances. All unrated bonds were underwritten according to loan underwriting standards and have an average loan risk rating of 2, indicating very high quality. Additionally, many of these bonds are funding essential municipal services such as water, sewer, education, and medical facilities.
The Company’s municipal securities are owned by each of the four charters, whose investment policies set forth limits for various subcategories within the municipal securities portfolio. Each charter is monitored individually, and as of September 30, 2017, all were well within policy limitations approved by the board of directors. Policy limits are calculated as a percentage of each charter’s total risk-based capital.
As of September 30, 2017, the Company’s standard monitoring of its municipal securities portfolio had not uncovered any facts or circumstances resulting in significantly different credit ratings than those assigned by a nationally recognized statistical rating organization, or in the case of unrated bonds, the rating assigned using the credit underwriting standards.
NOTE 3 – LOANS/LEASES RECEIVABLE
The composition of the loan/lease portfolio as of September 30, 2017 and December 31, 2016 is presented as follows:
As of September 30,
As of December 31,
C&I loans***
CRE loans
Owner-occupied CRE
Commercial construction, land development, and other land
Other non owner-occupied CRE
Direct financing leases *
Residential real estate loans **
Installment and other consumer loans
Plus deferred loan/lease origination costs, net of fees
Less allowance
* Direct financing leases:
Net minimum lease payments to be received
Estimated unguaranteed residual values of leased assets
Unearned lease/residual income
Plus deferred lease origination costs, net of fees
*Management performs an evaluation of the estimated unguaranteed residual values of leased assets on an annual basis, at a minimum. The evaluation consists of discussions with reputable and current vendors, which is combined with management’s expertise and understanding of the current states of particular industries to determine informal valuations of the equipment. As necessary and where available, management will utilize valuations by independent appraisers. The large majority of leases with residual values contain a lease options rider, which requires the lessee to pay the residual value directly, finance the payment of the residual value, or extend the lease term to pay the residual value. In these cases, the residual value is protected and the risk of loss is minimal. There were no losses related to residual values for the three and nine months ended September 30, 2017 and 2016.
**Includes residential real estate loans held for sale totaling $290,320 and $1,135,500 as of September 30, 2017, and December 31, 2016, respectively.
*** Includes equipment financing agreements outstanding at m2 totaling $60,981,381 and $38,668,209 as of September 30, 2017 and December 31, 2016, respectively.
Changes in accretable yield for acquired loans were as follows:
Three months ended September 30, 2017
Nine months ended September 30, 2017
PCI
Performing
Loans
Balance at the beginning of the period
Accretion recognized
Balance at the end of the period
Three months ended September 30, 2016
Nine months ended September 30, 2016
Discount added at acquisition
The aging of the loan/lease portfolio by classes of loans/leases as of September 30, 2017 and December 31, 2016 is presented as follows:
As of September 30, 2017
Classes of Loans/Leases
Current
30-59 Days
Past Due
60-89 Days
Accruing Past Due
90 Days or More
Nonaccrual
C&I
CRE
Owner-Occupied CRE
Commercial Construction, Land Development, and Other Land
Other Non Owner-Occupied CRE
Direct Financing Leases
Residential Real Estate
Installment and Other Consumer
As a percentage of total loan/lease portfolio
As of December 31, 2016
Nonaccrual Loans/Leases
NPLs by classes of loans/leases as of September 30, 2017 and December 31, 2016 are presented as follows:
Accruing Past
Due 90 Days or
More
Loans/Leases *
AccruingTDRs
Total NPLs
Percentage of
*Nonaccrual loans/leases included $2,291,666 of TDRs, including $258,598 in C&I loans, $1,198,439 in CRE loans, $607,882 in direct financing leases, $177,606 in construction loans, $40,405 in residential real estate loans, and $8,736 in installment loans.
Loans/Leases **
**Nonaccrual loans/leases included $2,300,479 of TDRs, including $48,501 in C&I loans, $1,380,047 in CRE loans, $816,149 in direct financing leases, $43,579 in residential real estate loans, and $12,203 in installment loans.
Changes in the allowance by portfolio segment for the three and nine months ended September 30, 2017 and 2016, respectively, are presented as follows:
Three Months Ended September 30, 2017
Direct Financing
Leases
Residential Real
Estate
Installment and
Other Consumer
Balance, beginning
Provisions (credits) charged to expense
Loans/leases charged off
Recoveries on loans/leases previously charged off
Balance, ending
Three Months Ended September 30, 2016
Provisions charged to expense
Nine Months Ended September 30, 2017
Nine Months Ended September 30, 2016
The allowance by impairment evaluation and by portfolio segment as of September 30, 2017 and December 31, 2016 is presented as follows:
Allowance for impaired loans/leases
Allowance for nonimpaired loans/leases
Impaired loans/leases
Nonimpaired loans/leases
Allowance as a percentage of impaired loans/leases
Allowance as a percentage of nonimpaired loans/leases
Total allowance as a percentage of total loans/leases
Information for impaired loans/leases is presented in the tables below. The recorded investment represents customer balances net of any partial charge-offs recognized on the loan/lease. The unpaid principal balance represents the recorded balance outstanding on the loan/lease prior to any partial charge-offs.
Loans/leases, by classes of financing receivable, considered to be impaired as of and for the nine months ended September 30, 2017 are presented as follows:
Recorded
Investment
Unpaid Principal
Balance
Related
Allowance
Income
Recognized
Recognized for
Cash Payments
Received
Impaired Loans/Leases with No Specific Allowance Recorded:
Impaired Loans/Leases with Specific Allowance Recorded:
Total Impaired Loans/Leases:
Impaired loans/leases for which no allowance has been provided have adequate collateral, based on management’s current estimates.
Loans/leases, by classes of financing receivable, considered to be impaired as of and for the three months ended September 30, 2017 and 2016, respectively, are presented as follows:
Loans/leases, by classes of financing receivable, considered to be impaired as of December 31, 2016 are presented as follows:
Unpaid
Principal
For C&I and CRE loans, the Company’s credit quality indicator consists of internally assigned risk ratings. Each commercial loan is assigned a risk rating upon origination. The risk rating is reviewed every 15 months, at a minimum, and on an as-needed basis depending on the specific circumstances of the loan.
For direct financing leases, residential real estate loans, and installment and other consumer loans, the Company’s credit quality indicator is performance determined by delinquency status. Delinquency status is updated daily by the Company’s loan system.
For each class of financing receivable, the following presents the recorded investment by credit quality indicator as of September 30, 2017 and December 31, 2016:
Non Owner-Occupied
Internally Assigned Risk Rating
Owner-Occupied
Commercial
Construction,
Land
Development,
and Other Land
Other CRE
As a % of
Pass (Ratings 1 through 5)
Special Mention (Rating 6)
Substandard (Rating 7)
Doubtful (Rating 8)
Delinquency Status *
As a % of Total
Nonperforming
*Performing = loans/leases accruing and less than 90 days past due. Nonperforming = loans/leases on nonaccrual, accruing loans/leases that are greater than or equal to 90 days past due, and accruing TDRs.
As of September 30, 2017 and December 31, 2016, TDRs totaled $9,854,487 and $8,647,007, respectively.
For each class of financing receivable, the following presents the number and recorded investment of TDRs, by type of concession, that were restructured during the three and nine months ended September 30, 2017 and 2016. The difference between the pre-modification recorded investment and the post-modification recorded investment would be any partial charge-offs at the time of the restructuring.
For the three months ended September 30, 2017
For the three months ended September 30, 2016
Loans /
Pre-
Modification Recorded
Post-
Specific
CONCESSION - Significant Payment Delay
TOTAL
For the nine months ended September 30, 2017
For the nine months ended September 30, 2016
CONCESSION - Extension of Maturity
CONCESSION - Interest Rate Adjusted Below Market
CRE - Other
Of the TDRs reported above, three with a post-modification recorded balance of $139,241 were on nonaccrual as of September 30, 2017. Two with a post-modification recorded balance of $1,384,680 were on nonaccrual as of September 30, 2016. Not included in the table above, the Company had one TDR that was restructured and charged off in 2016, totaling $236,545.
For the three and nine months ended September 30, 2017, four of the Company’s TDRs redefaulted within 12 months subsequent to restructure where default is defined as delinquency of 90 days or more and/or placement on nonaccrual status. Two of these TDRs were related to one customer whose loans were restructured in the second quarter of 2017 with pre-modification balances totaling $112 thousand and the other two TDRs related to another customer whose loans were restructured in the fourth quarter of 2016 with pre-modification balances totaling $195 thousand.
For the three and nine months ended September 30, 2016, none of the Company’s TDRs had redefaulted within 12 months subsequent to restructure.
NOTE 4 - EARNINGS PER SHARE
The following information was used in the computation of EPS on a basic and diluted basis:
Three months ended
Nine months ended
Basic EPS
Diluted EPS
Weighted average common shares outstanding*
Weighted average common shares issuable upon exercise of stock options and under the employee stock purchase plan
The increase in weighted average common shares outstanding when comparing the nine months ended September 30, 2017 to September 30, 2016 was primarily due to the common stock issuance discussed in Note 2 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
NOTE 5 – FAIR VALUE
Accounting guidance on fair value measurement uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy includes three levels and is based upon the valuation techniques used to measure assets and liabilities. The three levels are as follows:
●
Level 1 – Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in markets;
Level 2 – Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; and
Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair value measurement.
Assets and liabilities measured at fair value on a recurring basis comprise the following at September 30, 2017 and December 31, 2016:
Fair Value Measurements at Reporting Date Using
Quoted Prices
Significant
in Active
Markets for
Observable
Unobservable
Identical Assets
Inputs
(Level 1)
(Level 2)
(Level 3)
Interest rate caps
Interest rate swaps - assets
Total assets measured at fair value
Interest rate swaps - liabilities
Total liabilities measured at fair value
There were no transfers of assets or liabilities between Levels 1, 2, and 3 of the fair value hierarchy for the three and nine months ended September 30, 2017 or 2016.
A small portion of the securities available for sale portfolio consists of common stock issued by various unrelated bank holding companies. The fair values used by the Company are obtained from an independent pricing service and represent quoted market prices for the identical securities (Level 1 inputs).
The remainder of the securities available for sale portfolio consists of securities whereby the Company obtains fair values from an independent pricing service. The fair values are determined by pricing models that consider observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems (Level 2 inputs).
Interest rate caps are used for the purpose of hedging interest rate risk. The fair values are determined by pricing models that consider observable market data for derivative instruments with similar structures (Level 2 inputs).
Interest rate swaps are executed for select commercial customers. The interest rate swaps are further described in Note 1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. The fair values are determined by comparing the contract rate on the swap with the then-current market rate for the remaining term of the transaction (Level 2 inputs).
Certain financial assets are measured at fair value on a non-recurring basis; that is, the assets are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).
Assets measured at fair value on a non-recurring basis comprise the following at September 30, 2017 and December 31, 2016:
Level 1
Level 2
Level 3
OREO
Impaired loans/leases are evaluated and valued at the time the loan/lease is identified as impaired, at the lower of cost or fair value, and are classified as Level 3 in the fair value hierarchy. Fair value is measured based on the value of the collateral securing these loans/leases. Collateral may be real estate and/or business assets, including equipment, inventory and/or accounts receivable, and is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values are discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business.
OREO in the table above consists of property acquired through foreclosures and settlements of loans. Property acquired is carried at the estimated fair value of the property, less disposal costs, and is classified as Level 3 in the fair value hierarchy. The estimated fair value of the property is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values are discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the property.
The following table presents additional quantitative information about assets measured at fair value on a non-recurring basis for which the Company has utilized Level 3 inputs to determine fair value:
Quantitative Information about Level Fair Value Measurements
Fair ValueSeptember 30, 2017
Fair ValueDecember 31, 2016
Valuation Technique
Unobservable Input
Range
Appraisal of collateral
Appraisal adjustments
For the impaired loans/leases and OREO, the Company records carrying value at fair value less disposal or selling costs. The amounts reported in the tables above are fair values before the adjustment for disposal or selling costs.
There have been no changes in valuation techniques used for any assets measured at fair value during the three and nine months ended September 30, 2017 and 2016.
The following table presents the carrying values and estimated fair values of financial assets and liabilities carried on the Company’s consolidated balance sheets, including those financial assets and liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis:
Hierarchy
Carrying
Estimated
Level
Investment securities:
HTM
AFS
See Previous Table
Loans/leases receivable, net
Nonmaturity deposits
Time deposits
NOTE 6 – BUSINESS SEGMENT INFORMATION
Selected financial and descriptive information is required to be disclosed for reportable operating segments, applying a “management perspective” as the basis for identifying reportable segments. The management perspective is determined by the view that management takes of the segments within the Company when making operating decisions, allocating resources, and measuring performance. The segments of the Company have been defined by the structure of the Company’s internal organization, focusing on the financial information that the Company’s operating decision-makers routinely use to make decisions about operating matters.
The Company’s primary segment, Commercial Banking, is geographically divided by markets into the secondary segments comprised of the four subsidiary banks wholly owned by the Company: QCBT, CRBT, CSB and RB&T. Each of these secondary segments offers similar products and services, but is managed separately due to different pricing, product demand, and consumer markets. Each offers commercial, consumer, and mortgage loans and deposit services.
The Company’s Wealth Management segment represents the trust and asset management and investment management and advisory services offered at the Company’s four subsidiary banks in aggregate. This segment generates income primarily from fees charged based on assets under administration for corporate and personal trusts, custodial services, and investments managed. No assets of the subsidiary banks have been allocated to the Wealth Management segment.
The Company’s All Other segment includes the operations of all other consolidated subsidiaries and/or defined operating segments that fall below the segment reporting thresholds. This segment includes the corporate operations of the parent company.
Selected financial information on the Company’s business segments is presented as follows as of and for the three and nine months ended September 30, 2017 and 2016.
Commercial Banking
Wealth
Intercompany
Consolidated
QCBT
CRBT
CSB
RB&T
Management
All Other
Eliminations
Total revenue
Provision
NOTE 7 – REGULATORY CAPITAL REQUIREMENTS
The Company (on a consolidated basis) and the subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and subsidiary banks’ financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the subsidiary banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the subsidiary banks to maintain minimum amounts and ratios (set forth in the following table) of total common equity Tier 1 and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets, each as defined by regulation. Management believes, as of September 30, 2017 and December 31, 2016, that the Company and the subsidiary banks met all capital adequacy requirements to which they are subject.
Under the regulatory framework for prompt corrective action, to be categorized as “well capitalized,” an institution must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 leverage and common equity Tier 1 ratios as set forth in the following tables. The Company and the subsidiary banks’ actual capital amounts and ratios as of September 30, 2017 and December 31, 2016 are also presented in the following table (dollars in thousands). As of September 30, 2017 and December 31, 2016, each of the subsidiary banks met the requirements to be “well capitalized”.
For Capital
To Be Well
Adequacy Purposes
Capitalized Under
With Capital
Prompt Corrective
Actual
Conservation Buffer*
Action Provisions
Amount
Ratio
As of September 30, 2017:
Company:
Total risk-based capital
>
Tier 1 risk-based capital
Tier 1 leverage
Common equity Tier 1
Quad City Bank & Trust:
Cedar Rapids Bank & Trust:
Community State Bank:
Rockford Bank & Trust:
As of December 31, 2016:
*The minimums under Basel III increase by .625% (the capital conservation buffer) annually until 2019. The fully phased-in minimums are 10.5% (Total risk-based capital), 8.5% (Tier 1 risk-based capital), and 7.0% (Common equity Tier 1).
NOTE 8 – SUBSEQUENT EVENT - ACQUISITION OF GUARANTY BANK AND TRUST COMPANY
On October 2, 2017 the Company announced the completion of its previously announced acquisition of Guaranty Bank, headquartered in Cedar Rapids, Iowa, from Guaranty, on October 1, 2017. Guaranty Bank is an Iowa-chartered bank that operates five banking locations throughout the Cedar Rapids metropolitan area.
In the acquisition, the Company acquired 100% of Guaranty Bank’s outstanding common stock and purchased certain assets and assumed certain liabilities of Guaranty for aggregate consideration consisting of 79% QCR Holdings common stock (678,670 shares) and 21% cash ($7.8 million). On September 29, 2017, the last trading date before the closing, the Company’s common stock closed at $45.50, resulting in stock consideration valued at $30.9 million and total consideration paid by the Company of $38.7 million.
To help fund the cash portion of the purchase price, on September 27, 2017, the Company executed a $7.0 million four-year term note with principal and interest due quarterly. Interest is calculated at the effective LIBOR rate plus 3.00% per annum (4.34% at September 30, 2017). The first principal payment of $437,500 is due in the first quarter of 2018. The collateral on the borrowing is the original stock certificates and stock powers of all subsidiaries. This note is included within other borrowings on the September 30, 2017 Consolidated Balance Sheet. The remaining cash consideration paid to Guaranty came from operating cash.
As of the acquisition date, Guaranty Bank had assets with a book value of $257.2 million, loans with a book value of $196.1 million, and deposits with a book value of $212.3 million. The Company is in the process of determining the fair value of the individual assets and liabilities purchased/assumed. The Company expects core deposit intangible to be in the range of approximately $2.5-4.5 million. The remaininig fair value adjustments, including goodwill, are still in-process.
In the fourth quarter of 2017, the Company intends to merge Guaranty Bank with and into CRBT, with CRBT as the surviving bank. As part of the merger, the Guaranty Bank branches located at 302 3rd Avenue SE, Cedar Rapids, Iowa and 1819 42nd Street NE, Cedar Rapids, Iowa , will permanently close. The three remaining Guaranty Bank branches will become banking offices of CRBT. Until the banks are merged, the Company will own and operate Guaranty Bank as a separate bank subsidiary.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
This section reviews the financial condition and results of operations of the Company and its subsidiaries for the three and nine months ending September 30, 2017. Some tables may include additional periods to comply with disclosure requirements or to illustrate trends. When reading this discussion, also refer to the Consolidated Financial Statements and related notes in this report. The page locations and specific sections and notes that are referred to are presented in the table of contents.
Additionally, a comprehensive list of the acronyms and abbreviations used throughout this discussion is included in Note 1 to the Consolidated Financial Statements.
GENERAL
QCR Holdings, Inc. is a financial holding company and the parent company of QCBT, CRBT, CSB and RB&T.
QCBT, CRBT and CSB are Iowa-chartered commercial banks, and RB&T is an Illinois-chartered commercial bank. All are members of the Federal Reserve system with depository accounts insured to the maximum amount permitted by law by the FDIC.
QCBT commenced operations in 1994 and provides full-service commercial and consumer banking, and trust and asset management services to the Quad City area and adjacent communities through its five offices that are located in Bettendorf and Davenport, Iowa and Moline, Illinois. QCBT also provides leasing services through its wholly-owned subsidiary, m2, located in Brookfield, Wisconsin. In addition, QCBT owns 100% of Quad City Investment Advisors, LLC, which is an investment management and advisory company.
CRBT commenced operations in 2001 and provides full-service commercial and consumer banking, and trust and asset management services to Cedar Rapids, Iowa and adjacent communities through its main office located on First Avenue in downtown Cedar Rapids, Iowa and its branch facility located on Council Street in northern Cedar Rapids. Cedar Falls and Waterloo, Iowa and adjacent communities are served through three additional CRBT offices (two in Waterloo and one in Cedar Falls).
CSB was acquired in 2016, as further described in Note 2 of the Annual Report on Form 10-K for the year ended December 31, 2016. CSB provides full-service commercial and consumer banking to the Des Moines, Iowa area and adjacent communities through its 10 branch locations, including its main office located on North Ankeny Boulevard in Ankeny, Iowa.
RB&T commenced operations in January 2005 and provides full-service commercial and consumer banking, and trust and asset management services to Rockford, Illinois and adjacent communities through its main office located on Guilford Road at Alpine Road in Rockford and its branch facility in downtown Rockford.
The financial results of Guaranty Bank are not included in this report because the acquisition occurred on October 1, 2017.
FINANCIAL CONDITION AND RESULTS OF OPERATIONS – continued
EXECUTIVE OVERVIEW
The Company reported net income of $7.9 million and diluted EPS of $0.58 for the quarter ended September 30, 2017. By comparison, for the quarter ended June 30, 2017, the Company reported net income of $8.8 million and diluted EPS of $0.65. For the quarter ended September 30, 2016, the Company reported net income of $6.1 million and diluted EPS of $0.46.
For the nine months ended September 30, 2017, the Company reported net income of $25.8 million, and diluted EPS of $1.91. By comparison, for the nine months ended September 30, 2016, the Company reported net income of $19.2 million, and diluted EPS of $1.52.
The third quarter of 2017 was highlighted by several significant items:
Net interest margin (excluding acquisition accounting net accretion) improved three basis points when comparing the third quarter of 2017 to the second quarter of 2017;
Annualized loan and lease growth of 19% for the second consecutive quarter;
Noninterest expense growth, primarily due to increased salaries and employee benefits, as well as inflated legal expense; and
NPAs increased in third quarter primarily due to the addition of one large non owner-occupied CRE relationship.
Following is a table that represents the various net income measurements for the Company.
For the three months ended
For the nine months ended
June 30, 2017
Weighted average common and common equivalent shares outstanding*
The increase in weighted average common shares outstanding when comparing the first nine months ended September 30, 2017 to September 30, 2016 was primarily due to the common stock issuance discussed in Note 2 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.
Following is a table that represents the major income and expense categories for the Company.
Provision expense
Noninterest income
Noninterest expense
Following are some noteworthy changes in the Company’s financial results:
Net interest income in the third quarter of 2017 was up 2% compared to the second quarter of 2017 and up 21% compared to the third quarter of 2016. Net interest income increased 29% when comparing the first nine months of 2017 to the same period in the prior year, primarily due to the addition of CSB.
Provision expense in the third quarter of 2017 increased 3% compared to the second quarter of 2017 and 30% from the same period of 2016. The increase from the third quarter of 2016 to the third quarter of 2017 was primarily attributable to CSB. As acquired loans renew, the discount associated with those loans is eliminated and the Company must establish an allowance.
Noninterest income in the third quarter of 2017 decreased 1% compared to the second quarter of 2017, primarily due to smaller gains on the sale of government guaranteed portions of loans. Noninterest income in the third quarter of 2017 decreased 36% from the third quarter of 2016 which was primarily attributable to $4 million in gains on the sale of securities associated with a balance sheet restructuring strategy executed in the third quarter of 2016.
Noninterest expense increased 9% from the second quarter of 2017 which was primarily due to costs related to the acquisition of Guaranty Bank, post-acquisition transition and integration costs, increased salaries and employee benefits expense and inflated professional and data processing expense (primarily legal expense). Noninterest expense decreased 4% from the third quarter of 2016 primarily due to $4 million losses on debt extinguishment due to the balance sheet restructuring strategy executed in the third quarter of 2016.
Federal and state income tax expense in the third quarter of 2017 decreased 27% compared to the second quarter of 2017. Federal and state income tax in the third quarter of 2017 increased 3% compared to the third quarter of 2016. See the Income Taxes section of this report for additional details.
LONG-TERM FINANCIAL GOALS
As previously stated, the Company has established certain financial goals by which it manages its business and measures its performance. The goals are periodically updated to reflect changes in business developments. While the Company is determined to work prudently to achieve these goals, there is no assurance that they will be met. Moreover, the Company’s ability to achieve these goals will be affected by the factors discussed under “Forward Looking Statements” as well as the factors detailed in the “Risk Factors” section included under Item 1A. of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. The Company’s long-term financial goals are as follows:
Improve balance sheet efficiency by maintaining a gross loans and leases to total assets ratio in the range of 73 – 78%;
Improve profitability (measured by NIM and ROAA);
Improve asset quality by reducing NPAs to total assets to below 0.75% and maintain charge-offs as a percentage of average loans/leases of under 0.25% annually;
Maintain reliance on wholesale funding at less than 15% of total assets;
Grow noninterest bearing deposits to more than 30% of total assets;
Continue to focus on generating gains on sales of government guaranteed portions of loans and swap fee income to more than $4 million annually; and
Grow wealth management segment net income by 10% annually.
The following table shows the evaluation of the Company’s long-term financial goals.
Goal
Key Metric
Target**
For the Quarter Ending
September 30,2017
June 30,2017
Balance sheet efficiency
Gross loans and leases to total assets
73 - 78%
75%
74%
72%
Profitability
NIM(TEY)(non-GAAP)*
> 3.85%
3.71%
3.81%
ROAA
> 1.10%
0.90%
1.04%
0.85%
Core ROAA (non-GAAP)*
0.97%
1.03%
1.05%
Asset quality
NPAs to total assets
< 0.75%
0.95%
0.75%
0.69%
Net charge-offs to average loans and leases***
< 0.25% annually
0.11%
0.13%
0.15%
Reliance on wholesale funding
Wholesale funding to total assets****
< 15%
12%
10%
13%
Funding mix
Noninterest bearing deposits as a percentage of total assets
> 30%
20%
22%
23%
Consistent, high quality noninterest income revenue streams
Gains on sales of government guaranteed portions of loans and swap fee income***
> $4 million annually
$2.4 million
$3.0 million
$5.4 million
Grow wealth management segment net income***
> 10% annually
24%
(3%)
*
See GAAP to Non-GAAP reconciliations.
**
Targets will be re-evaluated and adjusted as appropriate.
***
Ratios and amounts provided for these measurements represent year-to-date actual amounts for the respective period, that are then annualized for comparison.
****
Wholesale funding to total assets is calculated by dividing total borrowings and brokered deposits by total assets.
STRATEGIC DEVELOPMENTS
The Company took the following actions to support its corporate strategy and the long-term financial goals shown above.
The Company grew loans and leases in the first nine months of 2017 by 15% on an annualized basis. This growth exceeded the targeted organic growth of 10-12% for the full year. Strong loan and lease growth for the remainder of the year will help keep the Company’s loan and leases to asset ratio within the targeted range of 73-78%.
The Company intends to continue to participate in a prudent manner as an acquirer in the consolidation taking place in our markets to further boost ROAA and improve the Company’s efficiency ratio. In the third quarter of 2016, the Company acquired CSB, headquartered in Ankeny, Iowa. See Note 2 of the Company’s 2016 Annual Report on Form 10-K for the year ended December 31, 2016 for additional details. On October 1, 2017, the Company completed the acquisition of Guaranty Bank. See Note 8 to the Consolidated Financial Statements for additional details.
The Company continues to focus on the NPAs to total assets ratio. This ratio increased by 20 basis points to 0.95%, as compared to the second quarter 2017, due to the addition of one large non owner-occupied CRE relationship. The Company remains committed to improving asset quality ratios in 2017.
Management continues to focus on reducing the Company’s reliance on wholesale funding. Wholesale funding increased in the third quarter 2017 due to the strong loan and lease growth in the second and third quarters of 2017 which has outpaced the Company’s deposit growth. Management continues to evaluate opportunities for reduction in wholesale funding.
Correspondent banking continues to be a core line of business for the Company. The Company is competitively positioned with experienced staff, software systems and processes to continue growing in the three states currently served – Iowa, Illinois and Wisconsin. The Company acts as the correspondent bank for 183 downstream banks with average total noninterest bearing deposits of $287.4 million during the third quarter of 2017. This line of business provides a strong source of noninterest bearing and interest bearing deposits, fee income, high-quality loan participations and bank stock loans.
SBA and USDA lending is a specialty lending area on which the Company has focused. Once these loans are originated, the government-guaranteed portion of the loan can be sold to the secondary market for premiums. The Company aims to continue to make this a more consistent source of noninterest income.
As a result of the low interest rate environment, the Company is focused on executing interest rate swaps on select commercial loans. The interest rate swaps allow the commercial borrowers to pay a fixed interest rate while the Company receives a variable interest rate as well as an upfront fee dependent on the pricing. Management believes that these swaps help position the Company more favorably for rising rate environments. The Company will continue to review opportunities to execute these swaps at all of its subsidiary banks, as the circumstances are appropriate for the borrower and the Company.
Wealth management is another core line of business for the Company and includes a full range of products, including trust services, brokerage and investment advisory services, asset management, estate planning and financial planning. As of September 30, 2017 the Company had $2.41 billion of total financial assets in trust (and related) accounts and $955.7 million of total financial assets in brokerage (and related) accounts. Continued growth in assets under management will help to drive trust and investment advisory fees. The Company offers trust and investment advisory services to the correspondent banks that it serves. As management continues to focus on growing wealth management fee income, expanding market share will continue to be a primary strategy.
GAAP TO NON-GAAP RECONCILIATIONS
The following table presents certain non-GAAP financial measures related to the “TCE/TA ratio”, “core net income”, “core net income attributable to QCR Holdings, Inc. common stockholders”, “core EPS”, “core ROAA”, “NIM (TEY)”, and “efficiency ratio”. In compliance with applicable rules of the SEC, all non-GAAP measures are reconciled to the most directly comparable GAAP measure, as follows:
TCE/TA ratio (non-GAAP) is reconciled to stockholders’ equity and total assets;
Core net income, core net income attributable to QCR Holdings, Inc. common stockholders, core EPS and core ROAA (all non-GAAP measures) are reconciled to net income;
NIM (TEY) (non-GAAP) is reconciled to NIM; and
Efficiency ratio (non-GAAP) is reconciled to noninterest expense, net interest income and noninterest income.
The TCE/TA non-GAAP ratio has been a focus for investors and management believes that this ratio may assist investors in analyzing the Company’s capital position without regard to the effects of intangible assets.
The table following also includes several “core” non-GAAP measurements of financial performance. The Company's management believes that these measures are important to investors as they exclude non-recurring income and expense items; therefore, they provide a better comparison for analysis and may provide a better indicator of future run-rates.
NIM (TEY) is a financial measure that the Company’s management utilizes to take into account the tax benefit associated with certain tax-exempt loans and securities. It is standard industry practice to measure net interest margin using tax-equivalent measures.
The efficiency ratio is a ratio that management utilizes to compare the Company to peers. It is a standard ratio in the banking industry and widely utilized by investors.
Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.
As of
June 30,
(dollars in thousands, except per share data)
TCE / TA RATIO
Stockholders' equity (GAAP)
Less: Intangible assets
TCE (non-GAAP)
Total assets (GAAP)
TA (non-GAAP)
TCE / TA ratio (non-GAAP)
For the Quarter Ended
For the Nine Months Ended
CORE NET INCOME
Net income (GAAP)
Less nonrecurring items (post-tax) (*):
Income:
Securities gains, net
Total nonrecurring income (non-GAAP)
Expense:
Losses on debt extinguishment
Total nonrecurring expense (non-GAAP)
Core net income (non-GAAP)
CORE EPS
Core net income (non-GAAP) (from above)
Core EPS (non-GAAP):
Basic
Diluted
CORE ROAA
Average Assets
Core ROAA (annualized) (non-GAAP)
* Nonrecurring items (after-tax) are calculated using an estimated effective tax rate of 35%.
GAAP TO NON-GAAP RECONCILIATIONS (CONTINUED)
(dollars in thousands)
NIM (TEY)
Net interest income (GAAP)
Plus: Tax equivalent adjustment
Net interest income - tax equivalent (Non-GAAP)
Average earning assets
NIM (GAAP)
NIM (TEY) (Non-GAAP)
EFFICIENCY RATIO
Noninterest expense (GAAP)
Noninterest income (GAAP)
Total income
Efficiency ratio (noninterest expense/total income) (Non-GAAP)
NET INTEREST INCOME - (TAX EQUIVALENT BASIS)
Net interest income, on a tax equivalent basis, increased 22% to $30.9 million for the quarter ended September 30, 2017, compared to the same quarter of the prior year. For the nine months ended September 30, 2017, net interest income, on a tax equivalent basis, increased 31% to $90.9 million, compared to the same period of 2016. Net interest income improved due to several factors:
The acquisition of CSB, whose strong net interest margin has significantly contributed to the Company’s results;
The Company’s continued strategy to redeploy funds from the taxable securities portfolio into higher yielding loans and leases; and
Organic loan and lease growth has been strong over the past twelve months, as evidenced by average gross loan/lease growth of 29% in that period.
A comparison of yields, spread and margin from the third quarter of 2017 to the third quarter of 2016 is as follows (on a tax equivalent basis):
The average yield on interest-earning assets increased 16 basis points.
The average cost of interest-bearing liabilities increased 18 basis points.
The net interest spread decreased 2 basis points from 3.49% to 3.47%.
NIM remained flat at 3.71% for both periods.
A comparison of yields, spread and margin from the first nine months of 2017 to the first nine months of 2016 is as follows (on a tax equivalent basis):
The average yield on interest-earning assets increased 25 basis points.
The average cost of interest-bearing liabilities increased 9 basis points.
The net interest spread increased 16 basis points from 3.43% to 3.59%.
NIM improved 16 basis points from 3.65% to 3.81%.
The Company’s management closely monitors and manages NIM. From a profitability standpoint, an important challenge for the Company’s subsidiary banks and leasing company is the improvement of their NIM. Management continually addresses this issue with pricing and other balance sheet management strategies.
The improvement in NIM was primarily the result of the acquisition of CSB. CSB’s margin will fluctuate based on the amortization and accretion of purchase accounting adjustments, most notably, the discount accretion on the loan portfolio. This benefit can fluctuate based on prepayments of both PCI and performing loans. As loans prepay, the associated discount is accelerated.
The Company continues to place an emphasis on shifting its balance sheet mix. With a stated goal of maintaining loans/leases as a percentage of assets in a range of 73-78%, the Company funded its loan/lease growth with a mixture of core deposits and cash from calls/maturities/redemptions in the investment securities portfolio. In 2015 and 2016, cash from called securities and the targeted sales of securities was redeployed into the loan portfolio, resulting in a significant increase in yield, while minimizing any extension of duration. Additionally, the Company recognized net gains on these sales due to the previous rate environment. As rates rise, the Company should also have less market volatility in the investment securities portfolio, as this is a smaller portion of the balance sheet.
There still exists some higher cost legacy borrowings and the Company continues to monitor and evaluate both prepayment and debt restructuring opportunities, as executing on such a strategy could potentially increase NIM at a much quicker pace than holding the debt until maturity.
The Company’s average balances, interest income/expense, and rates earned/paid on major balance sheet categories, as well as the components of change in net interest income, are presented in the following tables:
For the three months ended September 30,
Earned
Yield or
or Paid
Interest earning assets:
Investment securities (1)
Gross loans/leases receivable (1) (2) (3)
Total interest earning assets
Noninterest-earning assets:
Premises and equipment
Interest-bearing liabilities:
Interest-bearing deposits
Total interest-bearing liabilities
Noninterest-bearing demand deposits
Other noninterest-bearing liabilities
Stockholders' equity
Net interest spread
Net interest margin
Ratio of average interest-earning assets to average interest-bearing liabilities
(1) Interest earned and yields on nontaxable investment securities and nontaxable loans are determined on a tax equivalent basis using a 35% tax rate.
(2) Loan/lease fees are not material and are included in interest income from loans/leases receivable in accordance with accounting and regulatory guidance.
(3) Non-accrual loans/leases are included in the average balance for gross loans/leases receivable in accordance with accounting and regulatory guidance.
Analysis of Changes of Interest Income/Interest Expense
Inc./(Dec.)
Components
from
of Change (1)
Prior Period
Rate
Volume
2017 vs. 2016
INTEREST INCOME
Investment securities (2)
Gross loans/leases receivable (2) (3) (4)
Total change in interest income
INTEREST EXPENSE
Total change in interest expense
Total change in net interest income
(1)
The column "Inc./(Dec.) from Prior Period" is segmented into the changes attributable to variations in volume and the changes attributable to changes in interest rates. The variations attributable to simultaneous volume and rate changes have been proportionately allocated to rate and volume.
(2)
Interest earned and yields on nontaxable investment securities and nontaxable loans are determined on a tax equivalent basis using a 35% tax rate.
(3)
Loan/lease fees are not material and are included in interest income from loans/leases receivable in accordance with accounting and regulatory guidance.
(4)
Non-accrual loans/leases are included in the average balance for gross loans/leases receivable in accordance with accounting and regulatory guidance.
For the nine months ended September 30,
Part IItem 2
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with GAAP. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Certain critical accounting policies are described below.
ALLOWANCE FOR LOAN AND LEASE LOSSES
Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policy to be that related to the allowance.
The Company’s allowance methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in NPLs, and other factors. Quantitative factors also incorporate known information about individual loans/leases, including borrowers’ sensitivity to interest rate movements.
Qualitative factors include management’s view regarding the general economic environment in the Company’s markets, including economic conditions throughout the Midwest, and in particular, the state of certain industries. Size and complexity of individual credits in relation to loan/lease structures, existing loan/lease policies and pace of portfolio growth are other qualitative factors that are considered in the methodology.
Management may report a materially different amount for the provision in the statement of income to change the allowance if its assessment of the above factors were different. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the section entitled “Financial Condition” of this Management’s Discussion and Analysis that discusses the allowance.
Although management believes the level of the allowance as of September 30, 2017 was adequate to absorb losses in the loan/lease portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.
OTHER–THAN-TEMPORARY IMPAIRMENT
The Company’s assessment of OTTI of its investment securities portfolio is another critical accounting policy due to the level of judgment required by management. Investment securities are evaluated to determine whether declines in fair value below their cost are other-than-temporary.
In estimating OTTI losses, management considers a number of factors including, but not limited to, (1) the length of time and extent to which the fair value has been less than amortized cost, (2) the financial condition and near-term prospects of the issuer, (3) the current market conditions, and (4) the Company’s lack of intent to sell the security prior to recovery and whether it is not more-likely-than-not that the Company will be required to sell the security prior to recovery. The discussion regarding the Company’s assessment of OTTI should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein.
RESULTS OF OPERATIONS
Interest income increased 26%, comparing the third quarter of 2017 to the same period of 2016 and increased 32%, comparing the first nine months of 2017 to the same period of 2016. This increase was primarily the result of the CSB acquisition during the third quarter of 2016, as well as strong organic loan growth.
Overall, the Company’s average earning assets increased 22%, comparing the third quarter of 2017 to the third quarter of 2016. During the same time period, average gross loans and leases increased 27%, while average investment securities increased 13%. Average earning assets increased 25%, comparing the first nine months of 2017 to the same period of 2016. Average gross loans and leases increased 29% and average investment securities increased 9%, comparing the first nine of 2017 to the same period of 2016. These increases were also the result of the acquisition of CSB, as well as strong loan growth.
Additionally, the Company continued to diversify its securities portfolio, including increasing its portfolio of tax exempt municipal securities. The large majority of these are privately placed debt issuances by municipalities located in the Midwest and require a thorough underwriting process before investment. Execution of this strategy has led to increased interest income on a tax equivalent basis over the past several years. Management understands that this strategy has extended the duration of its securities portfolio and continually evaluates the combined benefit of increased interest income and reduced effective income tax rate and the impact on interest rate risk.
The Company intends to continue to grow quality loans and leases as well as diversify its securities portfolio to maximize yield while minimizing credit and interest rate risk.
Interest expense for the third quarter of 2017 increased 66% from the third quarter of 2016. For the first nine months of 2017, interest expense increased 49% compared to the first nine months of 2016. The acquisition of CSB contributed to this increase. Additionally, the Company has rate sensitive deposits with select major customers that have repriced with the increase in certain market interest rates.
Management has placed a strong focus on reducing the reliance on long-term wholesale funding as it tends to be higher in cost than deposits. Several balance sheet restructuring strategies were executed in 2016. Refer to Notes 10 and 11 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 for additional details.
The Company’s management intends to continue to shift the mix of funding from wholesale funds to core deposits, including noninterest-bearing deposits. Continuing this trend is expected to strengthen the Company’s franchise value, reduce funding costs, and increase fee income opportunities through deposit service charges.
PROVISION FOR LOAN/LEASE LOSSES
The provision is established based on a number of factors, including the Company’s historical loss experience, delinquencies and charge-off trends, the local and national economy and risk associated with the loans/leases in the portfolio as described in more detail in the “Critical Accounting Policies” section.
The Company’s provision totaled $2.1 million for the third quarter of 2017, which was an increase of $478 thousand or 30% from the same quarter of the prior year. Provision for the first nine months of the year totaled $6.2 million, which was up $1.3 million or 27%, compared to the first nine months of 2016. The increase from the third quarter of 2016 to the third quarter of 2017 was primarily attributable to CSB. As acquired loans renew, the discount associated with those loans is eliminated and the Company must establish an allowance. This provision, when coupled with net charge-offs of $2.0 million for the first nine months of 2017, increased the Company’s allowance to $35.0 million at September 30, 2017. As of September 30, 2017, the Company’s allowance to total loans/leases was 1.31%, which is flat from June 30, 2017 and up from 1.22% at September 30, 2016.
In accordance with GAAP for business combination accounting, the loans acquired through the acquisition of CSB were recorded at fair value; therefore, there was no allowance associated with CSB’s loans at acquisition. Management continues to evaluate the allowance needed on the acquired CSB loans factoring in the net remaining discount ($5.6 million at September 30, 2017). When factoring this remaining discount into the Company’s allowance to total loans and leases calculation, the Company’s allowance as a percentage of total loans and leases increases from 1.31% to 1.52%.
A more detailed discussion of the Company’s allowance can be found in the “Financial Condition” section of this report.
NONINTEREST INCOME
The following tables set forth the various categories of noninterest income for the three and nine months ended September 30, 2017 and 2016.
$ Change
% Change
%
In recent years, the Company has been successful in expanding its wealth management customer base. Trust department fees continue to be a significant contributor to noninterest income and, due to favorable market conditions in early 2017 coupled with strong growth in assets under management, trust department fees increased 13%, comparing the third quarter of 2017 to the same period of the prior year. Trust department fees increased 12% when comparing the first nine months of 2017 to the same period of the prior year. Income is generated primarily from fees charged based on assets under administration for corporate and personal trusts and for custodial services. The majority of the trust department fees are determined based on the value of the investments within the fully managed trusts. Additionally, the Company recently started offering trust operations services to correspondent banks. Management has placed a stronger emphasis on growing its investment advisory and management services. Part of this initiative has been to restructure the Company’s Wealth Management Division to allow for more efficient delivery of products and services through selective additions of talent as well as the leverage of and collaboration among existing resources (including the aforementioned trust department). Similar to trust department fees, these fees are largely determined based on the value of the investments managed. And, similar to the trust department, the Company has had some success in expanding its customer base. Due to this growth and favorable market conditions in 2017, investment advisory and management fees increased 26%, comparing the third quarter of 2017 to the same period of the prior year and they increased 32% when comparing the first nine months of 2017 to the first nine months of 2016. The acquisition of CSB also contributed to this increase, as it had an established investment advisory and management services department at acquisition.
Deposit service fees expanded 32% comparing the third quarter of 2017 to the same period of the prior year and expanded 42% when comparing the first nine months of 2017 to the same period of the prior year. This increase was primarily the result of the acquisition of CSB. Additionally, the Company continues its emphasis on shifting the mix of deposits from brokered and retail time deposits to non-maturity demand deposits across all its markets. With this continuing shift in mix, the Company has increased the number of demand deposit accounts, which tend to be lower in interest cost and higher in service fees. The Company plans to continue this shift in mix and to further focus on growing deposit service fees.
Gains on sales of residential real estate loans decreased 32% when comparing the third quarter of 2017 to the same period of the prior year and increased 6% when comparing the first nine months of 2017 to the same period of the prior year. Overall, with the continued low interest rate environment, refinancing activity has slowed, as many of the Company’s existing and prospective customers have already executed a refinancing. Therefore, this area has generally become a smaller contributor to overall noninterest income.
The Company’s gains on the sale of government-guaranteed portions of loans for the third quarter of 2017 decreased 58% compared to the third quarter of 2016 and decreased 58% when comparing the first nine months of 2017 to the same period of the prior year. Given the nature of these gains, large fluctuations can occur from quarter-to-quarter and year-to-year. As one of its core strategies, the Company continues to leverage its expertise by taking advantage of programs offered by the SBA and the USDA. The Company’s portfolio of government-guaranteed loans has grown as a direct result of the Company’s strong expertise in SBA and USDA lending. In some cases, it is more beneficial for the Company to sell the government-guaranteed portion on the secondary market for a premium rather than retain the loans in the Company’s portfolio. Sales activity for government-guaranteed portions of loans tends to fluctuate depending on the demand for loans that fit the criteria for the government guarantee. Further, the size of the transactions can vary and, as the gain is determined as a percentage of the guaranteed amount, the resulting gain on sale can vary. Lastly, a strategy for improved pricing is packaging loans together for sale. From time to time, the Company may execute on this strategy, which may delay the gains on sales of some loans to achieve better pricing.
As a result of the continued low interest rate environment, the Company was able to execute numerous interest rate swaps on select commercial loans over the past two years. The interest rate swaps allow the commercial borrowers to pay a fixed interest rate while the Company receives a variable interest rate as well as an upfront fee dependent upon the pricing. Management believes that these swaps help position the Company more favorably for rising rate environments. Management will continue to review opportunities to execute these swaps at all of its subsidiary banks, as the circumstances are appropriate for the borrower and the Company. A good interest rate swap candidate must be of a certain size and sophistication which can lead to volatility in activity from quarter to quarter. Swap fee income totaled $194 thousand for the third quarter of 2017, compared to $334 thousand for the third quarter of 2016. Swap fee income totaled $635 thousand for the first nine months of 2017 compared to $1.4 million in the first nine months of 2016. Future levels of swap fee income are dependent upon prevailing interest rates.
Securities losses were $64 thousand for the third quarter of 2017, compared to gains of $4.3 million for the third quarter of 2016. Securities losses totaled $25 thousand for the first nine months of 2017, compared to gains of $4.6 million for the first nine months of 2016. In September 2016, the Company sold an equity security and recognized a pre-tax gross gain on the sale of $4 million. The equity security was acquired by the Company at no cost as part of a membership in the invested company in 2002.
Earnings on BOLI decreased 5% comparing the third quarter of 2017 to the third quarter of 2016 and increased 3% comparing the first nine months of 2017 to the first nine months of 2016. There were no purchases of BOLI within the last twelve months. Notably, a small portion of the Company’s BOLI is variable rate whereby the returns are determined by the performance of the equity market. Equity market performance accounted for the majority of the volatility. Management intends to continue to review its BOLI investments to be consistent with policy and regulatory limits in conjunction with the rest of its earning assets in an effort to maximize returns while minimizing risk.
Debit card fees are the interchange fees paid on certain debit card customer transactions. Debit card fees increased 59% comparing the third quarter of 2017 to the third quarter of the prior year and increased 95% comparing the first nine months of 2017 to the first nine months of 2016. The primary reason for the increase was the addition of CSB. CSB has a large retail customer base and therefore generates significant interchange revenue. These fees can vary based on customer debit card usage, so fluctuations from period to period may occur. As an opportunity to maximize fees, the Company offers a retail deposit product with a higher interest rate that incentivizes debit card activity.
Correspondent banking fees decreased 6% comparing the third quarter of 2017 to the third quarter of the prior year and decreased 15% when comparing the first nine months of 2017 to the first nine months of 2016. As interest rates rise, the correspondent bank deposit accounts receive a higher earnings credit, which then reduces the direct fees that the Company receives. Management will continue to evaluate earnings credit rates and the resulting impact on deposit balances and fees while balancing the ability to grow market share. Correspondent banking continues to be a core strategy for the Company, as this line of business provides a high level of noninterest bearing deposits that can be used to fund loan growth as well as a steady source of fee income. The Company now serves approximately 183 banks in Iowa, Illinois and Wisconsin.
NONINTEREST EXPENSE
The following tables set forth the various categories of noninterest expense for the three and nine months ended September 30, 2017 and 2016.
)%
Management places a strong emphasis on overall cost containment and is committed to improving the Company’s general efficiency.
Salaries and employee benefits, which is the largest component of noninterest expense, increased from the third quarter of 2016 to the third quarter of 2017 by 20%. This line item also increased 21% when comparing the first nine months of 2017 to the first nine months of 2016. This increase was primarily related to the acquisition of CSB late in the third quarter of 2016.
Occupancy and equipment expense increased 21%, comparing the third quarter of 2017 to the same period of the prior year and increased 33% comparing the first nine months of 2017 to the same period of the prior year. The increased expense was mostly due to the addition of CSB.
Professional and data processing fees increased 53%, comparing the third quarter of 2017 to the same period in 2016 and increased 50% comparing the first nine months of 2017 to the same period in 2016. This increased expense was partially due to the addition of CSB. Legal expense for the past quarter was elevated due to a legal matter in Rockford where two Bank officers have been charged with wrongdoing in connection with an SBA loan application. The Company anticipates these legal expenses will continue until the court proceedings are completed, which the Company expects to be sometime in 2018. Neither RB&T, nor the Company, have been charged in the case. Generally, professional and data processing fees can fluctuate depending on certain one-time project costs. Management will continue to focus on minimizing such one-time costs and driving recurring costs down through contract renegotiation or managed reduction in activity where costs are determined on a usage basis.
FDIC and other insurance expense increased 19%, comparing the third quarter of 2017 to the third quarter of 2016, and increased 5% comparing the first nine months of 2017 to the same period of 2016. The increase in expense was due to the acquisition of CSB, partially offset by a decrease in the assessment rate designated by the FDIC.
Loan/lease expense increased 151%, comparing the third quarter of 2017 to the same quarter of 2016, and increased 93% when comparing the first nine months of 2017 to the same period of 2016. The Company incurred elevated levels of expense in the first nine months of 2017 for certain existing NPLs in connection with the work-out of these loans. Generally, loan/lease expense has a direct relationship with the level of NPLs; however, it may deviate depending upon the individual NPLs.
Net cost of or income from operations of other real estate includes gains/losses on the sale of OREO, write-downs of OREO and all income/expenses associated with OREO. Income from operations of other real estate totaled $161 thousand for the third quarter of 2017, compared to net costs of operations of $133 thousand for the third quarter of 2016. Income from operations of other real estate totaled $118 thousand for the first nine months of 2017, compared to net costs of operations of $513 thousand for the first nine months of 2016. Occupancy rates for one of the OREO properties managed by the Company have improved over the past year, increasing cash flow from that property and reducing net operating costs.
Bank service charges, a large portion of which includes indirect costs incurred to provide services to QCBT’s correspondent banking customer portfolio, increased 11% from the third quarter of 2016 to the third quarter of 2017 and increased 7% from the first nine months of 2016 to the first nine months of 2017. The increase was due, in large part, to the success QCBT has had in growing its correspondent banking customer portfolio. As transactions volumes continue to increase and the number of correspondent banking clients increases, the associated expenses will also increase.
In the first nine months of 2016, the Company incurred $4.2 thousand of losses on debt extinguishment, net. These losses relate to the prepayment of certain FHLB advances and wholesale structured repurchase agreements. Additionally, the Company recognized gains on extinguishment related to the repurchase of junior subordinated debentures that were acquired at a discount through auction.
Correspondent banking expense was down 1% when comparing the third quarter of 2017 to the third quarter of 2016 and up 7% when comparing the first nine months of 2017 to the same period of 2016 due to both increases in volume and in the number of correspondent banking clients. These are direct costs incurred to provide services to QCBT’s correspondent banking customer portfolio, including safekeeping and cash management services.
Other noninterest expense was up 33% when comparing the third quarter of 2017 to the third quarter of 2016 and up 35% when comparing the first nine months of 2017 to the same period of 2016. A large portion of that increase was due to core deposit intangible amortization. Core deposit intangible amortization expense was up $120 thousand when comparing the third quarter of 2017 to the third quarter of 2016 and increased $482 thousand when comparing the first nine months of 2017 to the same period of 2016. Increases were due to the acquisition of CSB.
INCOME TAXES
In the third quarter of 2017, the Company incurred income tax expense of $1.9 million. During the first nine months of the year, the Company incurred income tax expense of $6.9 million. Following is a reconciliation of the expected income tax expense to the income tax expense included in the consolidated statements of income for the three and nine months ended September 30, 2017 and 2016.
For the Three Months Ended September 30,
For the Nine Months Ended September 30,
% of
Pretax
Computed "expected" tax expense
Tax exempt income, net
State income taxes, net of federal benefit, current year
Excess tax benefit on stock options exercised and restricted stock awards vested*
The effective tax rate for the quarter ended September 30, 2017 was 19.7% which was a decrease from the effective tax rate of 23.3% for the quarter ended September 30, 2016. The effective tax rate for the nine months ended September 30, 2017 was 21.2%, which was a decrease over the effective tax rate of 23.9% for the nine months ended September 30, 2016. This shift was primarily due to the implementation of ASU 2016-09, which resulted in a tax benefit of $191 thousand for the third quarter of 2017 and $813 thousand for the first nine months of 2017. The effective rate for the three months ended September 30, 2017 was also positively impacted by higher levels of tax exempt interest income.
FINANCIAL CONDITION
Following is a table that represents the major categories of the Company’s balance sheet.
December 31, 2016
Federal funds sold and interest-bearing deposits
Net loans/leases
Total borrowings
During the third quarter of 2017, the Company’s total assets increased $93.3 million, or 3%, to a total of $3.6 billion. Total gross loans and leases grew $123.2 million. This loan and lease growth was funded by deposits, which increased $24.0 million in the third quarter of 2017, and borrowings, which increased $65.9 million in the third quarter of 2017. Stockholders’ equity increased $8.0 million, or 3%, in the current quarter due to net retained income.
INVESTMENT SECURITIES
The composition of the Company’s securities portfolio is managed to meet liquidity needs while prioritizing the impact on interest rate risk and maximizing return, while minimizing credit risk. The Company has further diversified the portfolio by decreasing U.S government sponsored agency securities, while increasing residential mortgage-backed and related securities and tax-exempt municipal securities. Of the latter, the large majority are privately placed tax-exempt debt issuances by municipalities located in the Midwest (with some in or near the Company’s existing markets) and require a thorough underwriting process before investment.
Following is a breakdown of the Company’s securities portfolio by type, the percentage of unrealized gains (losses) to carrying value on the total portfolio, and the portfolio duration:
Securities as a % of Total Assets
Net Unrealized Gains (Losses) as a % of Amortized Cost
Duration (in years)
Quarterly Yield on investment securities (tax equivalent)
Management monitors the level of unrealized gains/losses including performing quarterly reviews of individual securities for evidence of OTTI. Management identified no OTTI in any of the periods presented.
The duration of the securities portfolio extended modestly with the TEY on the portfolio improving 32 bps over the first nine months of 2017.
The Company has not invested in private mortgage-backed securities or pooled trust preferred securities. Additionally, the Company has not invested in the types of securities subject to the Volcker Rule (a provision of the Dodd-Frank Act).
See Note 2 to the Consolidated Financial Statements for additional information regarding the Company’s investment securities.
LOANS/LEASES
Total loans/leases grew 19.2% on an annualized basis during the third quarter of 2017. The mix of the loan/lease types within the Company’s loan/lease portfolio is presented in the following table.
C&I loans
Direct financing leases
Residential real estate loans
Total loans/leases
As CRE loans have historically been the Company’s largest portfolio segment, management places a strong emphasis on monitoring the composition of the Company’s CRE loan portfolio. For example, management tracks the level of owner-occupied CRE loans relative to non owner-occupied loans. Owner-occupied loans are generally considered to have less risk. As of September 30, 2017 and June 30, 2017, approximately 28% of the CRE loan portfolio was owner-occupied.
Over the past several quarters, the Company has been successful in shifting the mix of its commercial loan portfolio by adding more C&I loans. C&I loans grew $92.0 million in the current quarter, or an annualized rate of 39%.
A syndicated loan is a commercial loan provided by a group of lenders and is structured, arranged and administered by one or several commercial or investment banks known as arrangers. The nationally syndicated loans invested in by the Company consist of fully funded, highly liquid term loans for which there is a liquid secondary market. As of September 30, 2017 and December 31, 2016, the amount of nationally syndicated loans totaled $55.0 million and $46.5 million, respectively.
The Company also has several loans that are syndicated to borrowers in our existing markets or purchased from peer banks that we have a relationship with. These loans were immaterial as of September 30, 2017 and December 31, 2016.
Following is a listing of significant industries within the Company’s CRE loan portfolio:
As of June 30,
Lessors of Nonresidential Buildings
Lessors of Residential Buildings
New Housing For-Sale Builders
Nonresidential Property Managers
Hotels
Land Subdivision
Nursing Care Facilities
Other *
Total CRE Loans
* “Other” consists of all other industries. None of these had concentrations greater than $23.2 million, or approximately 2% of total CRE loans in the most recent period presented.
The Company’s residential real estate loan portfolio consists of the following:
Certain loans that do not meet the criteria for sale into the secondary market. These are often structured as adjustable rate mortgages with maturities ranging from three to seven years to avoid the long-term interest rate risk.
A limited amount of 15-year fixed rate residential real estate loans that meet certain credit guidelines.
The remaining residential real estate loans originated by the Company were sold on the secondary market to avoid the interest rate risk associated with longer term fixed rate loans. Loans originated for this purpose were classified as held for sale and are included in the residential real estate loans above. In addition, the Company has not originated any subprime, Alt-A, no documentation, or stated income residential real estate loans throughout its history.
Following is a listing of significant equipment types within the m2 loan and lease portfolio:
Construction - General
Trucks & Vans
Manufacturing - General
Food Processing Equipment
Computer Hardware
Marine - Travelifts
Trailers
Restaurant
Manufacturing - CNC
Total m2 loans and leases
* “Other” consists of all other equipment types. None of these had concentrations greater than 3% of total m2 loan and lease portfolio in the most recent period presented.
See Note 3 to the Consolidated Financial Statements for additional information regarding the Company’s loan and lease portfolio.
ALLOWANCE FOR ESTIMATED LOSSES ON LOANS/LEASES
Changes in the allowance for the three and nine months ended September 30, 2017 and 2016 are presented as follows:
The allowance was determined based on factors that included the overall composition of the loan/lease portfolio, types of loans/leases, past loss experience, loan/lease delinquencies, potential substandard and doubtful credits, economic conditions, collateral positions, governmental guarantees and other factors that, in management’s judgment, deserved evaluation. To ensure that an adequate allowance was maintained, provisions were made based on a number of factors, including the increase in loans/leases and a detailed analysis of the loan/lease portfolio. The loan/lease portfolio is reviewed and analyzed monthly with specific detailed reviews completed on all loans risk-rated worse than “fair quality”, as described in Note 1 to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, and carrying aggregate exposure in excess of $250 thousand. The adequacy of the allowance is monitored by the loan review staff and reported to management and the board of directors.
The Company’s levels of criticized and classified loans are reported in the following table.
Internally Assigned Risk Rating *
Criticized Loans **
Classified Loans ***
Criticized Loans as a % of Total Loans/Leases
Classified Loans as a % of Total Loans/Leases
* Amounts above include the government guaranteed portion, if any. For the calculation of allowance, the Company assigns internal risk ratings of Pass (Rating 2) for the government guaranteed portion.
** Criticized loans are defined as commercial and industrial and commercial real estate loans with internally assigned risk ratings of 6, 7, or 8, regardless of performance.
*** Classified loans are defined as commercial and industrial and commercial real estate loans with internally assigned risk ratings of 7 or 8, regardless of performance.
The Company experienced a modest increase in classified loans during the first nine months of 2017. Criticized loans increased 12% during the same period due to one large non owner-occupied CRE relationship that was downgraded in the third quarter of 2017. The Company continues its strong focus on improving credit quality in an effort to limit NPLs.
The following table summarizes the trend in the allowance as a percentage of gross loans/leases and as a percentage of NPLs.
Allowance / Gross Loans/Leases
Allowance / NPLs *
*NPLs consist of nonaccrual loans/leases, accruing loans/leases past due 90 days or more, and accruing TDRs.
Although management believes that the allowance at September 30, 2017 was at a level adequate to absorb losses on existing loans/leases, there can be no assurance that such losses will not exceed the estimated amounts or that the Company will not be required to make additional provisions in the future. Unpredictable future events could adversely affect cash flows for both commercial and individual borrowers, which could cause the Company to experience increases in problem assets, delinquencies and losses on loans/leases, and require further increases in the provision. Asset quality is a priority for the Company and its subsidiaries. The ability to grow profitably is in part dependent upon the ability to maintain that quality. The Company continually focuses efforts at its subsidiary banks and leasing company with the intention to improve the overall quality of the Company’s loan/lease portfolio.
In accordance with GAAP for business combination accounting, the loans acquired through the acquisition of CSB were recorded at market value; therefore, there was no allowance associated with CSB’s loans at acquisition. Management continues to evaluate the allowance needed on the acquired CSB loans factoring in the net remaining discount ($5.6 million at September 30, 2017). When factoring this remaining discount into the Company’s allowance to total loans and leases calculation, the Company’s allowance as a percentage of total loans and leases increases from 1.31% to 1.52%. This elimination of CSB’s allowance also resulted in a decrease of the allowance to NPLs ratio, as CSB’s NPLs no longer have an allowance allocated to them and instead, have a loan discount that is separate from the allowance.
See Note 3 to the Consolidated Financial Statements for additional information regarding the Company’s allowance.
NONPERFORMING ASSETS
The table below presents the amount of NPAs and related ratios.
Nonaccrual loans/leases (1) (2)
Accruing loans/leases past due 90 days or more
TDRs - accruing
Other repossessed assets
Total NPAs
NPLs to total loans/leases
NPAs to total loans/leases plus repossessed property
Includes government guaranteed portion of loans, as applicable.
Includes TDRs of $2.3 million at September 30, 2017, $2.2 million at June 30, 2017, $2.3 million at December 31, 2016, and $4.9 million at September 30, 2016.
.
NPAs at September 30, 2017 were $33.7 million, which was up $7.8 million from June 30, 2017 and up $10.9 million from September 30, 2016. These increases were due to the addition of one large non owner-occupied CRE relationship in the third quarter of 2017.
The ratio of NPAs to total assets was 0.95% at September 30, 2017, which was up from 0.75% at June 30, 2017, and up from 0.69% at September 30, 2016.
The large majority of the NPAs consist of nonaccrual loans/leases, accruing TDRs, and OREO. For nonaccrual loans/leases and accruing TDRs, management has thoroughly reviewed these loans/leases and has provided specific allowances as appropriate.
OREO is carried at the lower of carrying amount or fair value less costs to sell.
The Company’s lending/leasing practices remain unchanged and asset quality remains a priority for management.
Item IPart 2
DEPOSITS
Deposits increased $24.0 million during the third quarter of 2017. The table below presents the composition of the Company’s deposit portfolio.
Noninterest bearing demand deposits
Interest bearing demand deposits
Brokered deposits
In an effort to strengthen the relationship and maximize the liquidity potential of its correspondent banking clients, the Company introduced an interest-bearing money market deposit account to its correspondent banking clients and this generated strong deposit growth in the first nine months of 2017.
Quarter-end balances can greatly fluctuate due to large customer and correspondent bank activity. Management will continue to focus on growing its noninterest bearing deposit portfolio, including its correspondent banking business at QCBT, as well as shifting the mix from brokered and other higher cost deposits to lower cost core deposits.
BORROWINGS
The subsidiary banks offer short-term repurchase agreements to a few of their significant customers. Also, the subsidiary banks purchase federal funds for short-term funding needs from the FRB or from their correspondent banks. The table below presents the composition of the Company’s short-term borrowings.
Overnight repurchase agreements with customers
Federal funds purchased
The Company is nearing the completion of a process to transition its overnight repurchase agreements with customers into a comparable interest bearing demand deposit product that offers full FDIC insurance. This transition has freed up securities that were previously pledged as collateral to the overnight repurchase agreements with customers and has enhanced the Company’s ability to further rotate its earning assets from securities to loans.
As a result of their memberships in either the FHLB of Des Moines or Chicago, the subsidiary banks have the ability to borrow funds for short or long-term purposes under a variety of programs. FHLB advances are utilized for loan matching as a hedge against the possibility of rising interest rates, and when these advances provide a less costly or more readily available source of funds than customer deposits.
The table below presents the Company’s term FHLB advances and overnight FHLB advances.
Term FHLB advances
Overnight FHLB advances
Term FHLB advances increased in the current quarter by $1.6 million. Overnight FHLB advances have increased by $61.0 million due to the strong loan and lease growth in the second and third quarters of 2017 which has outpaced the Company’s deposit growth.
The table below presents the composition of the Company’s other borrowings.
Wholesale structured repurchase agreements
Term note
Revolving line of credit
Other borrowings include structured repos which are utilized as an alternative funding source to FHLB advances and customer deposits. Structured repos are collateralized by certain U.S. government agency securities and residential mortgage backed and related securities.
As described in Note 11 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, the Company has an outstanding five-year term note and revolving line of credit. As of September 30, 2017, the term debt had been paid down to $25.5 million, as scheduled. Also, in the first quarter of 2017, the Company paid off the full outstanding amount of the revolving line of credit. The term note and revolving line of credit were used to help fund the acquisition of CSB. As of September 30, 2017, the full $10.0 million line of credit was available. If the line of credit is used, interest is calculated at the effective LIBOR rate plus 2.50% per annum (3.84% at September 30, 2017). In the third quarter of 2017, the Company entered into a $7.0 million term note with a four-year term and interest calculated at the effective LIBOR rate plus 3.00% per annum (4.34% at September 30, 2017) to fund a portion of the cash consideration for the acquisition of Guaranty. See further discussion in Note 8 to the Consolidated Financial Statements.
The Company executed several balance sheet restructuring strategies in 2016. Refer to Note 11 of the Annual Report on Form 10-K for the year ended December 31, 2016 for addition information regarding these prepayments.
It is management’s intention to reduce its reliance on wholesale funding, including FHLB advances, structured repos, and brokered deposits. Replacement of this funding with core deposits helps to reduce interest expense as wholesale funding tends to be higher cost. However, the Company may choose to utilize advances and/or brokered deposits to supplement funding needs, as this is a way for the Company to effectively and efficiently manage interest rate risk.
The table below presents the maturity schedule including weighted average interest cost for the Company’s combined wholesale funding portfolio.
Weighted
Maturity:
Amount Due
Interest Rate
Year ending December 31:
(dollar amounts in thousands)
2018
2019
2020
Total Wholesale Funding
During the first nine months of 2017, wholesale funding increased $101.7 million. Year-to-date, the Company has repaid $6.0 million of term borrowings at maturity. However, this was more than offset by growth in short-term borrowings used to temporarily fund strong earning asset growth.
STOCKHOLDERS’ EQUITY
The table below presents the composition of the Company’s stockholders’ equity.
Common stock
Additional paid in capital
AOCI (loss)
TCE* / TA
*TCE is defined as total common stockholders’ equity excluding goodwill and other intangibles. This ratio is a non-GAAP financial measure. See GAAP to Non-GAAP Reconciliations.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity measures the ability of the Company to meet maturing obligations and its existing commitments, to withstand fluctuations in deposit levels, to fund its operations, and to provide for customers’ credit needs. The Company monitors liquidity risk through contingency planning stress testing on a regular basis. The Company seeks to avoid over-concentration of funding sources and to establish and maintain contingent funding facilities that can be drawn upon if normal funding sources become unavailable. One source of liquidity is cash and short-term assets, such as interest-bearing deposits in other banks and federal funds sold, which averaged $126.4 million during the third quarter of 2017 and $139.5 million during the full year of 2016. The Company’s on balance sheet liquidity position can fluctuate based on short-term activity in deposits and loans.
The subsidiary banks have a variety of sources of short-term liquidity available to them, including federal funds purchased from correspondent banks, FHLB advances, wholesale structured repurchase agreements, brokered deposits, lines of credit, borrowing at the Federal Reserve Discount Window, sales of securities AFS, and loan/lease participations or sales. The Company also generates liquidity from the regular principal payments and prepayments made on its loan/lease portfolio, and on the regular monthly payments on its securities portfolio (both residential mortgage-backed securities and municipal securities).
At September 30, 2017, the subsidiary banks had 34 lines of credit totaling $375.0 million, of which $3.0 million was secured and $372.0 million was unsecured. At September 30, 2017, the full $375.0 million was available as none was utilized for short-term borrowing needs at QCBT.
At December 31, 2016, the subsidiary banks had 33 lines of credit totaling $381.4 million, of which $34.4 million was secured and $347.0 million was unsecured. At December 31, 2016, $361.4 million was available as $20.0 million was utilized for short-term borrowing needs.
The Company has emphasized growing the number and amount of lines of credit in an effort to strengthen this contingent source of liquidity. Additionally, the Company maintains a $10.0 million secured revolving credit note with a variable interest rate and a maturity of June 30, 2018. At September 30, 2017, the full $10.0 million was available.
As of September 30, 2017, the Company has $384.1 million in correspondent banking deposits spread over 183 relationships. While the Company believes that these funds are very stable, there is the potential for large fluctuations that can impact liquidity. Seasonality and the liquidity needs of these correspondent banks can impact balances. Management closely monitors these fluctuations and runs stress scenarios to measure the impact on liquidity and interest rate risk with various levels of correspondent deposit run-off.
Investing activities used cash of $271.1 million during the first nine months of 2017, compared to $132.1 million for the same period of 2016. The net decrease in interest-bearing deposits at financial institutions was $22.7 million for the first nine months of 2017, compared to a net increase of $24.0 million for the same period of 2016. Proceeds from calls, maturities, paydowns, and sales of securities were $92.5 million for the first nine months of 2017, compared to $219.1 million for the same period of 2016. Purchases of securities used cash of $103.5 million for the first nine months of 2017, compared to $111.6 million for the same period of 2016. The net increase in loans/leases used cash of $269.3 million for the first nine months of 2017 compared to $144.6 million for the same period of 2016. In 2017, cash prepaid for the acquisition of Guaranty Bank was $7.8 million. In 2016, the net cash paid for the acquisition of CSB was $69.9 million.
Financing activities provided cash of $229.6 million for the first nine months of 2017, compared to $125.7 million for same period of 2016. Net increases in deposits totaled $225.1 million for the first nine months of 2017, compared to $227.9 million for the same period of 2016. During the first nine months of 2017, the Company’s short-term borrowings decreased $24.0 million, while they decreased $84.6 million for the same period of 2016. In the first nine months of 2017, the Company increased FHLB advances and other borrowings by $44.6 million through a mixture of term advances, proceeds from other borrowings and net change in short-term and overnight advances, while borrowing maturities and principal payments on borrowings totaled $15.5 million. In the first nine months of 2016, the Company reduced FHLB advances and borrowings by $83.8 million through a mixture of maturities, prepayments, and debt retirement. In the same period, the Company received $29.8 million of proceeds from the common stock offering of 1.2 million shares of common stock. In the first nine months of 2016, the Company received $35.0 million in cash from the proceeds of other borrowings.
Total cash provided by operating activities was $27.2 million for the first nine months of 2017, compared to $25.8 million for the same period of 2016.
Throughout its history, the Company has secured additional capital through various sources, including the issuance of common and preferred stock, as well as trust preferred securities.
The following table presents the details of the trust preferred securities outstanding as of September 30, 2017 and December 31, 2016.
Name
Date Issued
OutstandingSeptember 30,
Amount OutstandingDecember 31,
Interest Rate as ofSeptember 30, 2017
Interest Rate as ofDecember 31, 2016
QCR Holdings Statutory Trust II
February 2004
2.85% over 3-month LIBOR
QCR Holdings Statutory Trust III
QCR Holdings Statutory Trust V
February 2006
1.55% over 3-month LIBOR
Community National Statutory Trust II
September 2004
2.17% over 3-month LIBOR
Community National Statutory Trust III
March 2007
1.75% over 3-month LIBOR
Weighted Average Rate
The Company assumed the trust preferred securities originally issued by Community National in connection with its acquisition in May 2013. As a result of acquisition accounting, the liabilities were recorded at fair value upon acquisition with the resulting discount being accreted as interest expense on a level yield basis over the expected term. The original discount totaled $2.6 million. As of September 30, 2017, the remaining discount was $2.0 million.
The Company filed a universal shelf registration statement on Form S-3 with the SEC on October 27, 2016, as amended on January 11, 2017. Declared effective by the SEC on January 31, 2017, the registration statement allows the Company to offer and sell various types of securities, including common stock, preferred stock, debt securities and/or warrants, from time to time up to an aggregate amount of $100 million. The Company utilized $30.1 million of its $100 million previous shelf registration filing through the offer and sale of its common stock in the second quarter of 2016 to help fund the acquisition of CSB. This Form S-3 filing replenished the amount available to the previous level of $100 million. The specific terms and prices of any securities offered pursuant to the registration statement will be determined at the time of any future offering and described in a separate prospectus supplement, which would be filed with the SEC at the time of the particular offering, if any. There were no securities issued under this shelf registration statement during the nine months ended September 30, 2017.
The Company filed a registration statement on Form S-4 with the SEC on July 27, 2017which was amended on August 14, 2017. In connection with the acquisition of Guaranty Bank, the Company issued 678,670 shares of common stock on October 1, 2017 pursuant to the S-4.
The Company (on a consolidated basis) and the subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and subsidiary banks’ financial statements. Refer to Note 7 of the Consolidated Financial Statements for additional information regarding regulatory capital.
SPECIAL NOTE CONCERNING FORWARD-LOOKING STATEMENTS
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995. This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “bode,” “predict,” “suggest,” “project,” “appear,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should,” “likely,” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. The factors which could have a material adverse effect on the Company’s operations and future prospects are detailed in the “Risk Factors” sections included under Item 1A of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 and Item 1A of Part II of this report. In addition to the risk factors described in that section, there are other factors that may impact any public company, including the Company, which could have a material adverse effect on the Company’s operations and future prospects of the Company and its subsidiaries. One should not consider the risk factors to be a complete discussion of risks, uncertainties and assumptions.
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company, like other financial institutions, is subject to direct and indirect market risk. Direct market risk exists from changes in interest rates. The Company’s net income is dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.
In an attempt to manage the Company’s exposure to changes in interest rates, management monitors the Company’s interest rate risk. Each subsidiary bank has an asset/liability management committee of the board of directors that meets quarterly to review the bank’s interest rate risk position and profitability, and to make or recommend adjustments for consideration by the full board of each bank.
Internal asset/liability management teams consisting of members of the subsidiary banks’ management meet weekly to manage the mix of assets and liabilities to maximize earnings and liquidity and minimize interest rate and other risks. Management also reviews the subsidiary banks’ securities portfolios, formulates investment strategies, and oversees the timing and implementation of transactions to assure attainment of the board's objectives in an effective manner. Notwithstanding the Company’s interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.
In adjusting the Company’s asset/liability position, the board of directors and management attempt to manage the Company’s interest rate risk while maintaining or enhancing net interest margins. At times, depending on the level of general interest rates, the relationship between long-term and short-term interest rates, market conditions and competitive factors, the board of directors and management may decide to increase the Company’s interest rate risk position somewhat in order to increase its net interest margin. The Company’s results of operations and net portfolio values remain vulnerable to increases in interest rates and to fluctuations in the difference between long-term and short-term interest rates.
One method used to quantify interest rate risk is a short-term earnings at risk summary, which is a detailed and dynamic simulation model used to quantify the estimated exposure of net interest income to sustained interest rate changes. This simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest sensitive assets and liabilities reflected on the Company’s consolidated balance sheet. This sensitivity analysis demonstrates net interest income exposure annually over a five-year horizon, assuming no balance sheet growth and various interest rate scenarios including no change in rates; 200, 300, 400, and 500 basis point upward shifts; and a 100 basis point downward shift in interest rates, where interest-bearing assets and liabilities reprice at their earliest possible repricing date.
The model assumes parallel and pro rata shifts in interest rates over a twelve-month period for the 200 basis point upward shift and 100 basis point downward shift. For the 400 basis point upward shift, the model assumes a parallel and pro rata shift in interest rates over a twenty-four month period. For the 500 basis point upward shift, the model assumes a flattening and pro rata shift in interest rates over a twelve-month period where the short-end of the yield curve shifts upward greater than the long-end of the yield curve.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - continued
Further, in recent years, the Company added additional interest rate scenarios where interest rates experience a parallel and instantaneous shift upward 100, 200, 300, and 400 basis points and a parallel and instantaneous shift downward 100 basis points. The Company will run additional interest rate scenarios on an as-needed basis.
The asset/liability management committees of the subsidiary bank boards of directors have established policy limits of a 10% decline in net interest income for the 200 basis point upward parallel shift and the 100 basis point downward parallel shift. For the 300 basis point upward shock, the established policy limit has been increased to 25% decline in net interest income. The increased policy limit is appropriate as the shock scenario is extreme and unlikely and warrants a higher limit than the more realistic and traditional parallel/pro-rata shift scenarios.
Application of the simulation model analysis for select interest rate scenarios at the most recent quarter-end available is presented in the following table:
NET INTEREST INCOME EXPOSURE in YEAR 1
INTEREST RATE SCENARIO
POLICY LIMIT
As of December 31, 2015
100 basis point downward shift
200 basis point upward shift
300 basis point upward shock
The simulation is well within the board-established policy limits for all three scenarios. Additionally, for all of the various interest rate scenarios modeled and measured by management (as described above), the results at September 30, 2017 were within established risk tolerances as established by policy or by best practice (if the interest rate scenario didn’t have a specific policy limit).
In 2014, the Company executed two interest rate cap transactions, each with a notional value of $15.0 million, for a total of $30.0 million. The interest rate caps purchased essentially set a ceiling to the interest rate paid on the $30.0 million of short-term FHLB advances that are being hedged, minimizing the interest rate risk associated with rising interest rates. The Company will continue to analyze and evaluate similar transactions as an alternative and cost effective way to mitigate interest rate risk.
Interest rate risk is considered to be one of the most significant market risks affecting the Company. For that reason, the Company engages the assistance of a national consulting firm and its risk management system to monitor and control the Company’s interest rate risk exposure. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities.
CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) promulgated under the Exchange Act of 1934) as of September 30, 2017. Based on that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective, as of the end of the period covered by this report, to ensure that information required to be disclosed in the reports filed and submitted under the Exchange Act was recorded, processed, summarized and reported as and when required.
Changes in Internal Control over Financial Reporting. There have been no significant changes to the Company’s internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II - OTHER INFORMATION
There have been no material changes in the risk factors applicable to the Company from those disclosed in Part I, Item 1.A. “Risk Factors,” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. Please refer to that section of the Company’s Form 10-K for disclosures regarding the risks and uncertainties related to the Company’s business.
Item1A
None
Defaults Upon Senior Securities
Not applicable
PART II - OTHER INFORMATION - continued
Item 6 Exhibits
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2017 and September 30, 2016; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2017 and September 30, 2016; (iv) Consolidated Statements of Changes in Stockholders’ Equity for the three and nine months ended September 30, 2017 and September 30, 2016; (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and September 30, 2016; and (vi) Notes to the Consolidated Financial Statements.
SIGNATURES
Pursuant to the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Date
November 8, 2017
Principal Accounting Officer