Item 1. Business
The disclosures set forth in this item are qualified by the discussions contained in Item 1A.
Item 1A. Risk Factors
Our business, financial condition and results of operations are subject to various risks, including those described below, which in turn may affect the value of our securities. In addition, other risks not presently known to us or that we currently believe to be immaterial may also adversely affect our business, financial condition and results of operations, perhaps materially. The risks discussed below also include forward-looking statements, and actual results and events may differ substantially from those discussed or highlighted in these forward-looking statements. Before making an investment decision with respect to any of our securities, you should carefully consider the following risks and uncertainties described below and elsewhere in this report.
Our business may be adversely affected by the highly regulated environment in which we operate.
The Company and the Bank are subject to extensive federal and state regulation, supervision and examination. Banking regulations are primarily intended to protect depositors’ funds, FDIC funds, customers and the banking system as a whole, rather than stockholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things.
As a bank holding company, we are subject to regulation and supervision primarily by the Federal Reserve. The Bank, as an Illinois-chartered state member bank, is subject to regulation and supervision by both the IDFPR and the Federal Reserve. We and the Bank undergo periodic examinations by these regulators, which have extensive discretion and authority to prevent or remedy unsafe or unsound practices or violations of law by banks and bank holding companies.
The primary federal and state banking laws and regulations that affect us are described in this report under the section captioned “Supervision and Regulation” in Item 1. Business. These laws, regulations, rules, standards, policies and interpretations are constantly evolving and may change significantly over time. For example, on July 21, 2010, the Dodd-Frank Act was signed into law, which significantly changed the regulation of financial institutions and the financial services industry. The Dodd-Frank Act, together with the regulations to be developed thereunder, includes provisions affecting large and small financial institutions alike, including several provisions that will affect how community banks, thrifts and small bank and thrift holding companies will be regulated in the future. In addition, the Federal Reserve has adopted numerous new regulations addressing banks’ overdraft and mortgage lending practices. Further, the Bureau of Consumer Financial Protection was recently established, with broad powers to supervise and enforce consumer protection laws, and additional consumer protection legislation and regulatory activity is anticipated in the near future.
Such changes, including changes regarding interpretations and implementation, could affect the Company in substantial and unpredictable ways and could have a material adverse effect on the Company’s business, financial condition and results of operations. Further, such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things.
Failure to comply with applicable laws, regulations or policies could result in sanctions by regulatory agencies, civil monetary penalties, and/or damage to the Company’s reputation, which could have a material adverse effect on the Company’s business, financial condition and results of operations. Although the Company has policies and procedures designed to mitigate the risk any such violations, there can be no assurance that such violations will not occur.
The policies of the Federal Reserve also have a significant impact on us. Among other things, the Federal Reserve’s monetary policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits, and can also affect the value of financial instruments we hold and the ability of borrowers to repay their loans, which could have a material adverse effect on our business, financial condition and results of operations.
Competition from financial institutions and other financial services providers may adversely affect our growth and profitability.
We operate in a highly competitive industry and experience intense competition from other financial institutions in our market. We compete with these institutions in making loans, attracting deposits and recruiting and retaining talented people. We also compete with nonbank financial service providers, including mortgage companies, finance companies, mutual funds and credit unions. Many of these competitors are not subject to the same regulatory restrictions that we are and may be able to compete more effectively as a result. We have observed that the competition in our market for making commercial loans has resulted in more competitive pricing and credit structure, as well as intense competition for qualified commercial lending officers. We also may face a competitive disadvantage as a result of our smaller size, limited branch network, narrower product offerings and lack of geographic diversification as compared to some of our larger competitors. Although our competitive strategy is to provide a distinctly superior customer and employee experience, we can give no assurance that this strategy will be successful. Our growth and profitability depend on our continued ability to compete effectively within our market area.
Our business is subject to the conditions of the local economy in which we operate and continued weakness in the local economy and the real estate markets may adversely affect us.
Our success is dependent to a large extent upon the general economic conditions in the Chicago area, where most of our banking and financial services are provided. Accordingly, the local economic conditions in Chicago have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources.
Our operating results have been negatively impacted by the historically high level of nonperforming loans in our commercial loan portfolio. Continued weakness in the Chicago area economy has had and may continue to have a material adverse affect on our business, financial condition and results of operations, including higher provisions for loan losses and net loan charge-offs, lower net interest income caused by an increase in nonaccrual loans, and higher legal and collection costs. In addition, we may be required to continue to devote substantial additional attention and resources to nonperforming asset management rather than focusing on business growth activities. Continued adverse conditions in the local economy could also reduce demand for new loans and other financial services and impair our ability to attract and retain deposits.
Our business is subject to domestic and, to a lesser extent, international economic conditions and other factors, many of which are beyond our control and could adversely affect our business.
From December 2007 through June 2009, the United States economy was in recession. Business activity across a wide range of industries and regions in the United States was greatly reduced. Although general economic conditions have improved, certain sectors, such as real estate and manufacturing, remain weak, and unemployment remains at historically high levels, including within the Chicago area, where most of our customers are located. In addition, local governments and many businesses continue to experience serious difficulty due to lower consumer spending and decreased liquidity in the credit markets.
Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.
The Company’s financial performance generally, and in particular the ability of customers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services the Company offers, is highly dependent upon on the business environment in the markets where the Company operates, in the state of Illinois generally and in the United States as a whole. A favorable business environment is generally characterized by, among other factors: economic growth; efficient capital markets; low inflation; low unemployment; high business and investor confidence; and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by: declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment; natural disasters; or a combination of these or other factors.
On August 5, 2011, Standard & Poor’s lowered its long term sovereign credit rating on the United States of America from AAA to AA+. A further downgrade or a downgrade by other rating agencies could have a material adverse impact on financial markets and economic conditions in the United States and worldwide. Any such adverse impact could have a material adverse effect on the Company’s liquidity, financial condition and results of operations. Many of our investment securities are issued by U.S. government sponsored entities.
Further, concerns about the European Union’s sovereign debt crisis have also caused uncertainty for financial markets globally. Such risks could indirectly affect the Company by affecting its hedging or other counterparties, as well as the Company’s customers with European businesses or assets denominated in the euro or companies in the Company’s market with European businesses or affiliates.
Overall, during 2011, the business environment was unfavorable for many households and businesses in the United States. While economic conditions in the Chicago area, the state of Illinois and the United States have generally improved since the recession, there can be no assurance that this improvement will continue or occur at a meaningful rate. Such conditions could adversely affect the credit quality of the Company’s loans, business, results of operations and financial condition.
The preparation of our consolidated financial statements requires us to make estimates and judgments, which are subject to an inherent degree of uncertainty and which may differ from actual results.
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and general reporting practices within the financial services industry, which require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Some accounting policies, such as those pertaining to our allowance for loan loss and deferred tax asset and the necessity of any related valuation allowance, require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty and actual results may differ from these estimates and judgments under different assumptions or conditions, which may have an adverse effect on our financial condition or results of operations in subsequent periods.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Making loans is a substantial part of our business, and every loan we make is subject to the risk that it will not be repaid or that any underlying collateral in the case of secured loans will not be sufficient to assure full repayment. Among other things, the risk of non-payment is affected by:
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changes in economic, market and industry conditions,
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the credit risks associated with the particular borrower and type of loan,
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cash flow of the borrower and/or the project being financed,
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the duration of the loan, and
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opportunities to identify potential loan repayment issues when remedial action may be most effective.
We maintain an allowance for loan losses, which is established through an accounting reserve established through a provision for loan losses charged to expense, which we believe is adequate to provide for probable losses inherent in our loan portfolio as of the corresponding balance sheet date. The determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which are subject to material changes. Continuing deterioration in or stagnation of economic conditions affecting borrowers, new information regarding existing loans and any underlying collateral, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance for loan losses.
In addition, our federal and state regulators periodically review our allowance for loan losses and, based on judgments that differ from those of our management, may require an increase in our provision for loan losses or the recognition of further loan charge-offs. Further, if loan charge-offs in future periods exceed our allowance for loan losses, we will need additional provisions to increase the allowance. Any increases in our allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our business, financial condition and results of operations. See the section captioned “Allowance for Loan Losses” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the process for determining the appropriate level of our allowance for loan losses.
Our mortgage loan repurchase reserve for losses could be insufficient.
We currently maintain a repurchase reserve, which is a liability on the Balance Sheets, to reflect best estimate of expected losses that have incurred on loans that we have sold or securitized into the secondary market and must subsequently repurchase or with respect to which we must indemnify the purchasers and insurers because of violations of customary representations and warranties. Increases to this reserve for current loan sales reduce mortgage banking revenue. The level of the reserve reflects management’s continuing evaluation of loss experience on repurchased loans, indemnifications, and present economic conditions, as well as the actions of loan purchasers and guarantors. The determination of the appropriate level of the secondary market reserve inherently involves a high degree of subjectivity and requires us to make significant estimates of repurchase risks and expected losses subsequently experienced. Both the assumptions and estimates used could be inaccurate, resulting in a level of reserve that is less than actual losses. If additional reserves are required, it could have an adverse effect on our business, financial condition and results of operations.
We are subject to interest rate risk, including interest rate fluctuations that could reduce our profitability.
Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Open Market Committee of the Federal Reserve.
Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect:
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the Company’s ability to originate loans and obtain deposits,
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the fair value of the Company’s financial assets and liabilities, and
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the average duration of the Company’s securities portfolio.
If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company’s net interest income, and therefore, earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies, including the use of derivatives as hedging instruments, to reduce the potential effects of changes in interest rates on the Company’s results of operations, if these strategies prove ineffective, or if any substantial, unexpected and prolonged change in market interest rates occurs, such events could have a material adverse effect on the Company’s business, financial condition and results of operations.
Certain hedging strategies that we use to manage investment in mortgage servicing rights (“MSRs”) may be ineffective to offset any adverse changes in the fair value of these assets due to changes in interest rates and market liquidity.
We invest in MSRs to support mortgage banking strategies and diversify revenue streams from our mortgage banking segment. The value of these assets and the income they provide tend to be counter-cyclical to the changes in production volumes and gain on sale of loans. We also enter into derivatives to hedge MSRs to offset changes in fair value resulting from the actual or anticipated changes in prepayments and changing interest rate environments. The primary risk associated with MSRs is that in a declining interest rate environment, they will likely lose a substantial portion of their value as a result of higher than anticipated prepayments. Conversely,
these assets generally increase in value in a rising interest rate environment to the extent that prepayments are slower than previously estimated. Our hedging strategies are highly susceptible to prepayment risk, basis risk, market volatility and changes in the shape of the yield curve, among other factors. In addition, hedging strategies rely on assumptions and projections regarding assets and general market factors. If these assumptions and projections prove to be incorrect or our hedging strategies do not adequately mitigate the impact of changes in interest rates or prepayment speeds, it may incur losses that would adversely impact earnings.
Our residential mortgage lending profitability could be significantly reduced if we are not able to originate and resell a high volume of mortgage loans.
Mortgage production, especially refinancings, decline in rising interest rate environments. While we have been experiencing historically low interest rates, the low interest rate environment likely will not continue indefinitely. When interest rates increase, there can be no assurance that our mortgage production will continue at current levels. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking operations depends in large part upon our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (i) the existence of an active secondary market and (ii) our ability to profitably sell loans into that market.
Our ability to sell mortgage loans readily is dependent upon the availability of an active secondary market for single-family mortgage loans, which in turn depends in part upon the continuation of programs currently offered by the GSEs and other institutional and non-institutional investors. These entities account for a substantial portion of the secondary market in residential mortgage loans. Because the largest participants in the secondary market are government-sponsored enterprises whose activities are governed by federal law, any future changes in laws that significantly affect them could, in turn, adversely affect our operations. The impact on us of existing proposals to reform Fannie Mae and Freddie Mac, which were place into conservatorship in 2008, is difficult to predict. In addition, our ability to sell mortgage loans readily is dependent upon our ability to remain eligible for the programs offered by GSEs and other market participants. Our ability to remain eligible to originate and securitize government insured loans may also depend on having an acceptable peer-relative delinquency ratio for Federal Housing Administration (the “FHA”) loans.
Any significant impairment of our eligibility with any of the GSEs could materially and adversely affect our operations. Further, the criteria for loans to be accepted under such programs may be changed from time-to-time by the sponsoring entity which could result in a lower volume of corresponding loan originations or other administrative costs.
We have counterparty risk and therefore we may be adversely affected by the soundness of other financial institutions.
Our ability to engage in routine funding and other transactions could be negatively affected by the actions and the soundness of other financial institutions. Financial services institutions are generally interrelated as a result of trading, clearing, counterparty, credit or other relationships. We have exposure to many different industries and counterparties and regularly engage in transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional customers. Many of these transactions may expose us to credit or other risks if another financial institution experiences adverse circumstances. In certain circumstances, the collateral that we hold may be insufficient to fully cover the risk that a counterparty defaults on its obligations, which may cause us to experience losses that could have a material adverse affect on our business, financial condition and results of operations.
We are subject to certain operational risks, including, but not limited to, data processing system failures and errors and customer or employee fraud. The Company’s controls and procedures may fail or be circumvented.
There have been a number of highly publicized cases involving fraud or other misconduct by employees of financial services firms in recent years. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. Employee fraud, errors and employee and customer misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to civil claims for negligence.
We maintain a system of internal controls and procedures designed to reduce the risk of loss from employee or customer fraud or misconduct, employee errors and operational risks, including data processing system failures and errors and customer or employee fraud. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, financial condition and results of operations.
The Company is dependent upon outside third parties for processing and handling of Company records and data.
The Company relies on software developed by third party vendors to process various Company transactions. In some cases, the Company has contracted with third parties to run their proprietary software on behalf of the Company. These systems include, but are not limited to, general ledger, payroll, employee benefits, loan and deposit processing, mortgage origination, secondary marketing, MSRs, servicing of mortgage loans and securities portfolio management. While the Company performs a review of controls instituted by the applicable vendor over these programs in accordance with industry standards and performs its own testing of user controls, the Company must rely on the continued maintenance of controls by these third party vendors, including safeguards over the security of customer data. In addition, the Company maintains, or contracts with third parties to maintain, backups of key processing output daily in the event of a failure on the part of any of these systems. Nonetheless, the Company may incur a temporary disruption in its ability to conduct its business or process its transactions, or incur damage to its reputation if the third party vendor fails to adequately maintain internal controls or institute necessary changes to systems. Such disruption or a breach of security may have a material adverse effect on the Company’s business, financial condition and results of operations.
System failure or breaches of our network security, including with respect to our internet banking activities, could subject us to increased operating costs as well as litigation and other liabilities.
The computer systems and network infrastructure we use in our operations and internet banking activities could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. Computer break-ins, “phishing” and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, as well as that of our customers engaging in internet banking activities. In addition, advances in computer capabilities or other developments could result in a compromise or breach of our systems designed to protect customer data. Although we have procedures in place to prevent or limit the effects of any of these potential problems and intend to continue to implement security technology and establish operational procedures to mitigate the risk of such occurrences, there can be no assurance that these measures will be successful. Any interruption in, or breach in security of, our computer systems and network infrastructure, or that of our internet
banking customers, could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We are subject to lending concentration risks.
We have focused on repositioning our portfolio to reduce our exposure to industries and sectors that we no longer consider economically desirable. As a business bank, our loan portfolio is comprised primarily of commercial loans to businesses. As of December 31, 2011, approximately 90% of our loan portfolio consisted of commercial loans of which approximately 35% are commercial real estate loans. Our commercial loans are typically larger in amount than loans to individual consumers and, therefore, have the potential for higher losses on an individual loan basis. Credit quality issues on larger commercial loans, if they were to occur, could cause greater volatility in reported credit quality performance measures, such as total impaired or nonperforming loans, and the amount of charge-offs and recoveries between periods. The deterioration of any one or a few of these loans may cause a significant increase in uncollectible loans, which would have a material adverse impact on our results of operations and financial condition.
The problems that have occurred in the residential real estate and mortgage markets throughout much of the United States also affected the commercial real estate market. In our market areas, we have generally experienced a downturn in credit performance by our commercial real estate loan customers, and in light of the uncertainty that exists in the economy and credit markets, there can be no guarantee that we will not experience further deterioration in the performance of commercial real estate and other real estate loans in the future. In such case, we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results, financial condition or capital.
We may not be able to access sufficient and cost-effective sources of liquidity.
Liquidity is essential to our business and drives our ability to make new loans or invest in securities. In addition, the Company requires liquidity to meet its deposit and debt obligations as they come due. Our access to funding sources in amounts adequate to finance our activities or on terms that are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or the economy generally. Factors that could reduce our access to liquidity sources include a downturn in the Chicago area market, difficult credit markets or adverse regulatory actions against us.
As part of our liquidity management, we use a number of funding sources in addition to what is provided by in-market deposits and repayments and maturities of loans and investments. Although we have increased our funding from our core customers to reduce our reliance on wholesale funding, we continue to use brokered money market accounts and certificates of deposits, out-of-local-market certificates of deposit, broker/dealer repurchase agreements, federal funds purchased and Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) advances as a source of liquidity.
Under FDIC regulations, only “well-capitalized” institutions may issue brokered certificates of deposit (“CDs”) without prior regulatory approval. The Bank is currently categorized as “well-capitalized” and, therefore, may continue to utilize this funding source. Brokered CD distributors may use other criteria in determining which banks to allow to issue brokered CDs through their distribution network. If our access to the brokered CD market were reduced in any material respect, it could lead to an inability to replace brokered deposits at maturity, which would result in higher costs to, or reduced asset levels at, the Bank.
Our liquidity position is affected by the amount of cash and other liquid assets on hand, payment of interest and dividends on our outstanding debt and equity instruments, capital we inject into the Bank, redemption of our previously issued debt, proceeds we raise through the issuance of debt and equity instruments, and dividends received from the Bank (if permitted). Our future liquidity position may be materially adversely affected if, in the future, one or a combination of the following events occur:
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the Bank reports net losses or its earnings are weak relative to our cash flow needs as a holding company,
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we deem it advisable or are required by our regulators to use cash at the holding company level to support loan growth of the Bank or address other capital needs of the Bank through downstream capital injections, or
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we have difficulty raising cash at the holding company level through the issuance of debt or equity securities or accessing additional sources of credit.
Given the losses recorded by the Bank from 2008 through 2010 and the resulting limitations imposed by our regulators on the ability of the Bank to pay dividends to us, we have been dependent upon our current cash position and cash proceeds generated by capital raises to meet liquidity needs at the holding company level. If we foresee that we face diminished liquidity, we may, to the extent possible, seek to manage this risk by reducing the amount of capital we inject into the Bank. This may further reduce the capital position of the Bank, cause our growth to slow and result in regulatory criticism.
We are subject to liquidity risk, including unanticipated deposit volatility.
Our usual liquidity management challenges include responding to potential volatility in our customers’ deposit balances. We primarily use advances from the FHLB, broker/dealer repurchase agreements and federal funds purchased to meet our immediate liquidity needs. Since 2008, we have experienced a significant increase in client deposits, which has allowed us to reduce our reliance on wholesale funding sources. However, there can be no assurance that this recent level of client deposit growth will continue, that client deposits will remain at current levels or that we will be able to maintain the recent reduced reliance on wholesale deposits. Increased customer confidence in general economic conditions, higher expected rates of return on other investments (including a rise in interest rates) or additional restrictions on the availability of FDIC coverage could each cause our customers to move all or a portion of their deposits to other investment options, thus causing a reduction in our deposits and increasing our reliance on wholesale or other funding sources.
In addition, we have customers that maintain significant deposit balances with us, the immediate withdrawal of which could have a material adverse affect on our daily liquidity management. Further, the number of branches we maintain is small relative to our asset size, which could negatively impact our ability to acquire new deposits. In the event that we experience a significant deposit outflow, our liquidity could be negatively impacted such that our capital position, reputation or profitability could also be adversely affected. If we fail to effectively manage the risk of deposit volatility, our business, financial condition, results of operations and reputation could be materially adversely affected.
The recent repeal of federal prohibitions on payment of interest on business demand deposits could increase the Company’s interest expense.
All federal prohibitions on the ability of financial institutions to pay interest on business demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, some financial institutions have commenced offering interest on these demand deposits to compete for customers. If competitive pressures require the Company to pay interest on these demand deposits to attract and retain business customers, its interest expense would increase and its net interest margin would decrease. This could have a material adverse effect on the Company’s business, financial condition and results of operations. Further, the effect of the repeal of the prohibition could be more significant in a higher interest rate environment as business customers would have a greater incentive to seek interest on demand deposits.
Changes in our credit ratings could increase our financing costs or make it more difficult for us to obtain funding or capital on commercially acceptable terms.
We are rated by several different rating agencies, including IDC and Bankrate.com. Many factors, both within and out of our control, may cause these agencies to downgrade their ratings related to the Company, which could subject us to negative publicity, adversely impact our ability to acquire or retain deposits and increase our cost of borrowing or limit our asset growth. Also, our credit ratings are an important factor to the institutions that provide our sources of liquidity, and reductions in our credit ratings could adversely affect our liquidity, increase our borrowing costs, limit our access to the capital markets or trigger unfavorable contractual obligations. We cannot give any assurance that our current credit ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances in the future so warrant.
The Company is a bank holding company and its sources of funds are limited.
The Company is a bank holding company, and its operations are primarily conducted by the Bank, which is subject to significant federal and state regulation, as discussed above and elsewhere in this report. When available, cash to pay dividends to stockholders of the Company is derived primarily from dividends received from the Bank. The Company’s ability to receive dividends or loans from the Bank is restricted. Dividend payments by the Bank to the Company in the future will require generation of future earnings by the Bank and could require regulatory approval if any proposed dividends are in excess of prescribed guidelines. Further, as a structural matter, the Company’s right to participate in the assets of the Bank in the event of a liquidation or reorganization of the Bank would be subject to the claims of the Bank’s creditors, including depositors, which would take priority except to the extent the Company may be a creditor with a recognized claim. As of December 31, 2011, the Bank had deposits and other liabilities of approximately $4.3 billion.
Our business strategy is dependent on our continued ability to attract, develop and retain highly qualified and experienced personnel in senior management and customer relationship positions.
We believe our future success is dependent, in part, on our ability to attract and retain highly qualified and experienced personnel in key senior management and other positions. Our competitive strategy is to provide each of our commercial customers with a highly qualified relationship manager that will serve as the customer’s key point of contact with us. Achieving the status of a “trusted advisor” for our customers also requires that we minimize relationship manager turnover and provide stability to the customer relationship. Competition for experienced personnel in our industry is intense, and we may not be able to successfully attract and retain such personnel.
Our recent operating results have reduced our cash-based incentive awards to senior management and other key employees. In addition, our participation in the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”) places limits on executive compensation, which may adversely affect our ability to attract and retain certain key employees, especially if we are competing for talent against institutions that are not subject to such restrictions. Any inability to retain and attract key personnel could negatively impact our operations.
Our reputation could be damaged by negative publicity.
Reputational risk, or the risk to our business, financial condition or results of operations from negative publicity, is inherent in our business. Negative publicity can result from actual or alleged conduct in a number of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, inadequate protection of customer data, ethical behavior of our employees, and from actions taken by regulators, ratings agencies and others as a result of that conduct. Damage to our reputation could impact our ability to attract new or maintain existing loan and deposit customers, employees and business relationships.
New lines of business or new products and services may subject us to certain additional risks.
From time to time, we will consider and may enter into new lines of business or offer new products or services. These activities can involve a number of uncertainties, risks and expenses, including the investment of significant time and resources, and we can give no assurance that our projected price and profitability targets will be attainable or that our efforts will be successful. These initiatives have required and will continue to require us to enter geographical markets that are new to us. In addition, new lines of business and new products and services could significantly impact the effectiveness of our system of internal controls, and present requirements for legal compliance with which we were previously unfamiliar. Failure to successfully manage these risks could have a material adverse affect on our business, results of operations and financial condition.
We may experience difficulties in managing our future growth.
Our future success in part, depends on our achieving growth in commercial banking relationships that result in increased commercial loans outstanding at yields that are profitable to us. Achieving our growth targets requires us to attract customers who currently bank at other financial institutions in our market, thereby increasing our share of the market. Our commercial banking strategy is to provide a local, high-touch relationship servicing experience that we believe is attractive to customers in our marketplace. In addition, we actively pursue high quality relationship managers to extend our reach in the market place. Our success will also depend in part on continued growth in our mortgage banking business. Our mortgage growth goals will necessitate further expansion of our national mortgage platform and, to a lesser degree, additional diversification of revenue streams from this business. Although we believe that we have the necessary resources in place to successfully manage our future growth, our growth strategy exposes us to certain risks and expenses, and we cannot assure you that we will be able to expand our market presence or that any such expansion will not adversely affect our results of operations. Our strategy for future growth also may place a significant strain on our management, personnel, systems and resources. Maintaining credit quality while growing our loan portfolio is critical to achieving and sustaining profitable growth. We may not be able to manage our growth effectively. If we fail to do so, our business would be materially harmed.
In furtherance of our growth strategy, we may also seek to acquire other financial institutions or parts of those institutions in the future, and we may engage in banking center expansion. In connection with future acquisitions, we may issue equity securities which could cause ownership and economic dilution to our current stockholders. Moreover, we cannot assure you that our regulators will permit us to implement an acquisition strategy. Furthermore, there is no assurance that, following any future mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve a level of profitability that will justify the investment that we made in any such acquisition.
The Company and its subsidiaries are subject to changes in federal and state tax laws and changes in interpretation of existing laws.
The Company’s financial performance is impacted by federal and state tax laws. Given the current economic and political environment, and ongoing federal and state budgetary pressures, the enactment of new federal or state tax legislation may occur. For example, in January 2011, the State of Illinois passed an income tax increase for both individuals and corporations, which increased our state income tax rate. The further enactment of such legislation, or changes in the interpretation of existing law, including provisions impacting tax rates, apportionment, consolidation or combination, income, expenses, and credits, may have a material adverse effect on the Company’s business, financial condition and results of operations.
Our participation in the TARP CPP may place significant restrictions on our operations.
Under the TARP CPP, our ability to declare or pay dividends on any of our shares of common stock is limited. Specifically, we are not permitted to pay dividends on our common stock without the UST’s approval until November 21, 2012, unless all of the outstanding shares of our Series B Preferred have been redeemed or
transferred by the UST to unaffiliated third parties. In addition, our ability to repurchase shares of our common stock and other securities is restricted. The consent of the UST generally is required for us to make any stock repurchases (other than in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice) until November 21, 2012, unless all of the outstanding shares of our Series B Preferred have been redeemed or transferred by the UST to unaffiliated third parties. Further, we may not repurchase shares of our common stock or shares of our Nonvoting Convertible Preferred Stock, Series D (“Series D Preferred”), and 8.0% Nonvoting Convertible Preferred Stock, Series G (“Series G Preferred”), if we are in arrears on the payment of Series B Preferred dividends.
Due to our participation in the TARP CPP, we are also subject to the UST’s current standards for executive compensation and corporate governance for the period during which the UST holds our Series B Preferred, as set forth in the Interim Final Rule on TARP Standards for Compensation and Corporate Governance on June 10, 2009. The compensation standards apply to certain of our senior executive officers and certain other of our most highly compensated employees and, among other things, place specific restrictions on the types and amounts of compensation that we may pay to these individuals. Certain of these restrictions may force us to issue additional shares of our common stock, rather than cash or other non-equity awards, to compensate and retain our executive officers. Any such common stock issuances likely would result in dilution to our common stockholders, which would have an adverse impact on the market value of our common stock.
Regulatory requirements, growth plans or operating results may require us to raise additional capital, which may not be available on favorable terms or at all.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. At December 31, 2011, both we and the Bank were categorized as “well-capitalized” under the applicable regulatory capital framework. To the extent regulatory requirements change, our future operating results erode capital or we seek to expand through loan growth or acquisitions, we may be required to raise additional capital. Our ability to raise capital in any such event would depend on conditions in the capital markets, which are outside of our control, and on our financial condition and performance. Accordingly, we cannot be assured of our ability to raise capital when needed or on favorable terms. The inability to attract new capital investment, or to attract capital on terms acceptable to us, could have a material adverse impact on our business, financial condition, results of operations or our ability to maintain or expand our operations.
We have not paid a dividend on our common stock since the second quarter of 2008. In addition, regulatory restrictions and liquidity constraints at the holding company level could impair our ability to make distributions on our outstanding securities.
Historically, our primary source of funds at the holding company level has been dividends received from the Bank. In order to preserve capital, our Board of Directors suspended the payment of dividends on our common stock beginning in the second quarter of 2008. Current and future liquidity constraints at the holding company level could continue to impair our ability to declare and pay dividends on our common or preferred stock or pay interest on our outstanding debt securities in the future. We also have agreed, consistent with our past practice, to continue to provide the Federal Reserve and the IDFPR with notice before we declare dividends on our common or preferred stock or pay interest on our debt securities.
The UST may also impose additional limitations on our ability to use funds we received from our participation in the TARP CPP, including the payment of dividends or interest on our outstanding securities. For example, we are currently prohibited from declaring or paying any dividends on our common stock without the UST’s consent until the earlier of November 21, 2012 or the date on which the UST no longer holds any shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series B (“Series B Preferred”). If we are unable to pay dividends or interest on our outstanding securities in the future, the market value of such securities may be materially adversely affected.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Our principal offices are located at our Corporate Center at 9550 West Higgins Road, Rosemont, Illinois. We lease approximately 112,000 square feet for our Corporate Center under an operating lease that expires on August 31, 2019, with two five-year renewal options which could extend the lease to 2029. We also have an approximately 1,400 square foot banking center on the first floor of our Corporate Center.
We also maintain approximately 36,000 square feet of general office space for our administrative offices in downtown Chicago at 225 West Washington under an operating lease with a 15-year term expiring in 2022 with two five-year renewal options which could extend the lease to 2032.
We currently have nine banking centers located in the Chicago area. Of the nine banking center locations, we own five of the buildings in which the banking centers are operated, including our Ashland, Skokie, Yorktown, Old Orchard, and Milwaukee locations. We lease the land under the buildings at Yorktown, Old Orchard and Milwaukee. We lease the buildings for our Wheeling (term to February 2015), Burbank (term to June 2014), Rosemont (term to August 2019), and South Clark (term to June 2018) banking facilities.
The following is a list of our administrative and customer banking locations:
We have expanded our asset-based lending services and opened offices in geographical areas outside the Chicago area. Currently, we maintain offices in Kansas City, Missouri; Brookfield, Wisconsin; Baltimore, Maryland; Irvine, California; Dallas, Texas; Memphis, Tennessee; Minneapolis, Minnesota; Seattle, Washington and Atlanta, Georgia. Each of these offices operates under short-term operating leases.
The principal administrative offices of our residential mortgage banking line of business are located in a 27,812 square foot facility located in Ann Arbor, Michigan with a five year lease which will terminate in March 2017. In 2011, we terminated the lease on an 8,000 square foot facility in Hamburg, Michigan which had a lease expiring in November 2014, as the business had outgrown this space. A second facility in Hamburg, Michigan is an 8,000 square foot facility with a lease expiring in July 2014, which we anticipate terminating in July 2012 with four months notice. The mortgage division also has smaller retail offices located in Ann Arbor and Northville, Michigan; Louisville and Lexington, Kentucky; Lancaster, Maple Glen and Exton, Pennsylvania; Chicago, Illinois; Long Island and Hamburg, New York; Carrollton and Suwanee, Georgia; St. Louis, Missouri and Jacksonville, Florida. Thee spaces are subleased by the Bank and cancellable with 30 days notice.
Item 3.
Item 3. Legal Proceedings
We are a party to litigation from time to time arising in the normal course of business. As of the date of this annual report, management knows of no threatened or pending legal action against us that is likely to have a material adverse effect on our business, financial condition or results of operations.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
TAYLOR CAPITAL GROUP, INC.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock trades on the Nasdaq Global Select Market under the symbol “TAYC”. The high and low sales price per share of our common stock for the periods indicated is set forth below:
As of March 5, 2012, the closing price per share of our common stock as reported on the Nasdaq was $13.17.
As of March 5, 2012, there were 352 stockholders of record of our common stock, based upon securities position listings furnished to us by our transfer agent. We believe the number of beneficial owners is greater than the number of record holders because a large portion of our common stock is held of record through brokerage firms in “street name”.
There have been no dividends declared on our common stock for any quarter in 2011 and 2010. Holders of our common stock are entitled to receive any cash dividends that may be declared by our Board of Directors. In connection with our participation in TARP CPP and the issuance of our Series B Preferred, we need the consent of the UST before we can pay any dividends on our common stock. Subject to such restrictions, the declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, the capital requirements of the Company and our subsidiaries, regulatory conditions and considerations and other factors as our Board of Directors may deem relevant. We also have agreed, consistent with our past practice, to continue to provide our regulators notice before we pay dividends and interest at the holding company.
As a bank holding company, we are ultimately dependent upon the Bank to provide funding for our operating expenses, debt service and dividends. Various banking laws applicable to the Bank limit the payment of dividends, management fees and other distributions by the Bank to us, and may, therefore, limit our ability to pay dividends on our common stock. Because of operating losses incurred in past years, our Bank does not have the ability to pay us dividends without regulatory approval. We will also be prohibited from paying dividends on our common stock if we fail to make distributions or required payments on the trust preferred securities and our outstanding preferred stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Liquidity” for additional details of restrictions on our ability to pay dividends and the ability of the Bank to pay dividends to us.
Stock Performance Graph
The graph below compares our cumulative stockholder return on our common stock from December 31, 2006 through December 31, 2011, with the composite index for all U.S. companies included in the Nasdaq Stock Market and the SNL Nasdaq Stock Market Bank Index. The source for the information below is SNL Financial LC, Charlottesville, Virginia.
This graph is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to the SEC’s proxy rules or to the liabilities of Section 18 of the Exchange Act, and the graph shall not be deemed to be incorporated by reference into any prior or subsequent filing by us under the Securities Act or the Exchange Act.
Item 6.
Item 6. Selected Financial Data
The selected consolidated financial data presented below under the caption “Taylor Capital Group, Inc.” as of and for the five years ended December 31, 2011 is derived from our historical financial statements. The selected financial information presented below under the caption of “Cole Taylor Bank” is derived from unaudited financial statements of the Bank. You should read this information in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this annual report. Results from past periods are not necessarily indicative of results that may be expected for any future period.
N.M. Not Meaningful
(1) Net interest margin is determined by dividing net interest income, as reported, by average interest-earning assets.
(2) The efficiency ratio is determined by dividing noninterest expense by an amount equal to net interest income plus noninterest income, adjusted for gains or losses on investment securities.
(3) For purposes of calculating the ratio of earnings to fixed charges, earnings consist of earnings (loss) before income taxes plus interest and rent expense. Fixed charges consist of interest expense, rent expense and preferred stock dividend requirements.
(4) Nonperforming loans consist of nonaccrual loans and loans contractually past due 90 days or more but still accruing interest.
(5) Nonperforming assets consist of nonperforming loans and other real estate owned and other repossessed assets.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
We are a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago, and we derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank. We provide a range of products and services primarily to closely-held commercial businesses and their owner operators in the Chicago area. We also provide asset-based lending and residential mortgage banking services through offices both in Chicago and in other geographic markets. At December 31, 2011, we had assets of $4.7 billion, deposits of $3.1 billion and stockholders’ equity of $409.5 million.
The following discussion and analysis presents our consolidated financial condition at December 31, 2011 and December 31, 2010 and the results of operations for the years ended December 31, 2011, December 31, 2010, and December 31, 2009. This discussion should be read together with the “Selected Financial Data,” our audited consolidated financial statements and the notes thereto and other financial data contained elsewhere in this annual report. In addition to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and forward-looking statements as a result of certain factors, including those discussed in the section captioned “Risk Factors” and elsewhere in this annual report.
Application of Critical Accounting Policies
Our accounting and reporting policies conform, in all material respects, to accounting principles generally accepted in the United States of America and general reporting practices within the financial services industry. For additional details, see “Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting and Reporting Policies” from our audited financial statements contained elsewhere in this annual report.
The preparation of financial statements in conformity with these accounting principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available to us as of the date of the consolidated financial statements and, accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. The estimates, assumptions and judgments made by us are based upon historical experience, current information and other factors that we believe to be reasonable under the circumstances. Certain accounting policies inherently have greater reliance on the use of estimates, assumptions and judgments, and as such, have a greater possibility of producing results that could be materially different than actual results. We consider our policies for the allowance for loan losses, the realizability of deferred tax assets, derivatives and the valuation of investment securities to be critical accounting policies.
The following accounting policies materially affect our reported earnings and financial condition and require significant estimates, assumptions and judgments.
Allowance for Loan Losses
We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on regular, quarterly assessments of the probable estimated losses inherent in our loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include a general allowance computed by applying loss factors to categories of loans outstanding in the portfolio and specific allowances for identified problem loans and portfolio categories. We maintain our allowance for loan losses at a level that we consider sufficient to absorb probable losses inherent in our portfolio as of the balance sheet date. In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including historical charge-off experience, changes in the size of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent, criticized and impaired loans. In addition, we use information about specific borrower situations, including their financial position,
work-out plans and estimated collateral values under various liquidation scenarios to estimate the risk and amount of loss on loans to those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of risk of loss and amount of loss on any loan are complicated by the uncertainties surrounding not only our borrowers’ probability of default, but also the fair value of the underlying collateral. The current illiquidity in the Chicago area real estate market has increased the uncertainty with respect to real estate values. Because of the degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding holding periods until sale and the collateral liquidation method, our actual losses may materially vary from our current estimates.
Our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have the potential for higher losses for each loan. These larger loans can cause greater volatility in our reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate for any one loan may have a material impact on our reported impaired loans and related loss estimates. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of any one or a few of these loans can cause an increase in uncollectible loans and our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, our allowance for loan losses is adjusted through the recording of a provision for loan losses.
Income Taxes
We maintain net deferred tax assets for deductible temporary differences between book and taxable income, the largest of which relates to the allowance for loan losses. For income tax return purposes, only net charge-offs of loans are deductible, not the provision for loan losses. Under GAAP, a deferred tax asset valuation allowance is required to be recognized if it is more-likely-than-not that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, the forecasts of future taxable income, applicable tax planning strategies, and assessments of current and future economic and business conditions. We consider both positive and negative evidence regarding the ultimate ability to realize our deferred tax assets. Examples of positive evidence may include the existence, if any, of taxes paid in available carry-back years and the likelihood that taxable income will be generated in future periods, positive credit quality trends and the state of overall economic environment. Examples of negative evidence may include a cumulative loss in the current year and prior two years, no tax planning opportunities to accelerate income, availability of taxes paid in open carryback years and negative general business and economic trends. We currently do not maintain a valuation allowance against our net deferred tax assets because management has determined that it is more-likely-than-not that these deferred tax assets will be realized.
Derivative Financial Instruments
We use derivative financial instruments (“derivatives”), including interest rate exchange and corridor agreements, callable interest rate exchange agreements, as well as interest rate lock and forward loan sale commitments, to either accommodate individual customer needs or to assist in our interest rate risk management. All derivatives are measured and reported at fair value on our Consolidated Balance Sheets as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the effective portion of the hedged risk, are recognized in current earnings during the period of the change in the fair values. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of OCI and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value. Similarly, the changes in the fair value of derivatives that do not qualify for hedge accounting or are not designated as an accounting hedge are also reported currently in earnings.
At the inception of a formally designated hedge and quarterly thereafter, an assessment is made to determine whether changes in the fair values or cash flows of the derivatives have been highly effective in offsetting the changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. If it is determined that derivatives are not highly effective as a hedge, hedge accounting is discontinued for the period. Once hedge accounting is terminated, all changes in fair value of the derivatives are reported currently in the Consolidated Statements of Operations in other noninterest income, which could result in greater volatility in our earnings.
The estimates of fair values of certain of our derivative instruments, such as interest rate exchange agreements (or swaps) and corridors, are calculated using independent valuation models to estimate market-based valuations. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both us and our counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in volatility in our earnings.
Valuation of Investment Securities
The fair value of our investment securities portfolio is determined in accordance with GAAP, which requires that we classify financial assets and liabilities measured at fair value into a three-level fair value hierarchy. The determination of fair value is highly subjective and requires management to rely on estimates, assumptions, and judgments that can affect amounts reported in our financial statements. We obtain the fair value of investment securities from an independent pricing service. We periodically review the pricing methodology for each significant class of assets used by this third party pricing service to assess the compliance with accounting standards for fair value measurement and classification in the fair value measurement hierarchy. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current rating from credit rating agencies, and the bond’s terms and conditions, among other things. While we use an independent pricing service to obtain the fair values of our investment portfolio, we employ certain control procedures to determine the reasonableness of the valuations. We validate the overall reasonableness of the fair values by comparing information obtained from our independent pricing service to other third party valuation sources for selected assets and review the valuations and any significant differences in valuations with members of management who have the relevant technical expertise to assess the results. In addition, the Company reviews the third party valuation methodology on a regular basis.
Each quarter we review our investment securities portfolio to determine whether unrealized losses are temporary or other than temporary, based on an evaluation of the creditworthiness of the issuers/guarantors, as well as the underlying collateral, if applicable. Our analysis includes an evaluation of the type of security, the length of time and extent to which the fair value has been less than the security’s carrying value, the characteristics of the underlying collateral, the degree of credit support provided by subordinate tranches within the total issuance, independent credit ratings, changes in credit ratings and a cash flow analysis, considering default rates, loss severities based upon the location of the collateral, and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We use other independent pricing sources to obtain fair value estimates and perform discounted cash flow analysis for selected securities. When the discounted cash flow analysis obtained from those independent pricing sources indicates that we expect all future principal and interest payments will be received in accordance with their original contractual terms, we do not intend to sell the security, and we more-likely-than-not will not be required to sell
the security before recovery, the unrealized loss is deemed temporary. If such analysis shows that we do not expect to be able to recover our entire investment, an other-than-temporary impairment charge will be recorded in current earnings for the amount of the credit loss component. The amount of impairment related to factors other than the credit loss is recognized in OCI. Our assessments of creditworthiness and the resultant expected cash flows are complicated by the uncertainties surrounding not only the specific security and its underlying collateral but also the severity of the current overall economic downturn. Our cash flow estimates for mortgage related securities are based on estimates of mortgage default rates, severity of loss, and prepayments, which are difficult to predict. Changes in assumptions can result in material changes in expected cash flows. Therefore, unrealized losses that we have determined to be temporary may at a later date be determined to be other-than-temporary and have a material impact on our Consolidated Statements of Operations.
Outlook
Since 2008, we have pursued a two pronged strategy of asset quality remediation and earnings growth and diversification, which we call our “fix and grow” strategy. The “fix” component refers to our continuing efforts to improve asset quality issues largely caused by the downturn in the Chicago area economy, and the resulting impact on real estate prices and liquidity. The “grow” component of our strategy seeks to increase and diversify our pre-tax, pre-provision earnings by repositioning our commercial banking business to provide middle-market lending across a wide array of industries. In addition, “grow” also encompasses Cole Taylor Business Capital, our asset-based lending arm established in 2009, and Cole Taylor Mortgage, our mortgage banking business established in 2010.
We plan to continue pursuing our “fix and grow” strategy in 2012. Regarding the “fix” component of our strategy, we expect to continue to remediate asset quality and to reduce lending concentrations in areas of higher risk. Improvement in asset quality will in part depend on a sustained improvement in the economy and in particular the Chicago area real estate market.
We also expect to maintain focus on the growth component of our strategy emphasizing our commercial banking and mortgage origination and servicing businesses. Cole Taylor Business Capital and Cole Taylor Mortgage are relatively new businesses and we believe that each have meaningful potential for continued growth. We will also look for additional opportunities for strategic, measured expansion provided it increases stockholder value, especially in the areas of deposit franchise enhancement.
Results of Operations
We reported net income applicable to common stockholders of $71.5 million, or $3.45 per diluted common share outstanding for the year ended December 31, 2011, compared to a net loss applicable to common stockholders of $79.3 million, or $5.27 per diluted common share, for the year ended December 31, 2010. The higher net income applicable to common stockholders in 2011 was due to the combination of improved credit quality and strong business line growth and the reversal of the valuation allowance on our net deferred tax asset of $73.2 million.
2011 Highlights
Strong business line growth during 2011:
•
Pre-tax, pre-provision operating earnings were $72.5 million in 2011, up 4.6% from $69.3 million for the full year 2010.
•
Revenue was $180.2 million in 2011, up 7.6% from $167.4 million in 2010.
Credit quality significantly improved during 2011:
•
Provision for loan losses was $49.3 million in 2011, a decrease of 65.5% from $143.1 million in 2010. Nonperforming asset expense also decreased, moving from $19.8 million in 2010 to $5.3 million in 2011, a decrease of 73.2%.
•
Nonperforming loans were $103.1 million and 3.31% of total loans at December 31, 2011, compared to $159.7 million and 5.16% of total loans at December 31, 2010.
•
The allowance for loan losses was $103.7 million and 100.66% of nonperforming loans at December 31, 2011, compared to $124.6 million and 77.98% at December 31, 2010.
•
At December 31, 2011, commercial criticized and classified loans (special mention, substandard and nonaccrual loans in commercial loans) totaled $182.6 million down 39.9% from $303.9 million at December 31, 2010.
Stockholders’ equity nearly doubled during 2011:
•
Issued $25.0 million of 8% Non-cumulative, Non-voting, Contingent Convertible Preferred Stock, Series F (“Series F Preferred”) which was immediately converted to common stock or a common stock equivalent.
•
Converted our 8% Non-Cumulative Convertible Perpetual Preferred Stock, Series C (“Series C Preferred”) and 8% Non-Cumulative Convertible Perpetual Preferred Stock, Series E (“Series E Preferred”), totaling $37.5 million, into shares of common stock or, in the case of some stockholders, Nonvoting Non-Cumulative Convertible Perpetual Preferred Stock Series G (“Series G Preferred”).
•
We completed a $35.0 million rights offering. Rights holders exercising their subscription rights purchased a total of 4,424,778 shares of our common stock at $7.91 per share.
•
Our results, in combination with management’s belief that we have achieved sustainable profitability, supported the reversal of the previously established $73.2 million valuation allowance on our net deferred tax asset. This reversal, in combination with our strong business line growth, resulted in net income applicable to common stockholders of $71.5 million for the year ended December 31, 2011.
Highlights
•
Pre-tax, pre-provision earnings from operations were $69.3 million in 2010, up 30.8% from $53.6 million for the full year 2009.
•
Revenue was $167.4 million in 2010, up 20.5% from $138.9 million in 2009.
•
Net interest income increased 10.7% from $122.9 million for the year ended December 31, 2009 to $136.1 million for the year ended December 31, 2010.
•
Nonperforming loans were $159.7 million and 5.16% of total loans at December 31, 2010, compared to $141.5 million and 4.66% of total loans at December 31, 2009.
•
The allowance for loan losses was $124.6 million and 77.98% of nonperforming loans at December 31, 2010, compared to $106.2 million and 75.06% at December 31, 2009.
•
At December 31, 2010, commercial criticized and classified loans totaled $303.9 million down 25.2% from $406.3 million at December 31, 2009.
•
In May 2010, we completed a $75.0 million private offering which consisted of $37.5 million of Series C Preferred and $37.5 million in principal amount of 8% subordinated notes.
•
In May 2010, we also completed an exchange offer in which we issued an aggregate of 7.2 million shares of our common stock in exchange for all of the outstanding shares of our Series A Preferred. The Series A Preferred had an aggregate liquidation preference of $60 million and a non-cumulative preferred dividend that accrued at 8% per annum. By its terms, the Series A Preferred was convertible into 6.0 million shares of common stock. As an inducement to convert, holders of our Series A Preferred were offered, in the aggregate, an additional 1.2 million shares of common stock.
Our accounting and reporting policies conform to GAAP and general practice within the banking industry. Management uses certain non-GAAP financial measures to evaluate the Company’s financial performance such
as the non-GAAP measures of pre-tax, pre-provision operating earnings and of revenue. Management believes that these measures are useful because they provide a more comparable basis for evaluating financial performance from operations period to period.
Reconciliation of U.S. GAAP Financial Measures
The following table reconciles the income (loss) before income taxes to pre-tax, pre-provision operating earnings for the periods indicated.
The following table details the components of revenue for the periods indicated.
Net Interest Income
Net interest income is our principal source of revenue and is the difference between total interest income and fees generated by interest-earning assets and total interest expense incurred on interest-bearing liabilities. The amount of net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of rates earned or incurred on those assets and liabilities.
Year Ended December 31, 2011 as Compared to Year Ended December 31, 2010
Net interest income was $134.4 million in 2011, a decrease of $1.7 million, or 1.2%, from $136.1 million in 2010.
Net interest margin of 3.16% in 2011 was down slightly from 3.17% in 2010, as decreases in the yield on all interest-earning assets were largely offset by continued decreases in our funding costs. The lower funding costs were a result of deposit repricing and deliberate changes made to the funding mix.
The interest-earning asset yield declined to 4.41% in 2011 from 4.83% in 2010 due to decreased yields on both loans and investment securities. The yield earned on loans decreased to 4.76% during 2011 from 5.07% in 2010. The yield on our investment securities portfolio also declined to 3.66% in 2011 from 4.28% in 2010.
The yield on total interest-bearing liabilities dropped from 2.03% in 2010 to 1.55% in 2011. Significant, anticipated deposit repricing occurred in 2011, largely in customer certificates of deposit and brokered certificates of deposit. The decline in yield was also due in part to funding-related transactions, including the termination of certain derivative contracts and early extinguishments of debt in 2011. We determined that these actions were in our best long-term economic interest, despite the recognition of short-term losses and expenses.
Our average interest-earning assets during 2011 were $4.30 billion, a decrease of $65.7 million, or 1.5%, as compared to the $4.37 billion of average interest-earning assets during 2010. The decrease was driven by lower loan balances, primarily in the commercial real estate secured portfolio, excluding commercial owner-occupied real estate loans, due to pay downs and nonperforming loan resolutions during 2011. Offsetting this decline was an increase in consumer loans, largely due to certain mortgages originated by Cole Taylor Mortgage being held in the loan portfolio rather than being sold in the secondary market.
Our average interest-bearing liabilities decreased from $3.56 billion in 2010 to $3.46 billion in 2011, a decrease of $98.6 million or 2.8%. Other borrowings decreased $199.7 million, or 37.7%, from $529.9 million in 2010 to $330.2 million in 2011. Offsetting this was an increase in notes payable and other advances, which increased from $484.8 million in 2010 to $583.9 million in 2011, an increase of $99.1 million or 20.4%. These actions were taken to shift the funding mix to lower the overall cost of funds. Average interest-bearing deposit balances of $2.37 billion in 2011 were slightly lower than balances of $2.39 billion during 2010. Total deposits increased due to growth in average noninterest-bearing deposit balances, which increased $47.9 million, or 7.9% to $650.7 million during 2011, as compared to $602.8 million in 2010.
With an adjustment for tax-exempt income, our consolidated net interest income for 2011 was $136.1 million, compared to $138.6 million for 2010. This non-GAAP presentation is discussed below. See “Tax-Equivalent Adjustments to Yields and Margins”.
Year Ended December 31, 2010 as Compared to Year Ended December 31, 2009
Net interest income increased by $13.2 million, or 10.7%, to $136.1 million in 2010, compared to $122.9 million in 2009, that was largely driven by a 33 basis point increase in net interest margin.
Net interest margin increased to 3.17% in 2010, compared to 2.84% in 2009, as our funding costs continued to decrease by more than the yield on our interest-earning assets. Funding costs were lowered as the low interest rate environment enabled our portfolio of term deposits to continue to reprice to current market rates. Increased noninterest-bearing deposits from customers and the ability to take advantage of short-term funding opportunities also reduced funding costs.
The interest-earning asset yield declined to 4.83% in 2010 from 5.03% in 2009. The yield earned on loans increased slightly to 5.07% during 2010 from 5.04% in 2009. However, this was more than offset by a drop in the yield on our investment securities portfolio, which decreased to 4.28% in 2010 from 5.01% in 2009.
Our average interest-earning assets during 2010 were $4.37 billion, a decrease of $66.2 million, or 1.5%, as compared to the $4.43 billion of average interest-earning assets during 2009. The decrease was driven by lower loan balances largely offset by higher investment portfolio balances. Average loan balances fell due to the continued downward pressure from the economic environment.
Average interest-bearing deposit balances decreased to $2.39 billion in 2010, compared to $2.52 billion during 2009. The decrease was offset by increases in average noninterest-bearing deposit balances, which increased $18.3 million to $602.8 million during 2010, as compared to $584.5 million in 2009, and by other borrowings, which increased $163.1 million from $366.8 million during 2009 to $529.9 million during 2010.
With an adjustment for tax-exempt income, our consolidated net interest income for 2010 was $138.6 million, compared to $126.0 million for 2009. This non-GAAP presentation is discussed below. See “Tax-Equivalent Adjustments to Yields and Margins”.
Tax-Equivalent Adjustments to Yields and Margins
As part of our evaluation of net interest income, we review our consolidated average balances, our yield on average interest-earning assets, and the costs of average interest-bearing liabilities. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities. Because management reviews net interest income on a taxable equivalent basis, the analysis contains certain non-GAAP financial measures. In these non-GAAP financial measures, interest income and net interest income are adjusted to reflect tax-exempt interest income on an equivalent before-tax basis assuming a tax rate of 35%. This assumed rate may differ from our actual effective income tax rate. In addition, we adjusted the interest-earning asset yield, net interest margin, and the net interest rate spread to a fully taxable equivalent basis. We believe that these measures and ratios present a more meaningful measure of the performance of interest-earning assets because they provide a better basis for comparison of net interest income regardless of the mix of taxable and tax-exempt instruments.
The following table reconciles the tax-equivalent net interest income to net interest income as reported in our Consolidated Statements of Operations. In addition, the interest-earning asset yield, net interest margin and net interest spread are shown with and without the tax equivalent adjustment.
The following table presents, for the periods indicated, certain information relating to our consolidated average balances and reflects our yield on average interest-earning assets and costs of average interest-bearing liabilities. The table contains certain non-GAAP financial measures to adjust tax-exempt interest income on an equivalent before-tax basis assuming a tax rate of 35%.
(1) Investment securities average balances are based on amortized cost.
(2) Calculations are computed on a taxable-equivalent basis using a tax rate of 35%.
(3) Nonaccrual loans are included in the above stated average balances.
(4) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(5) Net interest margin is determined by dividing taxable equivalent net interest income by average interest-earning assets.
The following table presents, for the periods indicated, a summary of the changes in interest earned and interest incurred resulting from changes in volume and rates for the major components of interest-earning assets and interest-bearing liabilities on a tax-equivalent basis assuming a tax rate of 35%. The change due to both rate and volume has been allocated in proportion to the dollar amount of the change in each. The impact of changes in the mix of interest-earning assets and interest-bearing liabilities is reflected in net interest income.
* The calculation of the rate and volume variances included in this table for 2010 and 2009 has been updated to provide a more precise division between the two variances. There is no impact to the net increase/decrease; only the calculation of the individual rate and volume variances has changed.
Provision for Loan Losses
We determine a provision for loan losses that we consider sufficient to maintain an allowance to absorb probable losses inherent in our portfolio as of the balance sheet date. For additional information concerning this determination, see “Application of Critical Accounting Policies-Allowance for Loan Losses,” “Nonperforming Assets”, “Impaired Loans” and “Allowance for Loan Losses.”
Our provision for loan losses totaled $49.3 million during 2011, a decrease of $93.8 million, or 65.5%, as compared to the $143.1 million provision for loan losses recorded in 2010 as commercial criticized and classified loans continued to decline and asset quality improved.
Nonperforming loans and commercial criticized and classified loans decreased in 2011 as a result of significant nonperforming asset resolutions, combined with a slowdown in both migrations to nonperforming status and inflows to criticized and classified status. Nonperforming loans totaled $103.1 million at December 31, 2011, compared to $159.7 million at December 31, 2010, a decrease of $56.6 million, or 35.4%. The total allowance for loan losses decreased from $124.6 million at December 31, 2010 to $103.7 million at December 31, 2011 and the allowance for loan losses as a percent of nonperforming loans improved from 77.98% at December 31, 2010 to 100.66% at December 31, 2011. See “Nonperforming Assets” and “Allowance for Loan Losses” for further discussion of the credit quality of our loan portfolio and our allowance for loan losses.
The provision for loan losses of $143.1 million during 2010 was $53.5 million higher than the $89.6 million provision for loan losses during 2009. The provision in 2010 reflected the continued weakness in the Chicago area real estate market, deterioration in our bank and bank holding company loans, the rise in nonperforming and impaired loans, and the increase in the severity of the estimated losses associated with these loans.
Noninterest Income
The following table presents the composition of our noninterest income for the periods indicated:
Year Ended December 31, 2011 as Compared to Year Ended December 31, 2010
Total noninterest income during 2011 totaled $49.2 million, down from $72.7 million during 2010, a decrease of $23.5 million or 32.3%. The decrease was driven by a higher level of gains on sales of investment securities in 2010, partially offset by increased mortgage banking revenue and increased other derivative income in 2011.
We derive service charges principally from deposit accounts. Service charge income is affected by a number of factors, such as the volume of deposit accounts and service transactions, the price established for each deposit service, the earnings credit rate and the collected balances customers maintain in their commercial checking accounts. Service charges increased slightly from $11.3 million in 2010 to $11.5 million in 2011 due to increases in commercial account service charges and foreign exchange service charges.
Mortgage banking revenue increased from $14.3 million in 2010 to $20.4 million in 2011, an increase of $6.1 million or 42.7%. The increase is due to a rise in loan fundings at Cole Taylor Mortgage related to sustained low mortgage interest rates and continued expansion of the national platform. Also contributing to the increase was growth in mortgage servicing activities, including retained servicing and purchased mortgage servicing rights.
In 2011, we sold mortgage-backed securities from our available for sale investment securities portfolio to minimize prepayment risk. We recorded net gains on the sales of available for sale investment securities of $4.9 million in 2011. This compares to gains of $41.4 million in 2010. See “Investment Securities” below for a further discussion.
Other derivative income was $7.0 million in 2011, compared to $2.0 million in 2010, an increase of $5.0 million or 250.0%. The increase was due to higher volumes on interest rate swap agreements entered into by commercial clients of our Banking segment. See “Derivative Financial Instruments” following for further discussion of our derivative instruments.
Letter of credit and other loan fees decreased from $4.0 million in 2010 to $3.9 million in 2011 due to a decline in the volume and amount of fees charged per customer in our asset based lending operation in 2011.
Year Ended December 31, 2010 as Compared to Year Ended December 31, 2009
Total noninterest income during 2010 totaled $72.7 million, up from $33.6 million during 2009, an increase of $39.1 million or 116.4%. Increases in the gains on the sales of investment securities in 2010 of $23.8 million, mortgage banking revenue of $14.3 million from Cole Taylor Mortgage and letters of credit fees of $2.0 million drove the increase.
In 2010, we recorded gains on the sales of available for sale investment securities of $41.4 million from the sale of approximately $965 million of investment securities, mostly mortgage-related securities. We realized gains when we sold mortgage-backed securities that had been experiencing higher than anticipated prepayments and to take advantage of the low level of interest rates and tightening spreads in the market later in the year. See “Investment Securities” below for a further discussion.
Other derivative income totaled $2.0 million in 2010, compared to $1.4 million in 2009. The increase was almost entirely due to an increase in the number and the size of fees collected on customer related swaps. See “Derivative Financial Instruments” following for further discussion of our derivative instruments.
Standby letters of credit and other loan fees totaled $4.0 million in 2010, compared to $2.2 million in 2009. The increase in fees during 2010 was primarily due to our expanded asset based lending operations.
Noninterest Expense
The following table presents the composition of our noninterest expense for the periods indicated:
(1) The efficiency ratio is determined by dividing noninterest expense by an amount equal to net interest income plus noninterest income, excluding gains or losses on investment securities.
Year Ended December 31, 2011 as Compared to Year Ended December 31, 2010
Total noninterest expense was $116.4 million during 2011, a decrease of $1.8 million, or 1.5%, as compared to noninterest expense of $118.2 million during 2010. The decrease was driven by lower nonperforming asset expense in 2011, partially offset by increases in salaries and employee benefits and early extinguishment of debt expense.
Total salaries and employee benefits expense in 2011 was $64.7 million, compared to $54.1 million during 2010, an increase of $10.6 million, or 19.6%. The increase in expense in 2011 was largely due to an increase in base salaries and sales incentives at Cole Taylor Mortgage, a large portion of which is the full year impact in 2011 of adding 150 new employees in 2010, as that business segment’s loan fundings increased and it expanded its national presence. The total number of employees at the Company was 638 at December 31, 2011, compared to 607 at December 31, 2010.
Nonperforming asset expense decreased $14.5 million or 73.2% from 2010 to 2011. Nonperforming asset expense was $5.3 million during 2011 as compared to $19.8 million during 2010. The decrease was driven by lower write-downs expenses on other real estate owned (“OREO”) and repossessed assets and a reversal of unfunded commitment reserves that were resolved during 2011.
Nonperforming asset expense reported in noninterest expense includes expenses associated with impaired loans, OREO and other repossessed assets held for sale as well as expenses related to impaired and nonperforming loans held for investment.
For assets held for sale, nonperforming asset expense related to OREO and other repossessed assets includes costs associated with owning and managing these assets, including real estate taxes, insurance, utilities and property management costs as well as any subsequent write-downs required by changes in the fair value of the assets and any gains or losses on dispositions. In addition, nonperforming asset expense included losses on impaired and nonaccrual commercial loans classified as held for sale due to additional write-downs related to declines in the fair value subsequent to when such assets were classified as held for sale.
Nonperforming asset expense related to loans held for investment includes expenses incurred by the Company’s loan workout function for collection and foreclosure costs, receiver fees and expenses, and any other expenses incurred to protect the Company’s interests in any loan collateral. In addition, nonperforming asset expense includes changes in the liability that the Company established for estimated probable losses from off-balance sheet commitments associated with impaired loans, such as standby letters of credit or unfunded loan commitments.
A quantification of the amount of expense in each of these categories for the periods indicated is as follows:
Our FDIC insurance premium decreased from 2010 to 2011 by $1.5 million primarily due to a change in the methodology used in calculating the FDIC insurance premium, in conformance with FDIC requirements. The premium calculation now includes a component based on assets, rather than basing the calculation entirely on deposits.
In 2011, three structured repurchase agreements were terminated and we incurred $3.4 million in early extinguishment of debt expense related to these terminations.
Other noninterest expense was $17.2 million for the year ended December 31, 2011, compared to $16.3 million for the year ended December 31, 2010. The increase is largely due to a volume driven increase in loan related expenses.
Our efficiency ratio was 64.60% in 2011, compared to 70.64% in 2010. The improvement in the efficiency ratio is the result of higher noninterest income in 2011 primarily due to increased mortgage banking revenue and other derivative income, combined with a decrease in noninterest expense due to lower nonperforming asset expense in 2011.
Year Ended December 31, 2010 as Compared to Year Ended December 31, 2009
Total noninterest expense was $118.2 million during 2010, an increase of $20.6 million, or 21.1%, as compared to noninterest expense of $97.6 million during 2009. The increase in expense was primarily due to higher salaries and employee benefits expense of $11.2 million and nonperforming asset expense of $8.1 million. These increases were partly offset by lower FDIC assessments of $2.1 million.
Total salaries and employee benefits expense in 2010 was $54.1 million, compared to $42.9 million during 2009, an increase of $11.2 million, or 26.0%. The increase in expense in 2010 was largely due to the higher base salaries and sales incentives at Cole Taylor Mortgage as that business added 150 new employees during 2010. The total number of employees at the Company was 607 at December 31, 2010, compared to 443 at December 31, 2009.
Nonperforming asset expense reported in noninterest expense includes expenses associated with impaired loans, OREO and other repossessed assets held for sale as well as expenses related to impaired and nonperforming loans held for investment. Nonperforming asset expense increased to $19.8 million during 2010 as compared to $11.7 million during 2009. The increase was primarily associated with additional write-downs on OREO during 2010. The amount of nonperforming asset expense is impacted by the complexity and number of nonperforming loans and OREO and could continue to be significant in future periods.
A quantification of the amount of expense in each of these categories for the periods indicated is as follows:
Our FDIC insurance premium decreased in 2010 from 2009, primarily due to the nonrecurring FDIC special assessment in the second quarter of 2009 of $2.1 million.
Other noninterest expense was $16.3 million for the year ended December 31, 2010, compared to $12.3 million for the year ended December 31, 2009. Other noninterest expense includes costs for advertising and public relations, business meals and travel, board of directors’ fees, operational losses and other operating expenses such as telephone, postage, office supplies and printing.
Our efficiency ratio was 70.64% in 2010, compared to 70.27% in 2009. The impact of higher nonperforming asset expense was mostly offset by higher net interest and noninterest income.
Income Taxes
In 2008, we established a valuation allowance against our deferred tax asset because we concluded that, based upon the weight of all available evidence, it was more-likely-than-not that the deferred tax asset would not be realized. The valuation allowance increased $30.6 million during 2010 to $92.7 million at December 31, 2010, compared to $62.1 million at December 31, 2009. The increase in the required valuation allowance was largely due to the increase in our net deferred tax asset primarily due to changes in our allowance for loan losses and
federal net operating loss and tax credit carry forwards, and changes in the beginning of the year valuation allowance solely attributable to identifiable events recorded in OCI, primarily changes in unrealized gains and losses on available for sale investment securities, the tax effects of which were allocated to OCI.
We evaluate the need for a deferred tax asset valuation allowance on an ongoing basis. For the year ended December 31, 2011, management determined that is it more-likely-than-not that the deferred tax asset will be realized. This conclusion was based on an analysis of both positive and negative evidence. Positive evidence included our return to profitability, significant improvement in asset quality and credit ratios, the continued reduction in our liquidating real estate construction and bank and bank holding company loan portfolios that had produced substantial losses over the past three years and an improving economic environment. Negative evidence included our cumulative losses in the past three years, no available taxes paid in open carryback years and no significant tax planning opportunities to accelerate income. Management determined that the positive evidence outweighed the negative and therefore we released our $73.2 million valuation allowance against the net deferred tax asset on December 31, 2011 resulting in an income tax benefit.
During 2011, we recorded a total income tax benefit of $73.1 million, largely due to the reversal of the valuation allowance against our net deferred tax asset. In addition, income tax benefit for 2011 includes a benefit due to a change in the State of Illinois tax rate as applied to our beginning of the year net deferred tax asset after valuation allowance. Offsetting these benefits was income tax expense due to the release of the residual tax effects of changes in the beginning of the year valuation allowance previously allocated to OCI. These residual tax effects resulted from changes in the deferred tax liability associated with deferred gains on terminated cash flow hedges recorded in OCI.
During 2010, despite a loss of $52.6 million before income taxes, we recorded total income tax expense of $1.2 million. A current income tax benefit that would normally result from a pre-tax loss was offset by additional deferred tax expense due to an increase in the required valuation allowance. The tax expense recorded in 2010 was largely due to the release of the residual tax effects of changes in the beginning of the year valuation allowance previously allocated to OCI. These residual tax effects resulted from changes in the deferred tax liability associated with deferred gains on terminated cash flow hedges recorded in OCI. At December 31, 2010, the net deferred tax asset, after considering the $92.7 million valuation allowance, was $11.6 million, which was supported by available tax planning strategies.
During 2009, we reported income tax expense of $834,000 for the year on a pre-tax loss of $30.7 million. Because of the valuation allowance on our deferred tax asset, we were not able to record an income tax benefit related to the pre-tax loss incurred. A current income tax benefit that would normally result from a pre-tax loss was offset by additional deferred tax expense due to an increase in the required valuation allowance. The tax expense recorded in 2009 was largely due to the release of the residual tax effects of changes in the beginning of the year valuation allowance previously allocated to OCI. These residual tax effects resulted from changes in the deferred tax liability associated with deferred gains on terminated cash flow hedges recorded in OCI. At December 31, 2009, the net deferred tax asset, after considering the $62.1 million valuation allowance, was $4.6 million, which was supported by available tax planning strategies.
Segment Review
As described in Note 24, “Segment Reporting,” of the notes to the consolidated financial statements, we have two principal operating segments: Banking and Mortgage Banking.
The Banking segment consists of commercial banking, asset based lending, retail banking and all other functions that support those units. Net income for the Banking segment for the year ended December 31, 2011 was $19.4 million, an increase of $45.3 million from net loss of ($25.9) million for the year ended December 31, 2010. The improved performance is primarily attributable to a $94.3 million decrease in provision for loan losses. Noninterest income decreased from $58.2 million in 2010 to $28.4 million in 2011, a decrease of $29.8
million. This decrease was due to gains on the sale of available for sale investment securities of $41.4 million in 2010 compared to $4.9 million in 2011, partially offset by an increase in other derivative income of $5.0 million due to an increase in the number and size of fees collected on customer related swaps. Noninterest expense was $92.5 million in 2011 compared to $103.8 million in 2010, a decrease of $11.3 million. This decrease was due to a $13.1 million decline in nonperforming asset expense due to improved credit quality, partially offset by $3.4 million in early extinguishment of debt expense in 2011.
The Mortgage Banking segment originates mortgage loans for sale to investors and for retention in our loan portfolio through its retail and broker channels. This segment also services residential mortgage loans for various investors and for our own loans. Net income for the Mortgage Banking segment for the year ended December 31, 2011 was $1.1 million, a decrease of $600,000 from net income of $1.7 million for the year ended December 31, 2010 as the Mortgage Banking segment continues to build the infrastructure necessary for continued business growth. Net interest income increased $2.7 million, from $3.0 million in 2010 to $5.7 million in 2011. Noninterest income also increased, moving from $14.3 million in 2010 to $20.4 million in 2011, an increase of $6.1 million. These increases in revenue reflect this segment’s expansion of its national platform, diversification of its revenue streams and sustained low mortgage interest rates. Noninterest expense increased from $14.4 million in 2010 to $23.9 million in 2011, an increase of $9.5 million, primarily due to increased salaries and employee benefits expense, a portion of which is related to volume growth.
The Other category includes subordinated debt expense, certain parent company activities and residual income tax expense, representing the difference between the actual amount incurred and the amount allocated to operating segments. The income tax benefit due to the reversal of our net deferred tax asset valuation allowance is also included.
Impact of Inflation and Changing Prices
The consolidated financial statements and notes presented elsewhere in this report have been prepared in accordance with generally accepted accounting principles, which require the measurement of our financial position and operating results in terms of historical amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the cost of our operations. Unlike industrial companies, nearly all of our assets and liabilities are monetary in nature. As a result, in management’s opinion, interest rates have a greater impact on our performance than do the effects of the general levels of inflation. Interest rates do not necessarily move in the same direction or, to the same extent, as the price of goods and services. Interest rates are highly sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, the influences of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities, among other factors.
Financial Condition
Total assets increased by $202.0 million, or 4.5%, to $4.69 billion at December 31, 2011, compared to $4.48 billion at December 31, 2010. During 2011, total loan balances increased $19.9 million, or 0.7%, to $3.11 billion at December 31, 2011, compared to $3.09 billion at year-end 2010. Investment securities increased $25.2 million, or 2.0%, to a total of $1.28 billion at December 31, 2011, compared to $1.25 billion as of December 31, 2010. Other real estate and repossessed assets increased by $4.1 million, or 13.0%, to $35.6 million at December 31, 2011, compared to $31.5 million at December 31, 2010. In addition, other assets increased by $76.3 million, or 84.0%, at December 31, 2011 to $167.1 million, compared to $90.8 million at December 31, 2010.
Total liabilities remained flat at $4.28 billion as of December 31, 2011 and December 31, 2010. Total deposits increased $96.3 million, or 3.2%, to $3.12 billion at December 31, 2011, from $3.03 billion at December 31, 2010. Notes payable and other advances increased $242.5 million, or 48.0%, in 2011 to $747.5 million at December 31, 2011, compared to $505.0 million at December 31, 2010. Other borrowings decreased
$342.9 million, or 67.1%, to $168.1 million at December 31, 2011, compared to $511.0 at December 31, 2010. Total stockholders’ equity increased $200.7 million during 2011 to $409.5 million at December 31, 2011, from $208.8 million at December 31, 2010.
Interest-bearing Cash Equivalents
Interest-bearing cash equivalents consist of interest-bearing deposits with banks or other financial institutions, federal funds sold and securities purchased under agreements to resell with original maturities of less than 30 days. All federal funds are sold overnight with daily settlement required.
Investment Securities
Our investment portfolio is designed to provide a source of income with minimal risk of loss, a source of liquidity and interest rate risk management opportunities. In managing our investment portfolio within the composition of the entire balance sheet, we balance our earnings, credit, interest rate risk, and liquidity considerations, with a goal of maximizing longer-term overall profitability.
The following table presents the composition of our investment portfolio by major category as of the dates indicated:
Investment securities do not include investments in FHLB and FRB stock of $56.8 million, $40.0 million and $31.2 million, at December 31, 2011, 2010 and 2009, respectively. These investments are stated at cost.
Our total investment portfolio increased $25.2 million, or 2.0%, to $1.28 billion at December 31, 2011 as compared to $1.25 billion at December 31, 2010. During the year ended December 31, 2011 we purchased $229.8 million of investment securities, mostly mortgage related securities. Unrealized gains increased $63.5 million. Offsetting these increases, we received $130.6 million of proceeds from the sale of primarily mortgage-backed securities and collateralized mortgage obligations and $137.5 million of maturities, payoffs and principal paydowns.
Mortgage related securities include residential and commercial mortgage-backed securities and collateralized mortgage obligations, and comprised 92.4% of our investment portfolio at December 31, 2011, compared to 92.1% at December 31, 2010. As of December 31, 2011, over 99% of mortgage-related securities that we held were securities issued by government and government-sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. We do not hold subprime loans in our mortgage-related investment securities portfolio. While the fair value of these securities has been impacted by market illiquidity, we also take additional steps to review for other-than-temporary impairment.
At December 31, 2011, we had a net unrealized gain on the available for sale securities of $42.9 million, or 3.8% of amortized cost, compared to a net unrealized loss on the available for sale securities of $21.3 million, or 1.8% of amortized cost, at December 31, 2010. At December 31, 2011, we held five investment securities with a carrying value of $21.7 million that were in a gross unrealized loss position of $1.7 million. We analyzed each of these securities to determine if other-than-temporary impairment had occurred. Our analysis included an evaluation of the type of security; the length of time and extent to which the fair value has been less than the security’s carrying value; the characteristics of the underlying collateral; the degree of credit support provided by subordinate tranches within the total issuance; independent credit ratings; changes in credit ratings; and a cash flow analysis, considering default rates, loss severities based on the location of the collateral and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We obtained fair value estimates from additional independent sources and performed cash flow analysis to determine if other-than-temporary impairment had occurred. Of the five securities with gross unrealized losses at December 31, 2011, only three securities have been in a loss position for 12 months or more. Our analysis at December 31, 2011 determined that the one security for which we had previously recognized other-than-temporary impairment was additionally impaired. Therefore, we recorded an additional $190,000 of other-than-temporary impairment in 2011. Our analysis at December 31, 2011 indicated that the other two
securities did not have other-than-temporary impairment. For additional details, see “Notes to Consolidated Financial Statements-Investment Securities” from our audited financial statements contained elsewhere in this annual report.
One additional investment security was evaluated for other-than-temporary impairment at December 31, 2011. This security is in the Company’s state and municipal obligation portfolio and was received in 2008 in a loan work out arrangement. Scheduled payments were received as agreed from 2008 until the May 2011 interest payment, which was not received. Since the Company now believes that it will not recover all the expected payments of principal and interest as specified in the bond agreement, the expected future annual cash flows were analyzed and other-than-temporary impairment of $381,000 was recorded against earnings in 2011.
At December 31, 2011, we held no securities of any single issuer that exceeded 10% of stockholders’ equity, other than U.S. government agencies. Although we hold securities issued by municipalities within the State of Illinois that, in the aggregate, exceeded 10% of stockholders’ equity, none of the holdings from any individual municipal issuer exceeded this threshold.
As a member, we are required to hold stock in the FHLBC and the FRB, which as of December 31, 2011 and 2010 consisted of the following:
The amount of FHLBC stock required to be held is based on the Bank’s asset size and the amount of borrowings from the FHLBC. Currently, the FHLBC is under a cease and desist order with its regulator that requires prior regulatory approval to declare dividends and redeem member capital stock other than excess capital under limited circumstances. Based on our assessment at December 31, 2011 of the ultimate recoverability of our FHLBC stock, we believe no impairment has occurred. For additional details of these investments, see the “Notes to Consolidated Financial Statements-Investment Securities” from our audited financial statements contained elsewhere in this annual report. We did not hold any FHLBC debt securities in our investment portfolio as of December 31, 2011.
The amount of FRB stock required to be held is based on the Bank’s common stock and surplus. The increases in the Bank’s surplus during 2011 were primarily due to the conversion of both Series F Preferred and Series C Preferred to common stock and the rights offering, which caused the Bank to increase its holdings of FRB stock by $1.1 million.
Investment securities with an approximate book value of $930 million and $969 million at December 31, 2011 and 2010, respectively, were pledged to collateralize certain deposits, securities sold under agreements to repurchase, FHLB advances, and for other purposes as required or permitted by law.
Investment Portfolio-Maturity and Yields
The following table summarizes the contractual maturity of investment securities and their weighted-average yields:
(1) Based on estimated fair value.
(2) Maturities of mortgage-backed securities and collateralized mortgage obligations (“CMOs”) are based on anticipated lives of the underlying mortgages, not contractual maturities. CMO maturities are based on cash flow (or payment) windows derived from broker market consensus.
(3) Rates on obligations of states and political subdivisions have been adjusted to tax equivalent yields using a 35% income tax rate.
Loan Portfolio
Our primary source of revenue is interest on loans. The following table presents the composition of our loan portfolio by type of loan as of the dates indicated:
Loans Held for Portfolio
Our portfolio loans at December 31, 2011 of $2.93 billion represented an increase of $93.0 million, or 3.3%, as compared to portfolio loans at December 31, 2010 of $2.84 billion. Portfolio loans decreased $118.1 million from $2.95 billion at December 31, 2009 to $2.83 billion at December 31, 2010. Approximately 90% of our loan portfolio was comprised of commercial loans, which include commercial and industrial (“C&I”), commercial real estate secured, and real estate construction and land loans. Total commercial loans decreased to $2.63 billion at December 31, 2011, compared to $2.68 billion at December 31, 2010 and $2.80 billion at December 31, 2009. Although we originated new loans during 2011, including the funding of approximately $565.6 million of new commercial loans, this growth was more than offset as we repositioned our portfolio to reduce our exposure in industries and sectors that we no longer consider desirable. In addition, loan charge-offs and low line usage by our customers combined to produce lower commercial loan balances in 2011.
C&I loans are made to businesses or to individuals for business purposes. C&I loans are made on either a secured or unsecured basis for a wide range of business purposes, terms, and maturities. These loans are made primarily in the form of seasonal or working-capital loans or term loans. Repayment of these loans is generally provided through the operating cash flow of the borrower.
The risk characteristics of C&I loans are largely influenced by general economic conditions, such as inflation, recessionary pressures, the rate of unemployment, changes in interest rates and money supply, and other factors that affect the borrower’s operations and the value of the underlying collateral. The Company’s credit risk strategy emphasizes consistent underwriting standards and diversification by industry and customer size. The Company’s C&I loan portfolio is comprised of loans made to a variety of businesses in a diverse range of industries. This portfolio diversification is a significant factor used to mitigate the risk associated with fluctuations in economic conditions.
C&I loans also include those loans made by the Company’s asset-based lending division. Asset-based loans are made to businesses with the primary source of repayment derived from payments on the related assets securing the loan. Collateral for these loans may include receivables, inventory, equipment and other fixed assets, and is monitored regularly to ensure ongoing sufficiency of collateral coverage and quality. The primary risk for these loans is a significant decline in collateral values due to general market conditions. Loan terms that mitigate these risks include typical industry amortization schedules, percentage of collateral coverage, maintenance of cash collateral accounts and regular asset monitoring. Because of the national scope of the Company’s asset-based lending, the risk of these loans is also diversified by geography.
C&I loans increased $74.4 million, or 5.5%, to $1.43 billion at December 31, 2011, compared to $1.35 billion at December 31, 2010. We continue to develop new customer relationships and originate C&I loans as part of our growth strategy. C&I loans were $1.26 billion at December 31, 2009 and increased $87.5 million, or 6.9%, to $1.35 billion at December 31, 2010.
Commercial real estate loans on completed properties include loans for the purchase of real property or for other business purposes where the primary collateral is the underlying real property. The Company’s commercial real estate loans consist of loans on commercial owner-occupied properties and investment properties. Investment properties refer to multi-family residences and income producing non-owner occupied commercial real estate, including retail strip centers or malls, office and mixed use properties and other commercial and specialized properties, such as nursing homes, gas stations and convenience stores, churches, hotel, and motels. Repayment of these loans is generally provided through the operating cash flow of the property.
The risk in a commercial real estate loan depends primarily on the loan amount in relation to the value of the underlying collateral, the interest rate, and the borrower’s ability to repay in a timely fashion. The credit risk of these loans is influenced by general economic and market conditions and the resulting impact on a borrower’s operation of the owner-occupied business or upon the fluctuation in value and earnings performance of an income producing property. In addition, the value of the underlying collateral is influenced by local real estate market trends and general economic conditions. Credit risk is managed in this portfolio through underwriting standards, knowledge of the local real estate markets, periodic reviews of the loan collateral and the borrowers’ financial condition. In addition, all commercial real estate loans are supported by an independent third party appraisal at inception.
At December 31, 2011, December 31, 2010 and December 31, 2009, the composition of our commercial real estate secured portfolio by type of collateral was as follows:
* As a result of our 2011 core system conversion, we identified certain sub-codings within our loan system that changed the characterization of certain commercial real estate non-owner occupied loans to owner occupied real estate. Although there was no impact to the calculation of the total commercial real estate loans, we have adjusted the table above to reflect the revised classifications for all periods presented.
Total commercial real estate loans were $1.04 billion at December 31, 2011 as compared to $1.12 billion at December 31, 2010, a decrease of $82.4 million, or 7.4%. During 2011, loans secured by commercial owner occupied properties increased by $34.7 million, while loans on commercial non-owner occupied properties decreased by $81.5 million and multi-family property related loans decreased $35.7 million. Most of the decrease in non-owner occupied was in the retail strip centers or malls property category.
Total commercial real estate loans were $1.12 billion at December 31, 2010 as compared to $1.17 billion at December 31, 2009, a decrease of $51.4 million, or 4.4%. During 2010, loans secured by commercial owner occupied properties increased by $46.0 million, while loans on commercial non-owner occupied properties decreased by $72.8 million. Most of the decrease in non-owner occupied was in the office/mix use property category.
Residential real estate construction and land loans primarily consist of loans to real estate developers to construct single-family homes, town-homes and condominium conversions. Commercial real estate construction and land loans primarily consist of loans to construct commercial real estate or income-producing properties. Both the residential and commercial real estate construction and land loans are repaid from proceeds from the sale of the finished units by the developer or may be converted to commercial real estate loans at the completion of the construction process. The risk characteristics of these loans are influenced by national and local economic conditions, including the rate of unemployment and consumer confidence and the related impact that these conditions have on demand, housing prices and real estate values. In addition, credit risk on individual projects is influenced by the developers’ ability and efficiency in completing construction, selling finished units or obtaining tenants to occupy these properties. Credit risk for these loans is primarily managed by underwriting standards, lending primarily in local markets to developers with whom the Company has experience and ongoing oversight of project progress.
Our residential real estate construction and loan portfolio decreased $39.2 million, or 37.7%, during 2011 to $64.8 million at December 31, 2011, as compared to $104.0 million at December 31, 2010. Because of the continued slow down in the residential real estate markets and reduced real estate valuations, we have been actively reducing our exposure to this sector. Residential real estate construction loans decreased $117.8 million or 53.1%, from $221.9 million at December 31, 2009 to $104.0 million at December 31, 2010.
We continue to reduce our commercial construction and land portfolio, which declined $7.4 million, or 7.0%, to $99.0 million at December 31, 2011, as compared to $106.4 million at December 31, 2010. Commercial construction and land loans decreased $36.2 million, or 25.4%, in 2010, from $142.6 million at December 31, 2009 to $106.4 million at December 31, 2010.
The Company’s consumer loans consist of open and closed-end credit extended to individuals for household, family, and other personal expenditures. Consumer loans primarily include loans to individuals secured by their personal residence, including first mortgages and home equity and home improvement loans. The primary risks in consumer lending are loss of income of the borrower that can result from job losses or unforeseen personal hardships due to medical or family issues that may impact repayment. In the case of first and second mortgage or home equity lending, a significant reduction in the value of the asset financed can influence a borrower’s ability to repay the loan. Because the size of consumer loans is typically smaller than commercial loans, the risk of loss on an individual consumer loan is usually less than that of a commercial loan. Credit risk for these loans is managed by reviewing creditworthiness of the borrower, monitoring payment histories and obtaining adequate collateral positions.
Our portfolio of residential real estate mortgages, which includes both mortgages originated by Cole Taylor Mortgage and bulk purchased mortgage loans, totaled $232.0 million at December 31, 2011, as compared to $71.1 million at December 31, 2010 and $57.9 million at December 31, 2009. This increase was driven by a portion of the mortgages originated by Cole Taylor Mortgage being held in portfolio, rather than sold in the secondary market.
Our portfolio of home equity loans and lines of credit also continues to decline. At December 31, 2011, this portfolio totaled $61.9 million, compared to $73.3 million at December 31, 2010 and $86.2 million at December 31, 2009. This portfolio as a percentage of gross portfolio loans decreased to 2.1% at year-end 2011.
The following table shows our maturity distribution of loans as of the dates indicated:
(1) Maturities are based upon contractual dates. Demand loans are included in the one year or less category and totaled $1.3 million as of December 31, 2011.
Loans Held for Sale
At December 31, 2011, we held $186.0 million of residential mortgage loans classified as held for sale as compared to $259.0 million of residential mortgage loans classified as held for sale at December 31, 2010. This decline was due to improved efficiencies in the secondary marketing process in 2011 and faster turnover of mortgage loans held for sale.
Loans held for sale at December 31, 2011 and 2010 are entirely derived from Cole Taylor Mortgage. This business sources mortgages through both retail offices and brokers throughout the United States, as well as through the Chicago based banking centers. We intend to sell these loans as part of our normal mortgage operations and have elected to account for these loans at fair value.
Nonperforming Assets
Our lending officers and their managers are responsible for the ongoing review of present and projected future performance of the loans within their assigned portfolio and for risk rating such loans in accordance with the Bank’s risk rating system. In addition, a loan review function independently risk rates loans to monitor and confirm the reasonableness of the lending officer’s risk rating conclusion. Delinquency reports are reviewed monthly by the lending officers, their managers and credit administration. The responsible lending officer reports to a loan committee about the current status of loans past due or current but graded below a designated level. The committee evaluates whether the loan is appropriately risk rated and determines if the loan should be placed on nonaccrual, the need for a specific allowance for loan loss, or, if appropriate, a partial or full charge-off. Most loans rated substandard or below are transferred to a separate loan work-out department, staffed by collection professionals. Our loan work-out department is staffed at a level that can effectively handle nonperforming asset volume. When the loan is transferred to work-out, an independent legal review of the loan documents is performed and current appraisals are obtained for loans secured by real estate.
The following table sets forth the amounts of nonperforming loans and nonperforming assets as of the dates indicated:
The following table presents loans past due 30 to 89 days and still accruing interest as of the dates indicated:
Nonperforming Loans
Nonperforming loans include nonaccrual loans and interest-accruing loans that are contractually past due 90 days or more. We evaluate all loans on which principal or interest is contractually past due 90 days or more to determine if they are adequately secured and in the process of collection. If sufficient doubt exists as to the full collection of principal and interest on a loan, we place it on nonaccrual and no longer recognize interest income. After a loan is placed on nonaccrual status, any current period interest previously accrued but not yet collected is reversed against current income. Interest is included in income subsequent to the date the loan is placed on nonaccrual status only as interest is received and so long as management is satisfied that there is a high probability that principal will be collected in full. The loan is returned to accrual status only when the borrower has made required payments for a minimum length of time and demonstrates the ability to make future payments of principal and interest as scheduled.
The following table presents the composition of nonaccrual loans as of the dates indicated:
Nonaccrual loans decreased during 2011 to $103.1 million at December 31, 2011, compared to $159.7 million at December 31, 2010, a decrease of $56.6 million, or 35.4%. Nonaccrual loans at December 31, 2009 were $141.4 million. The decrease in total nonaccrual loans during 2011 was due to paydowns and charge-offs. The increase in total nonaccrual loans during 2010 was primarily due to the deterioration of loans to banks and bank holding companies largely offset by loan charge-offs.
Commercial and industrial is our largest category of nonaccrual loans and comprises approximately 42% of all nonaccrual loans at December 31, 2011. Nonaccrual commercial and industrial loans were $42.9 million at December 31, 2011, as compared to $71.4 million at December 31, 2010. This decrease was primarily due to paydowns and charge-offs. Commercial and industrial nonaccrual loans were $26.7 million at December 31, 2009, compared to $71.4 million at December 31, 2010. This increase was primarily due to the deterioration of loans to bank and bank holding companies.
Commercial real estate secured loans were our second largest category of nonaccrual loans. This category decreased to $35.2 million at December 31, 2011, from $42.2 million at December 31, 2010. Charge-offs and transfers to OREO, partly offset by few new nonaccrual loans, resulted in the decrease in this category in 2011. The balance of commercial real estate secured loans of $42.2 million at December 31, 2010 was $5.8 million greater than the balance of $36.4 million at December 31, 2009. The increase is due to new nonaccrual loans, partly offset by charge-offs and transfers to OREO.
Residential construction and land loans had previously been our largest category of nonaccrual loans, but were only 7.6% of all nonaccrual loans at December 31, 2011. Residential construction and land nonaccrual loans decreased to $7.8 million at December 31, 2011 as compared to $20.7 million at December 31, 2010 and $62.8 million at December 31, 2009. The decrease in these nonperforming loans during 2011 was due to net charge-offs and transfers to OREO.
The level of nonaccrual loans in our consumer portfolio decreased to $11.9 million at December 31, 2011 from $12.6 million at December 31, 2010 and $11.3 million at December 31, 2009. Approximately 73% of the consumer nonaccrual loans are from our portfolio of home mortgage loans and of this amount, most of the nonaccrual loans are related to bulk purchased mortgage loans, not to loans originated by Cole Taylor Mortgage.
Other Real Estate Owned and Repossessed Assets
Other real estate owned and repossessed assets increased from $31.5 million at December 31, 2010 to $35.6 million at December 31, 2011. The following table provides a rollforward, for the periods indicated, of OREO and repossessed assets:
During 2011, we transferred $25.1 million from loans into OREO and repossessed assets. Of the amount transferred, $10.9 million was from our residential construction and land portfolio, $5.4 million was from our commercial real estate secured portfolio, $4.7 million was from our commercial construction and land portfolio. We received net proceeds of $15.8 million on assets that had a carrying value of $17.4 million, resulting in a net loss of $1.6 million, which was included as additional nonperforming asset expense in noninterest expense. We wrote down the carrying value of certain OREO and repossessed assets by $5.2 million during 2011 to reflect a decrease in the estimated fair value of those assets. During 2010, we transferred $34.7 million from loans into OREO and repossessed assets. We received net proceeds of $16.8 million on the sale of OREO that had a carrying value of $16.0 million. This resulted in a net gain of $800,000, which was included in nonperforming asset expense in noninterest expense. We also wrote down the carrying value of certain OREO and repossessed assets by $13.5 million during 2010 to reflect a decrease in the estimated fair value of those assets. The level of OREO and repossessed assets increased during 2011, and we expect that these assets may continue to increase in the future as we work through the elevated level of nonperforming assets.
Impaired Loans
At December 31, 2011, impaired loans totaled $108.5 million, compared to $181.1 million at December 31, 2010, a decrease of $72.6 million, or 40.1%. Total impaired loans were $141.7 million at December 31, 2009. The balance of impaired loans and the related allowance for loan losses for impaired loans are as follows:
Impaired loans decreased in 2011, primarily the result of charge-offs and paydowns during the period. The allowance for loan losses related to impaired loans also decreased during 2011 and totaled $32.0 million at December 31, 2011, as compared to $59.9 million at December 31, 2010 and $33.6 million at December 31, 2009. The decrease in the allowance for losses on impaired loans in 2011 was primarily due to net charge-offs during the period, partially offset by an increase in the estimated impairment on impaired loans at December 31, 2011. The percentage of allowance on impaired loans to total impaired loans decreased to 29.5% at December 31, 2011, compared to 33.1% at December 31, 2010. C&I loans comprised approximately 45% of all impaired loans and 73% of the allowance for loan losses on impaired loans at December 31, 2011.
Once we determine that a loan is impaired, we perform an individual analysis to establish the amount of the related allowance for loan losses, if any, based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based upon the fair value of the collateral, less cost to sell. Generally, since the majority of our impaired loans are collateral-dependent real estate loans, the fair value is determined by a current appraisal. For impaired loans that are collateral dependent, the Company’s practice is to obtain an updated appraisal every nine to 18 months, depending on the nature and type of the collateral and the stability of collateral valuations, as determined by senior members of credit management. OREO and repossessed assets require an updated appraisal at least annually. The Company has established policies and procedures related to appraisals and maintains a list of approved appraisers who have met specific criteria. In addition, the Company’s policy for appraisals on real estate dependent commercial loans generally requires each appraisal to have an independent compliance and technical review by a qualified third party to ensure the consistency and quality of the appraisal and valuation. The Company discounts appraisals for estimated selling costs, and, when appropriate, considers the date of the appraisal and stability of the local real estate market when analyzing the estimated fair value of individual impaired loans that are collateral dependent.
The individual impairment analysis also considers available and reliable borrower guarantees and any cross-collateralization agreements. Certain other loans are collateralized by business assets, such as equipment, inventory, and accounts receivable. The fair value of these loans is based upon estimates of realizability and collectability of the underlying collateral. While impaired loans exhibit weaknesses that may inhibit repayment in compliance with the original note terms, the impairment analysis may not result in a related allowance for loan losses for each individual loan. At December 31, 2011, we determined that $71.5 million of our loans had impairment and had related allowances for loan losses of $32.0 million. We also held $37.0 million of impaired loans for which the individual analysis did not result in a measure of impairment, so no related allowance for loan losses was provided.
Impaired loans include all nonaccrual loans, accruing loans judged to have higher risk of noncompliance with the present contractual repayment schedule for both interest and principal, as well as troubled-debt restructurings. Unless modified in a troubled-debt restructuring, certain homogenous loans, such as residential mortgage and consumer loans, are collectively evaluated for impairment and are, therefore, excluded from impaired loans.
At December 31, 2011, we held $14.2 million of loans classified as performing restructured loans which included commercial loans of $9.4 million and consumer loans of $4.8 million. At December 31, 2011, we had $396,000 in commitments to lend on impaired loans with $329,000 of that amount in commitments to lend on loans considered troubled-debt restructurings.
The balance of nonaccrual loans and impaired loans as of December 31, 2011 is presented below:
Potential Problem Loans
As part of our standard credit administration process, we risk rate our commercial loan portfolio. As part of this process, loans that are rated with a higher level of risk are monitored more closely. We internally identify certain loans in our loan risk ratings that we have placed on heightened monitoring because of certain weaknesses that may inhibit the borrower’s ability to perform under the contractual terms of the loan agreement but have not reached the status of nonaccrual loans. As of December 31, 2011, these potential problem loans totaled $37.0 million of which $20.3 million were in our commercial construction and land portfolio, $12.6 million were in our commercial and industrial portfolio, and the remaining $4.1 million were loans in the commercial real estate secured portfolio. In comparison, potential problem loans at December 31, 2010 totaled $46.8 million. The largest category of potential problem loans at December 31, 2010 was commercial real estate secured which was $32.4 million. The remaining loans were construction and land loans of $5.1 million and C&I loans of $9.3 million. We do not necessarily expect to realize losses on potential problem loans, but we recognize potential problem loans can carry a higher probability of default and require additional attention by management.
Allowance for Loan Losses
We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include the formula described below and specific allowances for identified problem loans and portfolio categories.
We calculate the formula portion of the allowance by applying loss factors to categories of loans outstanding in the portfolio. The loans are categorized by loan type as commercial and industrial; commercial real estate secured; residential real estate construction; commercial real estate construction loans; residential real estate mortgage; and consumer loans. Those categories are further segregated by risk classification (for commercial loans) and by delinquency status (for consumer loans). Each commercial, commercial real estate and real estate construction loan has a risk grade based on formal defined criteria. For consumer loans, we further categorize the loans into consumer loan product types; such as residential mortgage loans and home equity loans. Segregation of the loans into more discrete pools facilitates greater precision in matching historic and expected loan losses with the source of the loss. We adjust these pools from time to time, based on the changing composition of the loan portfolio, grouping loans with similar attributes and risk characteristics. We calculate actual historic loss rates based upon current and prior year’s charge-off experience for each separate loan grouping identified. The historical loss rates are then weighted based on our evaluation of the duration of the economic cycle to arrive at a current expected loss rate. The allowance in 2011 and 2010 reflects loss experience from the prior three year period while the allowance in 2009 reflects loss experience from the preceding two year period. The current expected loss rates are adjusted, if deemed appropriate, for other relevant factors affecting the loan groupings, including changes in lending practices, trends in past due loans and industry, geographical, collateral and size concentrations. Finally, the resulting loss factors are multiplied against the current period loans outstanding to derive an estimated loss.
Impaired loans are evaluated with an individual analysis to establish the amount of related allowance for loan loss, if any. The amount in the allowance for loan losses for impaired loans is determined based on the present value of either expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, net of cost to sell. In recent periods, our estimate of the amount of loss on a loan secured by real estate has increased in complexity as a result of the current illiquidity in the real estate market. The degree of uncertainty and the sensitivity of real estate valuations to the underlying assumptions regarding holding period until sale and the collateral liquidation method can have a material impact on our loss estimates on loans. If the estimated recoverable amount of the impaired loan is less than the recorded investment in the loan, a specific allowance is established.
Management believes that the allowance for loan losses is adequate to absorb probable losses on existing loans that may become uncollectible. However, there can be no assurance that our allowance will prove sufficient to cover actual loan losses in the future. In addition, regulatory agencies, as an integral part of their examination process, periodically review the adequacy of our allowance for loan losses. Such agencies may require us to make additional provisions to the allowance based upon their judgments about information available to them at the time of their examinations.
The following table shows an analysis of our allowance for loan losses and other related data for the periods indicated:
* Separate commercial real estate amounts are not available for this period. The commercial real estate amounts are included in the commercial and industrial amount for this period only.
Our allowance for loan losses was $103.7 million at December 31, 2011, or 3.54% of end-of-year loans (excluding loans held for sale) and 100.66% of nonperforming loans. In comparison, the allowance for loan losses was $124.6 million at December 31, 2010, or 4.39% of total loans (excluding loans held for sale) and 77.98% of nonperforming loans. At December 31, 2009, the allowance for loan losses was $106.2 million, or 3.60% of total loans (excluding loans held for sale) and 75.06% of nonperforming loans.
Total nonperforming loans decreased from $159.7 million at December 31, 2010, to $103.1 million at December 31, 2011, while the level of impaired loans decreased to $108.5 million at December 31, 2011, from $181.1 million at December 31, 2010, primarily due to charge-offs and paydowns. Our continued efforts to resolve our nonperforming assets and impaired loans, resulted in a decreased provision for loan losses, lower charge-offs in 2011, and an overall decrease in the allowance for loan losses.
We charge-off loans when the loss is highly probable and clearly identified. For additional details, see the Allowance for Loan Losses section of the Note 1, “Summary of Significant Accounting and Reporting Policies” from our audited financial statements contained elsewhere in this annual report. During 2011, net charge-offs
were $70.1 million, or 2.37% of average loans. In comparison, during 2010 net charge-offs were $124.7 million, or 4.11% of average loans, and $112.0 million, or 3.53% of average loans during 2009. In 2011, most of our loan charge-offs were from the commercial and industrial and commercial real estate portfolios. In contrast, in 2010 and 2009, most of our loan charge-offs were from our construction and loan portfolios.
As a commercial bank, our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have higher potential for losses on an individual loan basis. The individually larger commercial loans can cause greater volatility in reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate with respect to a single sizable loan can have a material impact on our reported impaired loans and related loss exposure estimates and, therefore, our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, the allowance for loan losses is adjusted through the recording of a provision for loan losses.
The table below presents the allocation of the allowance for loan losses among the various loan categories and sets forth the percentage of loans in each category to gross loans. The allocation of the allowance for loan losses as shown in the table should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. While we allocated the allowance to loan losses to loan categories for analytical purposes, the total allowance for loan losses is available to absorb losses from any category of loans.
Deposits
Our deposits consist of noninterest and interest-bearing demand deposits, savings deposits, certificates of deposit (“CDs”), and certain public funds. Our customer repurchase agreements are reported in other borrowings. In addition to funding from customers, we also use brokered CDs and other out-of-local-market CDs to support our asset base.
The following table sets forth, for the periods indicated, the distribution of our average deposit account balances and average cost of funds on each category of deposits:
During 2011, average deposit balances increased $34.8 million, or 1.2%, to $3.02 billion from $3.00 billion during 2010. During 2010, average deposit balances decreased $114.4 million, or 3.7%, to $2.99 billion from $3.10 billion during 2009. During 2011 and 2010, we continued to focus on increasing deposits from our core customers in order to reduce our reliance on more costly brokered funding.
Average noninterest-bearing deposit balances during 2011 increased $47.9 million, or 7.9%, to $650.7 million, compared to $602.8 million during 2010. The increase in noninterest-bearing deposits was largely due to our in-market deposit initiative. Total average time deposits decreased $75.8 million, or 4.9%, to $1.46 billion during 2011 compared to $1.53 billion during 2010. During 2011, average CDs from our local customers decreased by $117.4 million, as compared to 2010. During 2011, we decreased our brokered CDs by $22.4 million and we increased our out-of-local-market CDs by $26.2 million, as compared to 2010. We participated in the Certificate of Deposit Account Registry Service (“CDARS”) network reciprocal program in all of 2011, and average CDARS time deposits for our local customers increased by $25.7 million. We are now participating in the CDARS one-way buy program in which we bid on funds from out-of-local market. In addition, between the two periods, NOW accounts decreased by $12.4 million, while money market accounts increased by $77.2 million from our efforts to increase our customer balances.
Average deposit balances decreased $114.4 million, or 3.7%, to $2.99 billion in 2010, from $3.10 billion during 2009. Total average time deposits decreased $282.2 million, or 15.5%. Brokered and out-of-local-market CDs decreased, with the average balance of these two categories decreasing by $248.3 million. The majority of the increase in time deposits was due to our participation in the CDARs network during 2010 and average CDARs time deposits increased by $41.4 million during 2010. Average NOW accounts increased by $44.7 million largely due to one customer, while money market account increased by $106.2 million due to our efforts to increase our customer balances.
The following table sets forth the period end balances of total deposits at December 31, 2011, December 31, 2010 and December 31, 2009, as well as categorizes our deposits as “in-market” and “out-of-market” deposits.
Total period end deposit balances increased $96.3 million, or 3.2%, to $3.12 billion at December 31, 2011, compared to $3.03 billion at December 31, 2010. Both average deposits balances and period end balances increased at December 31, 2011 from December 31, 2010.
Our total in-market deposits were $2.56 billion at December 31, 2011 as compared to $2.47 billion at December 31, 2010. Of these in-market deposits, noninterest-bearing deposits increased by $169.2 million, or 26.7%, NOW accounts increased by $76.2 million, or 30.7%, and money market accounts increased by $74.1 million, or 12.7%. During the same period, customer certificates of deposit balances decreased $156.2 million, or 21.8%. We also continued to issue CDARS time deposits to our local market customers and these CDARS deposits decreased by $60.7 million to $122.2 million at December 31, 2011.
Total period end deposit balances at December 31, 2010 increased $50.1 million, or 1.7%, to $3.03 billion, from $2.98 billion at December 31, 2009. Between December 31, 2010 and December 31, 2009, in-market deposits increased by $65.5 million, or 2.7%, while out-of-market deposits decreased by $15.4 million, or 2.7%. Out-of-market deposits decreased primarily as a result of a $34.2 million decrease in brokered CDs. Total in-market deposits were $2.47 billion at December 31, 2010, compared to $2.41 billion at December 31, 2009. Most of this increase was associated with a $145.3 million increase in money market accounts, offset by a $60.6 million decrease in customer certificates of deposit and a $58.4 million decrease in NOW accounts.
Time deposits in denominations of $100,000 or more, including public funds deposits, totaled $562.3 million at December 31, 2011. The following table sets forth the amounts and maturities of time deposits of $100,000 or more at December 31, 2011:
During 2011, the Bank continued to participate in the FDIC’s Temporary Liquidity Guarantee Program. The program consists of two parts: the Debt Guarantee Program, which the Bank elected to participate in, however, the Bank did not issue any debt under this program in 2011. The second part of the Temporary Liquidity Guarantee Program was the TAG Program which the FDIC discontinued at the end of 2010.
The Dodd-Frank Act requires that all financial institutions provide full deposit insurance on all noninterest-bearing transaction accounts through December 31, 2012.
In addition to CDs from our local market customers, we used other sources of time deposits to help fund our liquidity and funding needs. In October 2008, we entered the CDARS network. This network allows us to accommodate depositors with large cash balances to seek full deposit insurance protection, by placing these funds in CDs issued by other banks in the network. Through a matching system, we receive funds back for CDs that we issue for other banks in the network, thus allowing us to retain the full amount of the original deposit. At December 31, 2011, we had $122.2 million of deposits in the CDARS reciprocal program, as compared to $182.9 million at December 31, 2010.
We also utilize out-of-market CDs to fund the portion of our interest-earning asset growth that is not funded with in-market deposits and other borrowings. We offer CDs to out-of-local-market customers by providing rates to a private third-party electronic system that provides CD rates from institutions across the country to its subscribers. These CDs are generally issued at amounts that allow the purchasers to obtain full FDIC deposit insurance protection. The balance of CDs obtained through this channel was $135.8 million at December 31, 2011, as compared to $99.3 million at December 31, 2010. We began participating in the one-way buy CDARS program in 2011. This program enables us to bid on funds from out-of-local market customers who are attempting to maximize the return on their deposits while they are continuing to maintain the full FDIC insurance on their deposits. As of December 31, 2011, we have $21.9 million of deposits in the CDARS one-way buy program.
We also issue brokered CDs to support our asset growth, but we continued to reduce our reliance on this source of funding in 2011. The balance of our brokered CDs was $407.1 million at December 31, 2011, compared to $449.8 million at December 31, 2010. Total brokered money market balances also decreased in 2011 to zero at December 31, 2011 compared to $5.8 million at December 31, 2010.
At December 31, 2011 and 2010, the scheduled maturities of brokered CDs were as follows:
Brokered CDs are carried net of the related broker placement fees and other discounts and are amortized to the maturity date of the related brokered CDs and included in deposit interest expense.
Other Borrowings
Our other borrowings totaled $168.1 million at December 31, 2011 as compared to $511.0 million at December 31, 2010. Other borrowings include securities sold under agreements to repurchase (“repos”), federal
funds purchased and U.S. Treasury tax and loan note option accounts. The decrease in total other borrowings was largely a result of decreases of $286.3 million in repurchase agreements and $53.7 million in federal funds purchased.
Repos include overnight and term agreements. The overnight repos are collateralized financing transactions and are primarily executed with local Bank customers. Overnight repos totaled $14.3 million at December 31, 2011 and $39.2 million at December 31, 2010. Our term repos totaled $75.0 million at December 31, 2011 and $336.3 million at December 31, 2010.
In 2011, we modified the terms of a $40.0 million existing structured repo agreement to extend the maturity date and reduce the interest rate. In addition, three structured repo agreements in the total amount of $80.0 million were terminated in 2011. We incurred $3.4 million in early extinguishment of debt expense related to these terminations. This change was made to shift funding sources to lower cost alternatives. All remaining repo agreements are non-callable, with $35.0 million due to mature in 2012 and $40.0 million due to mature in 2015. During 2010, we paid $40.0 million of repo agreements early and incurred $368,000 of expense recorded as early extinguishment of debt within noninterest expense. At December 31, 2010, there were $120.0 million of repo agreements that remained callable at the counterparty’s option and were scheduled to mature in 2012. In addition, the repurchase agreements allowed the counterparty to terminate the agreement prior to the call date if the Bank were to lose its well-capitalized status. The remaining $216.3 million repurchase agreements were non-callable with $181.3 million due to mature in 2011 and $35.0 million due to mature in 2012.
At December 31, 2011 and December 31, 2010, subject to available collateral, the Bank had available pre-approved total repurchase agreement lines of $850 million and $930 million, respectively. Of the pre-approved repurchase agreement lines, we had uncollateralized lines available to borrow of $775.0 million at December 31, 2011 and $594.0 million at December 31, 2010. Remaining collateral available to pledge for repurchase agreement lines totaled $255.3 million at December 31, 2011, compared with $175.7 million at December 31, 2010.
At December 31, 2011, federal funds purchased totaled $78.8 million, a decrease of $53.7 million as compared to $132.6 million at December 31, 2010. These borrowings were unsecured and provided on an overnight basis. Of the federal funds purchased balance at December 31, 2011, $40.3 million was through our correspondent banking customers who may sell federal funds to the Bank in order to manage their own excess liquidity. The remaining $38.5 million of federal funds purchased at December 31, 2011 was through the Bank’s pre-approved lines with other banks. At December 31, 2011 and December 31, 2010, the Bank had pre-approved total overnight federal funds borrowing lines through other banks of $164 million and $119 million, respectively.
Under the U.S. Treasury tax and loan note option, the Bank is authorized to accept U.S. Treasury Department deposits of excess funds along with deposits of customer taxes. These borrowings are collateralized by investment securities. We had no borrowings from this source at December 31, 2011 as compared to $2.9 million at December 31, 2010. This program will no longer be offered as of January 1, 2012, and this will no longer be a borrowing source.
The following table shows categories of other borrowings having average balances during the period greater than 30% of stockholders’ equity at year-end. During the current reporting period, repos and federal funds purchased were the two categories meeting this standard.
(1) Based on amount outstanding at month end during each year.
For additional details on the other borrowings, see “Notes to Consolidated Financial Statements, Note 8-Other Borrowings” from our audited financial statements contained elsewhere in this annual report.
Notes Payable and Other Advances
Our FHLB advances consist of borrowings from the FHLBC. At December 31, 2011, total FHLB advances were $747.5 million, compared to $505.0 million at December 31, 2010. As of December 31, 2011, these advances were collateralized by $782.1 million of investment securities and a blanket lien on $390.8 million of qualified first-mortgage residential, home equity and commercial real estate loans. Based on the value of collateral pledged, we had additional borrowing capacity of $277.3 million at December 31, 2011. During 2011, we continued to increase our borrowing from the FHLBC due to our ability to borrow at a more favorable interest rate than other sources. As of December 31, 2011, none of the FHLB advances are callable and $685.0 million are overnight advances or scheduled to mature within the next 12 months.
In 2011, the Company modified the terms of two existing FHLB advances to extend the maturity date and convert the fixed rate to a variable rate. These changes were made to shift funding sources to lower cost alternatives.
At December 31, 2011 and December 31, 2010, we had no outstanding notes payable. We also had no outstanding borrowings at the FRB for these periods.
For additional details of the FRB and FHLB advances, see “Notes to Consolidated Financial Statements, Note 10-Notes Payable and Other Advances” from our audited financial statements contained elsewhere in this annual report.
Junior Subordinated Debentures
At December 31, 2011 and December 31, 2010, we had $86.6 million of junior subordinated debentures outstanding, $45.4 million issued to TAYC Capital Trust I and $41.2 million issued to TAYC Capital Trust II. Each of the trusts is a wholly-owned statutory trust formed for the purpose of issuing trust preferred securities.
Each of the trusts used proceeds from the sale of its trust preferred securities, along with proceeds it received from the purchase of its common equity securities, to invest in the junior subordinated debentures issued by us. We report a liability for the total balance of the junior subordinated debentures issued to the trusts. The equity investments in the trusts of $2.5 million at December 31, 2011 and $2.6 million at December 31, 2010 is recorded in other assets on our Consolidated Balance Sheets. Interest expense on the junior subordinated debentures is reported in interest expense.
For TAYC Capital Trust I, interest on both the trust preferred securities and junior subordinated debentures are payable quarterly at a rate of 9.75% per year. The interest rate on both the trust preferred securities and the junior subordinated debentures related to TAYC Capital Trust II equals the three-month LIBOR plus 2.68% and re-prices quarterly. The interest rates were 3.24% and 2.98% at December 31, 2011 and December 31, 2010, respectively. Each of these trust preferred securities are currently callable, at our option. Unamortized issuance costs would be recognized as an expense if the debentures were called. Total unamortized issuance costs related to both trusts totaled $2.5 million on December 31, 2011.
Our obligations with respect to each of the trust preferred securities and the related debentures, in the aggregate, constitute a full, irrevocable and unconditional guarantee on a subordinated basis by us of the obligations of each of the trusts under the respective trust preferred securities.
Subordinated Notes
In October 2010, we issued $3.6 million of 8% subordinated notes, which will mature on May 28, 2020, and are pre-payable at our option on or after May 28, 2012. In addition, a warrant to purchase 25 shares of our common stock at an exercise price of $12.28 per share was issued for every $1,000 in principal amount of the subordinated notes. The warrants represent an aggregate of 89,050 shares of common stock and will expire on May 28, 2015. The proceeds received from this transaction were allocated to the subordinated notes and the warrants based on their relative fair values. The fair value allocated to the warrants, totaling $420,000 at the issuance date in October 2010, net of issuance costs, was credited to surplus in stockholders’ equity on our Consolidated Balance Sheets. At December 31, 2011, the subordinated notes were reported at $3.1 million, which was net of $427,000 of unamortized discount. In comparison, at December 31, 2010, the subordinated notes were reported at $3.6 million, which was net of $455,000 of unamortized discount. The discount is being amortized as an additional interest expense of the subordinated notes over the remaining contractual life of the notes.
In May 2010, we issued $33.9 million of ten year, 8% subordinated notes, pre-payable at our option after two years. In addition, a warrant to purchase 25 shares of our common stock at an exercise price of $12.28 per share was issued for every $1,000 in principal amount of the subordinated notes. The warrants represent an aggregate of 848,450 shares of common stock and will expire on May 28, 2015, the fifth anniversary of issuance. The proceeds received from this transaction were allocated to the subordinated notes and the warrants based on their relative fair values. The fair value allocated to the warrants, totaling $4.4 million at the issuance date in May 2010, net of issuance costs, was credited to surplus in stockholders’ equity on our Consolidated Balance Sheets. At December 31, 2011, the subordinated notes were reported at $29.9 million, which was net of $4.1 million of unamortized discount. In comparison, at December 31, 2010, the subordinated notes were reported at $29.6 million, which was net of $4.3 million of unamortized discount. The discount is being amortized as an additional interest expense of the subordinated notes over the remaining contractual life of the notes.
In September 2008, the Bank issued $60.0 million of eight year, 10% subordinated notes, pre-payable at the Bank’s option after three years. In addition, a warrant to purchase 15 shares of our common stock at an exercise price of $10.00 per share was issued for every $1,000 in principal amount of the subordinated notes. The warrants represent an aggregate of 900,000 shares of common stock and will expire on September 29, 2013, the fifth anniversary of issuance. The proceeds received from this transaction were allocated to the subordinated notes and the warrants based upon their relative fair values. At December 31, 2011, the subordinated notes
reported on the Consolidated Balance Sheets totaled $56.6 million, which was net of $3.4 million of unamortized discount. In comparison, at December 31, 2010, the subordinated notes were reported at $56.1 million, which was net of $3.9 million of the unamortized discount. The discount consists primarily of the fair value allocated to the warrants and was reported as an addition to surplus in the equity portion of the Consolidated Balance Sheets. The discount is being amortized as an additional interest expense of the subordinated notes over the remaining contractual life of the notes.
Preferred Stock
In May 2010, we completed an exchange offering in which all of our outstanding shares of Series A Preferred were exchanged for 7.2 million shares of common stock that included 1.2 million shares as an inducement for Series A Preferred holders to exchange the Series A Preferred for common shares. The $15.8 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series A Preferred and resulted in no net impact to total stockholders’ equity. This implied noncash dividend was a deduction in arriving at net loss applicable to common stockholders on the Consolidated Statement of Operations and was considered in the determination of basic and diluted loss per common share. After the payment of the regular quarterly dividend of $1.2 million on April 15, 2010, we did not declare or pay any further dividends on the Series A Preferred.
In November 2008, we sold shares of Series B Preferred to the UST under the TARP CPP for gross proceeds of $104.8 million. Holders of the Series B Preferred are entitled to receive dividends at an annual rate of 5% for the first five years and 9% thereafter. Dividends on the Series B Preferred are cumulative. In connection with the Series B Preferred, we also issued a ten-year warrant for the UST to purchase 1,462,647 shares of our common stock at an exercise price of $10.75 per share. As a result of the issuance of subscription rights in our rights offering in November 2011, the TARP warrant was adjusted so that the number of shares that can be purchased under the warrant increased to 1,510,418 and the exercise price decreased to $10.41. At December 31, 2011, the recorded balance of the preferred stock totaled $102.0 million, which is equal to the liquidation amount, net of $3.6 million of unamortized discount plus accumulated but undeclared dividends. In comparison, the amount reported at December 31, 2010 was $100.4 million, was net of $5.1 million of unamortized discount and accumulated but undeclared dividends. The discount consists primarily of the fair value allocated to the warrants and was reported as an addition to surplus in the equity portion of the Consolidated Balance Sheets. The discount is being accreted as a noncash dividend on the Series B Preferred, and the discount accretion was $1.7 million and $1.5 million during 2011 and 2010, respectively. The discount accretion decreased the net income applicable to common stockholders and the net income per common share during 2011, and increased the net loss applicable to common stockholders and the net loss per common share during 2010. Accumulated but undeclared dividends totaled $670,000 at both December 31, 2011 and December 31, 2010. During 2011 and 2010, we declared and paid dividends in the amount of $5.2 million on the Series B Preferred.
Before November 21, 2011, the third anniversary of the UST’s purchase of the Series B Preferred, we were required to obtain the consent of the Treasury prior to us paying any dividend on our Common Stock or repurchasing our Common Stock or other equity or capital securities except in connection with benefit plans consistent with past practice and certain other circumstances specified in the Series B Preferred purchase agreement.
In December 2011, we completed a conversion in which of all of our outstanding shares of Series C Preferred were converted into 3,517,887 shares of common stock that included 919,249 shares issued in accordance with the amended terms of the stock, which were in addition to the number of shares to be issued upon such a conversion according to the original terms of the stock. The $8.9 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series C Preferred and resulted in no net impact to total stockholders’ equity. This noncash dividend was a deduction in arriving at net income applicable to common stockholders on the Consolidated Statement of Operations and was considered in the
determination of basic and diluted income per common share. Excluding the implied noncash dividend, the dividends declared and paid for the year ended December 31, 2011 totaled $1.9 million and were paid in 235,869 shares of common stock. This compares to the year ended December 31, 2010 when we declared and paid cash dividends on Series C Preferred in the amount of $1.6 million.
In October 2010, we issued a total of 405,330 shares of Series D Preferred, in exchange for 405,330 shares of common stock held by certain investors. The Series D Preferred participates in dividends with our common stock. Each share of Series D Preferred converts into one share of common stock immediately on any “Widely Dispersed Offering” or “Conversion Event” as defined in the Certificate of Designation establishing the Series D Preferred.
The holders of Series D Preferred are entitled to notice of all stockholder meetings at which all holders of common stock shall be entitled to vote, but the Series D Preferred holders shall not be entitled to vote on any matter presented to our stockholders unless required by law.
In the event of any reorganization, reclassification, consolidation, merger or sale of the Company, each holder of the Series D Preferred shall be treated the same as each holder of common stock. In the event that holders of common stock have the option to elect the form of consideration to be received, holders of Series D Preferred shall have the same election privileges. In all cases, if any of the securities otherwise receivable are “voting securities” for bank regulatory purposes, each Series D Preferred holder shall have the right to elect to receive “non-voting securities” in lieu of voting securities.
In December 2011, we completed a conversion in which of all of our outstanding Series E Preferred were converted into 616,020 shares of Series G Preferred that included 160,972 shares issued in accordance with the amended terms of such stock, which were in addition to the numbers of shares to be issued upon such a conversion according to the original terms of the stock. The $1.6 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series E Preferred and resulted in no net impact to total stockholders’ equity. This implied noncash dividend was a deduction in arriving at net income applicable to common stockholders on the Consolidated Statement of Operations and was considered in the determination of basic and diluted income per common share. Excluding the implied noncash dividend, the dividends declared and paid for the year ended December 31, 2011 totaled $335,000 and were paid in 41,324 shares of Series G Preferred. This compares to the year ended December 31, 2010 when we declared and paid cash dividends on Series E Preferred in the amount of $103,000.
In March 2011, we issued 1,000,000 shares of Series F Preferred in a private placement and then converted this Series F Preferred into an aggregate of 2,280,000 shares of common stock and 220,000 shares of Series G Preferred. This transaction raised $25.0 million of capital.
Also in March 2011, we authorized the designation for issuance of 1,350,000 shares of Series G Preferred. After stockholder approval was obtained at a special meeting of the stockholders’ held on March 29, 2011, the shares of Series F Preferred held by Prairie Capital IV, L.P. and Prairie Capital IV QP, L.P. (collectively, the “Prairie Fund”) were converted into 220,000 shares of Series G Preferred at a conversion price of $10.00 per share. In December 2011, the Company completed the conversion of all of its outstanding Series E Preferred into 616,020 shares of Series G Preferred.
The Series G Preferred participates in any dividends paid to holders of the Company’s common stock. Each share of Series G Preferred will be automatically converted into one share of common stock immediately on any Widely Dispersed Offering or Conversion Event (as defined in the Certificate of Designation establishing the Series G Preferred). The holders of Series G Preferred are entitled to notice of all stockholder meetings at which all holders of common stock shall be entitled to vote, but the Series G Preferred holders shall not be entitled to vote on any matter presented to the stockholders of the Company.
In the event of any reorganization, reclassification, consolidation, merger or sale of the Company, each holder of the Series G Preferred shall be treated the same as each holder of common stock. In the event that holders of common stock have the option to elect the form of consideration to be received, holders of Series G Preferred shall have the same election privileges. In all cases, if any of the securities otherwise receivable are “voting securities” for bank regulatory purposes, each Series G Preferred holder shall have the right to elect to receive “non-voting securities” in lieu of voting securities.
For additional details on our preferred stock, see “Notes to Consolidated Financial Statements-Note 15-Stockholders’ Equity” from our audited financial statements contained elsewhere in this annual report.
Common Stock
In September 2008, we increased our authorized common stock to 45 million shares from the prior authorization of 18 million shares to accommodate the issuance of convertible preferred stock and warrants to purchase common stock. Our Series A Preferred was exchanged for 7.2 million shares of common stock in May 2010. Our Series C Preferred was converted into an aggregate of 3.5 million shares of common stock in December 2011. Our Series F Preferred was converted into an aggregate of 2.3 million shares of common stock in March 2011. All dividends paid on Series C Preferred in 2011 were paid as an aggregate of 235,869 shares of common stock. In November 2011, a rights offering involved the distribution, at no charge, to holders of common stock, Series C Preferred, Series D Preferred, Series E Preferred, Series G Preferred and certain warrants of nontransferable subscription rights to purchase up to a total of 4.4 million shares of common stock. This rights offering was fully subscribed at the expiration, with gross proceeds of $35.0 million.
Warrants for the purchase of 3.8 million shares of common stock currently are exercisable by the holders at December 31, 2011. The number of warrants that were issued as part of the UST TARP CPP, have been adjusted under the anti-dilution adjustments defined in the original warrant, due to the subscription rights in the rights offering completed in December 2011. This adjustment caused the number of shares that can be purchased under the warrant to increase at a reduced exercise price. As of December 31, 2011, no warrants had been exercised.
For additional details on our warrants to purchase common stock, see “Notes to Consolidated Financial Statements-Note 15-Stockholders’ Equity” from our audited financial statements contained elsewhere in this annual report.
We did not declare or pay any common stock dividends in 2011 or 2010. Before November 21, 2011, the Series B Preferred required the consent of the UST to pay any dividend on our common stock. In addition, under the terms of the junior subordinated debentures issued in connection with our trust preferred securities any deferral of the payment of interest or dividends results in a defined restriction in the payment of common dividends.
Regulatory Capital
We monitor compliance with bank regulatory capital requirements, focusing primarily on the risk-based capital guidelines. Under the risk-based capital method of capital measurement, the ratio computed is dependent on the amount and composition of assets recorded on the balance sheet and the amount and composition of off-balance sheet items, in addition to the level of capital. Generally, Tier 1 Capital includes common stockholders’ equity, noncumulative perpetual preferred stock and trust preferred securities (up to certain limits). Bank regulators, however, also specifically approved the Series B Preferred for inclusion in Tier 1 capital in spite of its cumulative dividend feature. Tier 1 Capital is adjusted to exclude a portion of the deferred tax asset and the mortgage servicing rights asset. Total Capital represents Tier 1 Capital plus a portion of the allowance for loan loss (up to certain limits), subordinated debt and the portion of the trust preferred securities not includable in Tier 1 Capital.
At each December 31, 2011, December 31, 2010, and December 31, 2009, the Company was considered “well-capitalized” under capital guidelines set by the Federal Reserve for bank holding companies. All of the Company’s ratios increased in 2011, mostly due to net income for the year and capital raises totaling $60.0 million. The Company’s Total Capital ratio increased in 2010, largely due to increases in regulatory capital caused by our subordinated debt issuance in 2010 which more than outweighed the increase in risk weighted assets. The ratios of Tier 1 Capital to risk weighted assets and Tier 1 Capital to average assets declined compared to the ratio of Total Capital to risk weighted assets as Tier 1 capital was lower during 2010 as well as higher average assets and risk weighted assets.
At each of December 31, 2011, December 31, 2010, and December 31, 2009, the Bank was considered “well-capitalized” under regulatory capital guidelines. All of the Bank’s ratios increased during 2011 due to the net income earned by the Bank and the $25.0 million capital contribution from the Company.
While we, as well as our Bank, continue to be considered well-capitalized under the regulatory capital guidelines, our regulators could require us to maintain capital in excess of these required levels. We have agreed, consistent with past practice, to continue to provide our regulators notice before the payment of dividends.
The Company and the Bank’s capital ratios were as follows for the dates indicated:
Liquidity
In addition to the normal influx of liquidity from in-market deposits and repayments and maturities of loans and investments, the Bank uses brokered deposits, borrowings from the FHLB and FRB, broker/dealer repurchase agreements and federal funds purchased to meet its liquidity needs. During 2011, we worked to improve our liquidity position by increasing funding from core customers which allowed us to reduce our reliance on brokered deposits. We also used available collateral to take advantage of attractively priced short-term funding provided by the FHLB.
We manage the risks associated with this reliance on wholesale funding sources by maintaining adequate alternate sources of funding and excess collateral available for immediate use. At December 31, 2011, subject to
available collateral, we had total pre-approved overnight federal funds borrowing lines and repurchase agreement lines of $164 million and $865 million, respectively. In addition, the Bank is able to borrow from the FRB under the Borrower-in-Custody Program. At December 31, 2011, the Bank maintained $569.2 million of commercial loans as collateral at the FRB with a lendable value of approximately $463.3 million. The Bank also has pledged $782.1 million of investment securities and $390.8 million of qualified first-mortgage residential, home equity and commercial real estate loans at the FHLB and had a total borrowing capacity of $277.3 million at December 31, 2011. The Bank has further increased its ability to purchase federal funds by cultivating relationships with a growing group of correspondent banking customers who may sell Federal Funds to the Bank in order to manage their excess liquidity.
Our total assets increased to $4.69 billion at December 31, 2011 and $4.48 billion at December 31, 2010. During 2011, our loan portfolio increased by a net of $19.9 million, or 0.7%, while our investment securities portfolio increased by $25.2 million, or 2.0%. During 2011, the mix of our funding liabilities also changed. Total deposits increased by $96.3 million, or 3.2%, and notes payable increased by $242.5 million, or 48.0%. We partly offset these increases by decreasing other borrowings by $342.9 million, or 67.1%.
Interest received, net of interest paid, was the principal source of our operating cash inflows in each of the above periods. Management of investing and financing activities and market conditions determine the level and the stability of our net interest cash flows. During 2011, cash provided by operating activities was $140.7 million, compared to cash used in operating activities of $140.7 million in 2010 and cash used of $29.8 million in 2009. The increase in net cash provided by operating activities in 2011 is due to an increase in cash proceeds from loan sales of $1.2 billion, partially offset by an increase in loans originated for sale of $887.0 million. Cash used for loans originated for sale net of proceeds from loan sales of $190.6 million and $76.8 million of loans purchased in 2009, compared to none in 2010, caused the change in 2010 as compared to 2009.
Net outflows from investing activities totaled $143.2 million during 2011, compared to net inflows of $9.9 million during 2010. Our net outflow during 2011 was largely due to the purchase of $207.4 million of available for sale investment securities and a $178.2 million net increase in loans. This decrease was partly offset by proceeds from principal payments and maturities of available for sale securities of $118.3 million and $130.6 million in proceeds from sales of available for sale securities. In comparison, the inflow from investing activities in 2010 was largely due to the proceeds of $965.6 million from sales of available for sale investment securities and $248.0 million of proceeds from principal payments and maturities of available for sale investment securities. This increase was partly offset by purchases of $1.15 billion of available for sale securities. Net outflows from investing activities totaled $35.0 during 2009, primarily due to purchases of $975.3 million of available for sale securities, offset by proceeds from principal payments and maturities of available for sale securities of $312.5 million and proceeds from sales of available for sale securities of $497.4 million.
During 2011, we had net inflows from financing activities of $42.4 million, compared to $163.7 million during 2010. The new inflows in 2011 are primarily attributable to the net proceeds from the issuance of common stock of $33.8 million and net proceeds from the issuance of preferred stock of $24.4 million. During 2011, we increased deposits by $91.0 million and increased notes payable and other advances by $242.5 million. These inflows were offset by $342.9 million repayments of other borrowings. During 2010, net inflows from financing activities included increased other borrowings of $121.3 million, increased deposits by $48.6 million, net proceeds from the issuance of subordinated notes of $36.2 million and net proceeds from the issuance of preferred stock of $36.3 million. These inflows were partly offset by $115.0 million repayments of notes payable and other advances. During 2009, net inflows from financing activities included a $227.1 increase in other borrowings, offset by a net decrease in deposits of $156.3 million.
Holding Company Liquidity
Historically, the primary source of funds has been dividends received from the Bank. Because of the net losses incurred by the Bank in recent years, the Bank did not declare or pay any dividends to the Company in 2011 or 2010. The Bank is subject to dividend restrictions set forth by regulatory authorities, under which the
Bank may not, without prior approval of regulatory authorities, declare dividends in excess of the sum of the current year’s earnings plus the retained earnings from the prior two years. As of December 31, 2011, the Bank could not declare or pay dividends to us, without the approval of regulatory authorities.
At December 31, 2011, Company had cash of $45.0 million for general corporate purposes and to support future growth. The primary source of cash at the holding company was from the 2011 issuance of Series F Preferred and the rights offering of common stock. In 2011, we received net proceeds, after issuance costs, of $24.4 million from the issuance of our Series F Preferred and $33.8 million from the issuance of our common stock due to the rights offering. During 2011, cash outflows at the Company included $25.0 million in capital contributions to the Bank, $6.0 million of cash dividend payments on preferred stock issuances and general operating expenses.
Off-Balance Sheet Arrangements
Off-balance sheet arrangements include commitments to extend credit and financial guarantees. Commitments to extend credit and financial guarantees are used to meet the financial needs of our customers. We had commitments to extend credit of $846.7 million at December 31, 2011 and $905.5 million at December 31, 2010. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Many customers do not utilize the total approved commitment amounts, and, therefore, the total commitment amounts do not usually represent future cash requirements.
We had $75.0 million of financial and performance standby letters of credit at December 31, 2011 and $67.9 million at December 31, 2010. Financial standby letters of credit are conditional commitments issued by us to guarantee the payment of a specified financial obligation of a customer to a third party. Performance standby letters of credit are conditional commitments issued by us to make a payment to a specified third party in the event a customer fails to perform under a non-financial contractual obligation. The terms of these financial guarantees range from less than one to five years. The credit risk involved in issuing these letters of credit is essentially the same as that involved in extending loan facilities to customers. We expect most of these letters of credit to expire undrawn, and we expect no significant loss from our obligation under financial guarantees to the extent not already recognized as a liability on the Company’s Consolidated Balance Sheets. At December 31, 2011, we had a liability for $4.4 million for commitments under standby letters of credit for which we believed funding and loss were probable, compared to $5.4 million at December 31, 2010.
The following table shows as of December 31, 2011 the loan commitments and financial guarantees by maturity date.
The following table shows, as of December 31, 2011, our contractual obligations and commitments to make future payments under contracts, debt and lease agreements and maturing time deposits.
(1) Principal only, does not include interest.
Derivative Financial Instruments
We use derivative financial instruments to accommodate customer needs and to assist in our own interest rate risk management. From time to time, we use interest rate exchange agreements, or swaps, and callable interest rate swaps, interest rate floors and corridors to manage the interest rate risk associated with our commercial loan portfolio, brokered CDs, cash flows related to FHLB advances and repurchase agreements and mortgage servicing. We also have interest rate lock commitments and forward loan commitments that are considered derivatives. Periodically, we will sell options to a bank or dealer for the right to purchase certain securities that we hold within our investment portfolios (covered call options).
The following table describes the derivative instruments outstanding at both December 31, 2011 and 2010 (dollars in thousands):
We had derivative instruments with a notional amount of $106.9 million at December 31, 2011, which were designated as fair value hedges against the interest rate risk inherent in certain of its brokered CDs. Total ineffectiveness on the interest rate swaps was $89,000 for the year ended December 31, 2011 and was recorded in noninterest income.
We had derivative instruments with a notional amount of $60.0 million at December 31, 2011, which were designated as fair value hedges against the interest rate risk inherent in certain callable brokered CDs. Total ineffectiveness on these interest rate swaps was $292,000 for the year ended December 31, 2011 and was recorded in noninterest income.
We had $155.0 million of notional amount interest rate corridors at December 31, 2011, which were designated as cash flow hedges against certain borrowings. There was no ineffectiveness on these interest rate corridors for the year ended December 31, 2011.
In order to accommodate individual customer borrowing needs, we entered into interest rate swap agreements with customers. At the same time, in order to offset the exposure and manage interest rate risk, we entered into an interest rate swap with a different counterparty with offsetting terms. These derivative instruments are not designated as accounting hedges and any changes in fair value of these instruments, as well as any net cash settlements and upfront customer fees, are recognized in noninterest income as other derivative income or expense. As of December 31, 2011 and 2010, we had notional amounts of $413.1 million and $232.3 million, respectively, of interest rate swaps with customers in which we agreed to receive a fixed interest rate and pay a variable interest rate. In addition, as of December 31, 2011 and December 31, 2010, we had offsetting interest rate swaps with other counterparties with a notional amount of $413.1 million and $232.3 million, respectively, in which we agreed to receive a variable interest rate and pay a fixed interest rate.
We enter into interest rate swaps as a part of Cole Taylor Mortgage’s servicing business in order to minimize most of the price volatility of the mortgage servicing rights asset. At December 31, 2011, we had a notional amount of $22.5 million of interest rate swaps. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income.
We also enter into interest rate lock and forward loan sale commitments as a normal part of Cole Taylor Mortgage’s origination business. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income.
We enter into covered call option transactions that are designed primarily to increase the total return associated with the investment securities portfolio. There were no covered call options outstanding as of December 31, 2011 or December 31, 2010. In 2011, $178,000 of premium on covered call options was recognized in noninterest income. No covered call options were entered into in 2010.
In January 2009, we terminated a $100.0 million notional amount interest rate swap that was not designated as an accounting hedge. We discontinued hedge accounting in December 2008, when we determined the hedge would no longer be effective. The unrealized gain of $6.4 million upon de-designation, which had accumulated in OCI (net of tax), was being amortized to loan interest income over what would have been the life of the hedge. From the date of de-designation to December 31, 2008, the change in fair value, along with net settlements attributed to this period, was recorded in other derivative income in noninterest income and totaled $394,000. This derivative was terminated in January 2009 and we received a cash payment $6.6 million, which represented the fair value of the swap at the date of termination.
At December 31, 2011 the net settlement had been completely amortized and there is no longer any amount remaining in accumulated OCI. This compares with December 31, 2010 when we had $761,000 in accumulated OCI related to terminated cash flow hedges. The amount in accumulated OCI represents the net unamortized portion of the deferred gain that had accumulated in OCI when the hedging relationship was terminated. During 2011 and 2010, $1.2 million and $3.2 million, respectively, of deferred gains from previously terminated cash flow hedges were amortized as a net increase to loan interest income.
Hedges with the notional amount of $145.0 million were terminated in 2011, with net termination fees of $896,000 recognized in noninterest income for the year ended December 31, 2011. These hedges were terminated because the transaction which they hedged was no longer forecast to occur.
For additional details concerning the accounting treatment for our derivative instruments, please see “Application of Critical Accounting Policies-Derivative Financial Instruments” from our Management’s Discussion and Analysis contained elsewhere in this annual report.
Quantitative and Qualitative Disclosure about Market Risks
Interest rate risk is the most significant market risk affecting us. Other types of market risk, such as foreign currency risk and commodity price risk, do not arise in the normal course of our business activities. Interest rate risk can be defined as the exposure to a movement in interest rates that could have an adverse effect on our net interest income or the market value of our financial instruments. The ongoing monitoring and management of this risk is an important component of our asset and liability management process, which is governed by policies established by the Board of Directors and carried out by the Bank’s Asset/Liability Management Committee, (“ALCO”). ALCO’s objectives are to manage, to the degree prudently possible, our exposure to interest rate risk over both the one year planning cycle and the longer term strategic horizon and, at the same time, to provide a stable and steadily increasing flow of net interest income. Interest rate risk management activities include establishing guidelines for tenor and repricing characteristics of new business flow, the maturity ladder of wholesale funding and investment security purchase and sale strategies, as well as the use of derivative financial instruments.
We have used various interest rate contracts, including swaps, floors, collars and corridors to manage interest rate and market risk. These contracts can be designated as hedges of specific existing assets and liabilities. Our asset and liability management and investment policies do not allow the use of derivative financial instruments for trading purposes.
Our primary measurement of interest rate risk is earnings at risk, which is determined through computerized simulation modeling. The primary simulation model assumes a static balance sheet, a parallel interest rate rising or declining ramp and uses the balances, rates, maturities and repricing characteristics of all of our existing assets and liabilities, including derivative financial instruments. These models are built with the sole objective of measuring the volatility of the embedded interest rate risk as of the balance sheet date and, as such, do not provide for growth or any changes in balance sheet composition. Projected net interest income is computed by the model assuming market rates remain unchanged and compares those results to other interest rate scenarios with changes in the magnitude, timing, and relationship between various interest rates. The impact of embedded options in the balance sheet such as callable agencies and mortgage-backed securities, real estate mortgage loans and callable borrowings are also considered. Changes in net interest income in the rising and declining rate scenarios are then measured against the net interest income in the rates unchanged scenario. ALCO utilizes the results of the model to quantify the estimated exposure of net interest income to sustained interest rate changes.
Net interest income for year one in a 200 basis points rising rate scenario was calculated to decrease by $907,000, or 0.6%, as compared to the net interest income in the rates unchanged scenario at December 31, 2011. At December 31, 2010, the projected variance in the rising rate scenario was an increase of $2.7 million, or 1.9% higher than the rates unchanged scenario. These exposures were within our policy guidelines. No simulation for net interest income at risk in a falling rate scenario was calculated because of the low level of market interest rates at both December 31, 2011 and 2010.
Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including, among other factors, no change in the balance sheet size or composition, relative levels of market interest rates, product pricing, reinvestment strategies and customer behavior influencing loan and security prepayments and deposit decay and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions we may take in response to changes in market interest rates. We cannot assure you that our actual net interest income would increase or decrease by the amounts computed by the simulations.
The following table indicates the estimated impact on net interest income in year one under various parallel ramp interest rate scenarios at December 31, 2011 and December 31, 2010:
n/a - Not applicable
The following table sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding at December 31, 2011, on a consolidated basis, that we anticipate, based upon certain assumptions, to reprice or mature in each of the future time periods shown. The projected repricing of assets and liabilities anticipates prepayments and scheduled rate adjustments, as well as contractual maturities under an interest rate unchanged scenario within the selected time intervals. While we believe such assumptions are reasonable, there can be no assurance that assumed repricing rates would approximate our actual future experience.
Certain shortcomings are inherent in the method of analysis presented in the table. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. In addition, certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates, both on a short-term basis and over the life of the asset. More importantly, changes in interest rates, prepayments and early withdrawal levels may deviate from those assumed in the calculations in the table. As a result of these shortcomings, we focus more on earnings at risk simulation modeling than on a gap analysis. Management considers earnings at risk simulation modeling to be more informative in forecasting future income at risk.
Finally, we also monitor interest rate risk from an economic perspective with an economic value of equity analysis. This measure is used to evaluate long-term interest rate risk.
Litigation
We are from time to time a party to litigation arising in the normal course of business. Management knows of no such threatened or pending legal actions against us that are likely to have a material adverse impact on our business, financial condition, liquidity or operating results.
New Accounting Pronouncements
In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This ASU defers only those changes to ASU 2011-05 that relate to the presentation of reclassification adjustments in order to allow the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated OCI on the components of net income and OCI for all periods presented. While this issue is being reconsidered, entities should continue to report reclassifications out of accumulated OCI consistent with guidance in effect prior to ASU 2011-05. This ASU is effective for the interim or annual periods beginning after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” ASU No. 2011-05 provides guidance to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in OCI. The FASB has eliminated the option to present OCI as part of the statement of changes in stockholders’ equity. This ASU will require either the addition of OCI to the current statement of operations for one single statement of comprehensive income or the addition of a statement that presents total OCI. This ASU is effective for the interim or annual periods beginning after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU No. 2011-05 improves the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP (generally accepted accounting principles) and IFRSs (international financial reporting standards). The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. This ASU is effective for the interim and annual period that begins after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In April 2011, the FASB issued ASU No. 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 removes two criteria from the assessment of effective control when determining whether a repurchase agreement should be accounted for as a sale or as a secured borrowing. The remaining criteria indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) if all of certain conditions are met. This ASU is effective for the interim or annual period that begins after December 15, 2011, with no early adoption permitted. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In April 2011, the FASB issued ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” ASU No. 2011-02 provides guidance on determining whether a restructuring constitutes a troubled debt restructuring. In order to be classified as a trouble debt restructuring, the restructuring must contain a concession and the debtor is experiencing financial difficulties. This ASU became effective for the periods beginning on or after June 15, 2011 and was applied retrospectively to the beginning of the annual period of adoption. This ASU further states that all troubled debt restructuring disclosures required by ASU 2010-20 that had been deferred by ASU No. 2011-01, should be disclosed effective for interim and annual periods beginning on or after June 15, 2011. This accounting standard was adopted as of the third quarter 2011 and the adoption did not have a material effect on our consolidated financial statements.
Quarterly Financial Information
The following table sets forth unaudited financial data regarding our operations for each of the four quarters of 2011 and 2010. This information, in the opinion of management, includes all adjustments necessary to present fairly our results of operations for such periods, consisting only of normal recurring adjustments for the periods indicated. The operating results for any quarter are not necessarily indicative of results for any future period.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements that reflect our current expectations and projections about our future results, performance, prospects and opportunities. We have tried to identify these forward-looking statements by using words including “may,” “might”, “contemplate”, “plan”, “prudent”, “potential”, “should”, “will,” “expect,” “anticipate,” “believe,” “intend,” “could” and “estimate” and similar expressions. These forward-looking statements are based on information currently available to us and are subject to a number of risks, uncertainties and other factors that could cause our actual results, performance, prospects or opportunities in 2012 and beyond to differ materially from those expressed in, or implied by, these forward-looking statements.
These risks, uncertainties and other factors include, without limitation:
•
Our business may be adversely affected by the highly regulated environment in which we operate.
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Competition from financial institutions and other financial services providers may adversely affect our growth and profitability.
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Our business is subject to the conditions of the local economy in which we operate and continued weakness in the local economy and the real estate markets may adversely affect us.
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Our business is subject to domestic and to a lesser extent, international economic conditions and other factors, many of which are beyond our control and could adversely affect our business.
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The preparation of our consolidated financial statements requires us to make estimates and judgments, which are subject to an inherent degree of uncertainty and which may differ from actual results.
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Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
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Our mortgage loan repurchase reserve for losses could be insufficient.
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We are subject to interest rate risk, including interest rate fluctuations that could reduce our profitability.
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Certain hedging strategies that we use to manage investment in mortgage servicing rights may be ineffective to offset any adverse changes in the fair value of these assets due to changes in interest rates and market liquidity.
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Our residential mortgage lending profitability could be significantly reduced if we are not able to originate and resell a high volume of mortgage loans.
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We have counterparty risk and therefore we may be adversely affected by the soundness of other financial institutions.
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We are subject to certain operational risks, including, but not limited to, data processing system failures and errors and customer or employee fraud. The Company’s controls and procedures may fail or be circumvented.
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The Company is dependent upon outside third parties for processing and handling of Company records and data.
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System failure or breaches of our network security, including with respect to our internet banking activities, could subject us to increased operating costs as well as litigation and other liabilities.
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We are subject to lending concentration risks.
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We may not be able to access sufficient and cost-effective sources of liquidity.
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We are subject to liquidity risk, including unanticipated deposit volatility.
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The recent repeal of federal prohibitions on payment of interest on business demand deposits could increase the Company’s interest expense.
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Changes in our credit ratings could increase our financing costs or make it more difficult for us to obtain funding or capital on commercially acceptable terms.
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The Company is a bank holding company and its sources of funds are limited.
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Our business strategy is dependent on our continued ability to attract, develop and retain highly qualified and experienced personnel in senior management and customer relationship positions.
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Our reputation could be damaged by negative publicity.
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New lines of business or new products and services may subject us to certain additional risks.
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We may experience difficulties in managing our future growth.
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The Company and its subsidiaries are subject to changes in federal and state tax laws and changes in interpretation of existing laws.
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Our participation in the TARP CPP may place significant restrictions on our operations.
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Regulatory requirements, growth plans or operating results may require us to raise additional capital, which may not be available on favorable terms or at all.
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We have not paid a dividend on our common stock since the second quarter of 2008. In addition, regulatory restrictions and liquidity constraints at the holding company level could impair our ability to make distributions on our outstanding securities.
For further information about these and other risks, uncertainties and factors, please review the disclosure included in Item 1A. Risk Factors of this report.
You should not place undue reliance on any forward-looking statements. Except as otherwise required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements or risk factors, whether as a result of new information, future events, changed circumstances or any other reason.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The information contained in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Quantitative and Qualitative Disclosure about Market Risks” is incorporated herein by reference.
Item 8.
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors of Taylor Capital Group, Inc.:
We have audited the accompanying consolidated balance sheets of Taylor Capital Group, Inc. and subsidiaries (the Company) as of December 31, 2011 and 2010, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Taylor Capital Group, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 9, 2012 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Chicago, Illinois
March 9, 2012
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(in thousands, except per share data)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (continued)
(in thousands, except per share data)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS-(Continued)
(in thousands)
See accompanying notes to consolidated financial statements
TAYLOR CAPITAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting and Reporting Policies
The accounting and reporting policies of Taylor Capital Group, Inc. (the “Company”) conform to U.S. generally accepted accounting principles and general reporting practices within the financial services industry. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Significant items subject to such estimates and assumptions include the allowance for loan losses, the valuation of deferred tax assets and the valuation of financial instruments such as investment securities and derivatives. The current economic environment has increased the degree of uncertainty inherent in those estimates and assumptions.
The following is a summary of the more significant accounting and reporting policies:
Basis of Presentation and Consolidation:
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Cole Taylor Bank (the “Bank”). The Bank is a $4.7 billion asset commercial bank located primarily in the Chicago area with asset based lending and mortgage banking offices located nationwide. The Bank provides a full range of commercial banking services, primarily to small and midsize businesses, and consumer banking products and services. All significant intercompany balances and transactions between consolidated companies have been eliminated. In accordance with applicable accounting standards, the Company does not consolidate statutory trusts (TAYC Capital Trust I and TAYC Capital Trust II) created for the sole purpose of issuing trust preferred securities.
The Company’s products and services consist of commercial banking, asset based lending, retail banking and mortgage banking. These products are delivered by two operating segments-Banking and Mortgage Banking. Segment results are presented in Note 24-“Segment Reporting.”
Cash and Cash Equivalents:
Cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits with banks or other financial institutions, federal funds sold, and securities purchased under agreements to resell with original maturities of less than 90 days. All federal funds are sold overnight with daily settlement required.
Investment Securities:
Securities that may be sold as part of the Company’s asset/liability management strategies or because of liquidity needs, changes in interest rates and resulting prepayment risk, or for other similar reasons, are classified as available for sale and carried at fair value. Unrealized holding gains and losses on such securities are reported, net of tax, in accumulated other comprehensive income in stockholders’ equity. Securities that the Company has the ability and positive intent to hold until maturity are classified as held to maturity and carried at amortized cost. Premiums and discounts on investment securities are amortized over the estimated life of the security, using the effective interest method. In determining the estimated life of mortgage-related securities, certain judgments are required as to the time and amount of future principal repayments, and these judgments are made based upon the actual performance of the underlying security and the general market consensus regarding changes in mortgage interest rates and underlying prepayment estimates.
A decline in fair value of any available for sale or held to maturity security below cost that is deemed other-than-temporary results in a reduction in carrying amount and a new cost basis for the security. In determining if an impairment is other-than-temporary, the Company considers whether it expects to receive all future principal
and interest payments in accordance with the original terms, whether it intends to sell the security, or whether it more-likely-than-not will be required to sell the security before recovery. If the Company intends to sell the security or it is more-likely-than-not that it will be required to sell the security before recovery of its amortized cost basis, an other-than-temporary impairment charge will be recognized in earnings for the difference between the amortized cost basis and the fair value of the security. If the Company does not expect to sell the security or it is not more-likely-than-not that it will be required to sell the security before recovery, the other-than-temporary impairment is separated into the amount of the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income. Prior to the adoption of a new accounting standard on April 1, 2009 that amended accounting guidance for the measurement and recognition of other-than-temporary impairment, a decline in fair value of any available for sale or held to maturity security below cost that was deemed other-than-temporary resulted in a charge to earnings to reduce the carrying amount of the security to its fair value. In determining if an impairment was other-than-temporary, the Company considered whether it had the ability and intent to hold the investment until market price recovery, the reasons for impairment, the severity and duration of the impairment, and forecasted performance of the security.
Realized gains and losses on the sales of all securities are reported in income and computed using the specific identification method. Securities classified as trading are carried at fair value with unrealized gains or losses included in noninterest income. Dividends and interest income are recognized when earned.
Loans Held for Sale:
Loans held for sale consist solely of residential mortgage loans. The Company intends to sell these loans and has elected, at inception, to account for these loans at fair value with changes in fair value recognized through profit or loss.
The Company’s agreements to sell residential mortgage loans in the normal course of business usually require general representations and warranties on the underlying loans sold related to credit information, loan documentation, collateral and insurability. The Company may be required to repurchase mortgage loans in the event of a breach of contractual representations and warranties. A reserve is created at the time of loan funding that represents the Company’s estimate of losses for loans for which a repurchase reserve has been established.
Loans:
Loans are stated at the principal amount outstanding, net of unearned discount. Unearned discount on consumer loans is recognized as income over the terms of the loans using a method that approximates an effective interest method. Interest income on other loans is generally recognized using the level-yield method. Loan origination and commitment fees and certain direct loan origination costs are deferred and the net amount is amortized over the life of the loan as an adjustment of the related loans’ yields.
Allowance for Loan Losses:
An allowance for loan losses has been established to provide for those loans that may not be repaid in their entirety. The allowance is increased by provisions for loan losses charged to expense and decreased by charge-offs, net of recoveries. The Company’s policy is to charge-off a loan when a loss is highly probable and clearly identified. For consumer loans, the Company follows the guidelines issued by its primary regulator which specifies the number of days of delinquency to charge off a consumer loan by type of credit. For commercial loans, except for unsecured loans that are generally charged-off when a loan is 90 days past due, the Company does not have a policy to automatically charge-off a commercial loan when it reaches a certain status of delinquency. If a commercial loan is determined to have impairment, the Company will either establish a specific valuation allowance or, if management deems a loss to be highly probable and clearly identified, reduce the recorded investment in that loan by taking a full or partial charge-off. In making the determination that a loss is highly probable and clearly identified, management evaluates the type, marketability and availability of the collateral along with any credit enhancements supporting the loan. In determining when to fully or partially
charge-off a loan, management considers prospects for collection of assets, likely time frame for repayment, solvency status of the borrower, the existence of practical or reasonable collection programs, the existence of shortfalls after attempts to improve collateral position, prospects for near-term improvements in collateral valuations, and other considerations identified in its internal loan review and workout processes. After a loan is charged-off, collection efforts may continue and future recoveries may occur. Management maintains the allowance at a level considered adequate to absorb probable losses inherent in the portfolio as of the balance sheet date.
In evaluating the adequacy of the allowance for loan losses, consideration is given to numerous quantitative and qualitative factors, including historical charge-off experience, growth and changes in the composition of the loan portfolio, the volume of delinquent and criticized loans, information about specific borrower situations, including their financial position, work out plans, and estimated collateral values, general economic and business conditions, duration of the business cycle, impact of competition on the Company’s underwriting terms, general market collateral values, and other factors and estimates which are subject to change over time. Estimating the risk of loss and amount of loss on any loan is necessarily subjective and ultimate losses may vary from current estimates. These estimates are reviewed quarterly and, as changes in estimates are identified by management, the amounts are reflected in income through the provision for loan losses in the appropriate period.
A portion of the total allowance for loan losses is related to impaired loans. Certain homogenous loans, including residential mortgage and consumer loans, are collectively evaluated for impairment and, therefore, excluded from impaired loans unless modified in a troubled debt restructuring (“TDR”). A loan is considered impaired if, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans include all nonaccrual loans as well as certain accruing loans judged to have higher risk of noncompliance with the present contractual repayment schedule for both interest and principal. Once a loan has been determined to be impaired, it is measured to establish the amount of the impairment, if any, based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less cost to sell. If the value of the impaired loan is less than the recorded investment in the loan, a valuation allowance is established. While impaired loans exhibit weaknesses that may inhibit repayment in compliance with the original note terms, the measurement of impairment may not always result in an allowance for loan loss for every impaired loan.
Income Recognition on Nonaccrual Loans:
Loans are placed on a nonaccrual basis for recognition of interest income when sufficient doubt exists as to the full collection of principal and interest. Generally, when a loan’s principal and interest is contractually past due 90 days it is placed on nonaccrual, unless the loan is adequately secured and in the process of collection. The nonrecognition of interest income on an accrual basis does not constitute forgiveness of the interest. After a loan is placed on nonaccrual status, any current period interest previously accrued but not yet collected is reversed against current income. Interest is included in income subsequent to the date the loan is placed on nonaccrual status only as interest is received and so long as management is satisfied that there is a high probability that principal will be collected in full. The loan is returned to accrual status only when the borrower has demonstrated the ability to make future payments of principal and interest as scheduled.
Premises, Leasehold Improvements and Equipment:
Premises, leasehold improvements and equipment are reported at cost less accumulated depreciation and amortization. Depreciation and amortization is charged to operating expense using the straight-line method for financial reporting purposes over a three to twenty-five year period, based upon the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life of the improvement.
Other Real Estate and Repossessed Assets:
Other real estate and repossessed assets primarily includes properties acquired through foreclosure or deed in lieu of foreclosure. At foreclosure or obtaining possession of the asset, other real estate or repossessed assets are recorded at the lower of the recorded investment in the loan or the fair value, less estimated cost to sell, through a charge to the allowance for loan losses, if necessary. Generally, the fair value of the real estate at foreclosure is determined by a current appraisal and the fair value of other repossessed assets is based upon the estimated net proceeds from the sale or disposition of the underlying collateral. Subsequent write-downs required by changes in fair value or disposal expenses are recorded through a valuation allowance and a provision for losses charged to noninterest expense. Carrying costs of these properties, net of related income, and gains or losses on the sale from disposition are also reported as nonperforming asset expense.
Mortgage Servicing Rights:
The Company originates and sells residential mortgage loans in the secondary market and may retain the right to service the loans sold. Upon a sale of mortgage loans for which servicing rights are retained, the retained mortgage servicing rights asset is capitalized at the fair value of future net cash flows expected to be realized for performing servicing activities. Mortgage servicing rights may also be purchased in a bulk purchase. Purchased mortgage servicing rights are recorded at fair value at the time of purchase. The Company has elected to account for mortgage servicing rights using the fair value option where changes in fair value are recognized in profit and loss. Mortgage servicing rights are included in other assets in the Company’s Consolidated Balance Sheets.
Income Taxes:
Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the income tax provision in the period in which the law is enacted. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more-likely-than-not that some portion or all of the deferred tax asset will not be realized. In determining the realizability of the deferred tax assets, management evaluates both positive and negative evidence, including the existence of any cumulative losses in the current year and prior two years, the amount of taxes paid in available carry-back years, the forecasts of future income, any applicable tax planning strategies, and assessments of current and future economic and business conditions.
The Company applies different tax treatment for selected transactions for tax return purposes than for financial reporting purposes. The accrual for income taxes includes reserves for those differences in tax and financial reporting positions. The Company initially recognizes the financial statement effects (i.e., benefit) of an uncertain tax position when it is more-likely-than-not, based on the technical merits, that the position will be sustained upon examination. Subsequently, the tax benefits of uncertain tax positions are derecognized if the Company determines the more-likely-than-not threshold is no longer met. Reserves for uncertain tax positions are reversed or utilized once the statute of limitations has expired or the tax matter is effectively settled. The Company includes any interest and penalties associated with uncertain tax positions as income tax expense on the Consolidated Statements of Operations.
Earnings Per Share:
Basic earnings per share is computed as net income applicable to common stockholders divided by the weighted-average number of common shares outstanding that are eligible to participate in the net earnings or loss for the period using the two-class method. Net income applicable to common stockholders represents net income or loss for the period less dividends declared or accumulated on preferred stock, including any discount accretion. Diluted earnings per share considers the dilutive effect of common stock equivalents, including stock options, warrants to purchase shares of common stock and preferred stock that can be converted into shares of common stock. The dilutive impact of stock options and warrants are computed using the treasury stock method. The dilutive impact of convertible preferred stock is computed using the if-converted method which assumes the
convertible security is converted at the beginning of the period (or issuance, if later), resulting in an increase to the number of common shares outstanding but a decrease to the amount of preferred dividends that would have been included in the determination of net income applicable to common stockholders. The computation of diluted earnings per share does not assume conversion or exercise of common stock equivalents that would have an antidilutive effect on earnings per share. A reconciliation of the net income applicable to common stockholders and weighted average shares used in the basic and diluted earnings per share computation is included in Note 23-“Earnings Per Share.”
Employee Benefit Plans:
Stock-based Compensation: The Company has an incentive compensation plan that allows the issuance of nonqualified stock options and restricted stock awards to employees and directors. The Company recognizes compensation for all stock-based payment awards made to employees or directors over the award’s requisite service period using the straight-line method. The amount recognized is equal to the fair value of the award at the date of the grant. Since stock-based compensation expense recognized is based on awards ultimately expected to vest, the expense has been reduced by estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates.
Nonqualified Deferred Compensation Plan: The Company maintains a nonqualified deferred compensation program for certain key employees which allows participants to defer a portion of their base salaries, commissions, or incentive compensation. The amount of compensation deferred by a participant, along with any Company discretionary contributions to the plan, are held in a rabbi trust for the participant. The Company’s discretionary contributions are recorded as additional compensation expense when contributed. While the Company maintains ownership of the assets, the participants are allowed to direct the investment of the assets in several equity and fixed income mutual funds. These assets are recorded at their fair value in other assets on the Consolidated Balance Sheets. A liability is established, in accrued interest, taxes and other liabilities on the Consolidated Balance Sheets, for the fair value of the obligation to the participants. Any increase or decrease in the fair value of plan assets is recorded in other noninterest income on the Consolidated Statements of Operations. Any increase or decrease in the fair value of the deferred compensation obligation to participants is recorded as additional compensation expense or a reduction of compensation expense on the Consolidated Statements of Operations.
Derivative Financial Instruments and Hedging Activities:
The Company uses derivative financial instruments (derivatives), including interest rate exchange agreements, callable interest rate swap agreements, interest rate corridors, floors and collars, as well as interest rate lock and forward loan sale commitments to either accommodate individual customer borrowing needs or to assist in its own interest rate risk management. The Company’s asset and liability management and investment policies do not allow the use of derivatives for trading purposes. All derivatives are measured and reported at fair value on the Consolidated Balance Sheets as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in current earnings during the period of the change in the fair values. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value of the derivative. Similarly, the changes in the fair value of derivatives that do not qualify for hedge accounting or are not designated as an accounting hedge are also reported currently in earnings, in noninterest income.
The net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged. The net cash settlements on derivatives that do not qualify for hedge accounting or are not designated as an accounting hedge are reported in noninterest income.
At the inception of the hedge and quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivatives have been highly effective in offsetting the changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. The Company discontinues hedge accounting prospectively when it is determined that the derivative is or will no longer be effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative expires, is sold, or terminated, or management determines that designation of the derivative as a hedging instrument is no longer appropriate.
When hedge accounting is discontinued, the future gains and losses arising from any change in fair value are recorded as noninterest income. When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a cash flow hedge is discontinued but the hedged cash flows or forecasted transaction is still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized or accreted into earnings over the same periods in which the hedged transactions would have affected earnings.
The estimates of fair values of the Company’s derivatives are calculated using independent, third-party valuation models to estimate market-based valuations with the exception of the valuation of forward loan sale commitments and interest rate lock commitments, which are valued using internal models. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both the Company and the counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in income statement volatility.
Debt Issuance Costs and Discounts:
In connection with the issuance of the Company’s junior subordinated debentures and the Company’s and Bank’s subordinated notes, issuance costs were incurred, including underwriting fees, legal and professional fees, and other costs. These costs are included in other assets on the Company’s Consolidated Balance Sheets and are being amortized over the contractual life of the debt as additional interest expense using an effective interest method. In addition, the Company’s and Bank’s subordinated notes were issued with detachable warrants to purchase shares of the Company’s common stock. The proceeds from the issuance of the subordinated notes were allocated to the notes and warrants based upon their relative fair values. The allocation to the warrants created a discount on the subordinated notes. This discount is being accreted as additional interest expense on the subordinated notes over the remaining contractual life of the notes using an effective interest method.
Financial Instruments:
In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit, unused lines of credit, letters of credit, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded, except that the fair value of standby letters of credit are recorded as a liability on the Consolidated Balance Sheets and amortized over the commitment period. In addition, the Company establishes a reserve for unfunded commitments, in accrued interest, taxes and other liabilities on the Consolidated Balance Sheets, if it is probable that a liability has been incurred by the Company under a standby letter of credit or a loan commitment that has not been funded.
Comprehensive Income:
Comprehensive income or loss includes net income or loss, changes in unrealized holding gains and losses on available for sale securities, changes in unrealized gains and losses associated with cash flow hedging instruments, and the amortization of deferred gains and losses associated with terminated cash flow hedges. The statement of comprehensive income is included within the Consolidated Statements of Changes in Stockholders’ Equity. See Note 22-“Other Comprehensive Income (Loss)” for further details.
New Accounting Standards:
In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This ASU defers only those changes to ASU 2011-05 that relate to the presentation of reclassification adjustments in order to allow the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income (“OCI”) on the components of net income and OCI for all periods presented. While this issue is being reconsidered, entities should continue to report reclassifications out of accumulated OCI consistent with guidance in effect prior to ASU 2011-05. This ASU is effective for the interim or annual periods beginning after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” ASU No. 2011-05 provides guidance to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in OCI. The FASB has eliminated the option to present OCI as part of the statement of changes in stockholders’ equity. This ASU will require either the addition of OCI to the current statement of operations for one single statement of comprehensive income or the addition of a statement that presents total OCI. This ASU is effective for the interim or annual periods beginning after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU No. 2011-05 improves the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP (U.S. generally accepted accounting principles) and IFRSs (international financial reporting standards). The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. This ASU is effective for the interim and annual period that begins after December 15, 2011. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In April 2011, the FASB issued ASU No. 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 removes two criteria from the assessment of effective control when determining whether a repurchase agreement should be accounted for as a sale or as a secured borrowing. The remaining criteria indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) if all of certain conditions are met. This ASU is effective for the interim or annual period that begins after December 15, 2011, with no early adoption permitted. This accounting standard is not expected to have a material effect on our consolidated financial statements.
In April 2011, the FASB issued ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” ASU No. 2011-02 provides guidance on determining whether a restructuring constitutes a troubled debt restructuring. In order to be classified as a trouble debt restructuring, the restructuring must contain a concession and the debtor must be experiencing financial difficulties. This ASU became effective for the periods beginning on or after June 15, 2011 and was applied retrospectively to the beginning of the annual period of adoption. This ASU further states that all troubled debt restructuring disclosures required by ASU 2010-20 that had been deferred by ASU No. 2011-01, should be disclosed effective for interim and annual
periods beginning on or after June 15, 2011. This accounting standard was adopted as of the third quarter 2011 and the adoption did not have a material effect on our consolidated financial statements.
Reclassifications:
Amounts in the prior years’ consolidated financial statements are reclassified whenever necessary to conform to the current year’s presentation.
2. Cash and Due from Banks
The Bank is required to maintain a balance with the Federal Reserve Bank to cover reserve requirements. The average balance required to be maintained was $2.1 million for the year ended December 31, 2011 and $12.2 million for the year ended December 31, 2010.
3. Investment Securities
The amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of investment securities at December 31, 2011 and 2010 are as follows:
As of December 31, 2011, the Company had $1.19 billion (estimated fair value) of mortgage related investment securities which consisted of residential and commercial mortgage-backed securities and collateralized mortgage obligations. Residential mortgage-backed securities and collateralized mortgage obligations include securities collateralized by 1-4 family residential mortgage loans, while commercial mortgage-backed securities include securities collateralized by mortgage loans on multifamily properties. Of the total mortgage related investment securities, $1.18 billion (estimated fair value), or 99.6%, were issued by government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac, and the remaining $4.9 million were private-label mortgage related securities.
Investment securities with an approximate book value of $930 million at December 31, 2011 and $969 million at December 31, 2010, were pledged to collateralize certain deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes as required or permitted by law.
During 2011, the Company realized gross gains of $5.0 million and gross losses of $80,000 on the sale of available for sale investment securities. This compares to gross realized gains of $41.4 million and gross realized losses of $14,000 on the sales of available for sale investment securities during 2010 and gross realized gains of $17.6 million and gross realized losses of $10,000 on the sales of available for sale investment securities during 2009.
The following table summarizes, for investment securities with unrealized losses as of December 31, 2011 and 2010, the amount of the unrealized loss and the related fair value. The securities have been further segregated by those that have been in a continuous unrealized loss position for less than twelve months and those that have been in a continuous unrealized loss position for twelve or more months.
At December 31, 2011, the Company had three securities in its investment portfolio that have been in an unrealized loss position for twelve or more months with a total unrealized loss of $1.7 million. The three securities were from the Company’s portfolio of private-label residential mortgage-backed securities.
Of the three private-label residential mortgage related securities, one was in an unrealized loss position of less than 10% of amortized cost. As part of its normal process, the Company reviewed the security, considering the severity and duration of the loss and current credit ratings, and believes that the decline in fair value was not credit related but related to changes in interest rates and current illiquidity in the market for these types of securities. The other two private-label residential mortgage related securities had a total unrealized loss of $1.5 million, and were subject to further review for other-than-temporary impairment.
For any securities that have been in an unrealized loss position for more than 12 months that was greater than 10%, additional testing is performed to evaluate other-than-temporary impairment. For the two private-label residential mortgage-backed securities, the Company obtained fair value estimates from an independent source and performed a cash flow analysis, considering default rates, loss severities based upon the location of the collateral and estimated prepayments. Each of the private-label mortgage related securities had credit enhancements in the form of different investment tranches which impact how cash flows are distributed. The higher level tranches will receive cash flows first and as a result, the lower level tranches will absorb the losses, if any, from collateral shortfalls. The Company purchased the private-label securities that were either of the highest or one of the highest investment grades, as rated by nationally recognized credit rating agencies. The cash flow analysis takes into account the Company’s tranche and the current level of support provided by the lower tranches. The Company believes that market illiquidity has impacted the values of these private-label securities because of the lack of active trading. Neither of these securities contains subprime mortgage loans, but do include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. If this analysis shows that the Company does not expect to recover its entire investment, an other-than-temporary impairment charge would be
recorded for the amount of the credit loss. Previously, one of the two securities had other-than-temporary impairment recognized for the amount of the expected credit loss. The independent cash flow analysis performed at December 31, 2011 indicated that there was additional credit loss on this security and the Company recorded an additional $190,000 other-than-temporary-impairment charge in 2011. For the other private-label security reviewed, the independent cash flow analysis showed that the Company expects to recover its entire investment and, therefore, the decline in fair value was not due to credit, but was most likely caused by illiquidity in the market, and no other-than-temporary impairment charge was recorded.
One additional investment security was evaluated for other-than-temporary impairment at December 31, 2011. This security is in the Company’s state and municipal obligation portfolio and was received in 2008 in a loan work out arrangement. Scheduled payments were received as agreed from 2008 until the May 2011 interest payment, which was not received. Since the Company now believes that it will not recover all the expected payments of principal and interest as specified in the bond agreement, the expected future annual cash flows were analyzed and an other-than-temporary impairment charge of $381,000 was recorded against earnings in 2011.
At December 31, 2010, the Company had three securities in its investment portfolio that have been in an unrealized loss position for twelve or more months with a total unrealized loss of $1.7 million. The three securities were from the Company’s portfolio of private-label residential mortgage-backed securities.
The following table shows the contractual maturities of debt securities, categorized by amortized cost and estimated fair value, at December 31, 2011.
Investment securities do not include the Bank’s investment in Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank (“FRB”) stock of $56.8 million at December 31, 2011 and $40.0 million at December 31, 2010. These investments are required for membership and are carried at cost.
The Bank must maintain a specified level of investment in FHLBC stock based upon the amount of its outstanding FHLB borrowings. At December 31, 2011, the Company had a $45.1 million investment in FHLBC stock, compared to $29.5 million at December 31, 2010. Since 2007, the FHLBC has been under a cease and desist order with its regulators that requires prior regulatory approval to declare dividends and to redeem member capital stock other than excess capital stock under limited circumstances. The stock of the FHLBC is viewed as a long-term asset and its value is based upon the ultimate recoverability of the par value. In determining the recoverability of this investment, the Company considers factors such as the severity and duration of declines in the market value of the FHLBC’s net assets relative to its capital, its recent operating performance, its
commitment to make required payments, the structure of the FHLB system which enables the regulator of the FHLBs to reallocate debt among the FHLB entities, the impact of legislative and regulatory changes on the FHLBC and its operations, and its ability to continue to provide liquidity and funding to its members.
As of December 31, 2011, after evaluating these factors and considering that transactions in FHLBC stock continued to be made at par value during 2011 and the FHLBC paid dividends in each quarter of 2011, the Company believes that it will ultimately recover the par value of the FHLBC stock.
4. Loans
Loans segregated by class at December 31, 2011 and 2010 are as follows:
The total amount of loans transferred to third parties as loan participations at December 31, 2011 was $245.4 million, all of which has been recognized as a sale under the applicable accounting guidance in effect at the time of the transfer. The Company continues to have involvement with these loans through relationship management and servicing responsibilities.
At December 31, 2011, loans held for sale included $186.0 million of residential mortgage loans originated by Cole Taylor Mortgage. The Company has elected to account for these loans under the fair value option in accordance with ASC 825-Financial Instruments. The unpaid principal balance associated with these loans was $179.3 million at December 31, 2011. An unrealized gain on these loans of $6.7 million was included in mortgage banking revenues in noninterest income on the Consolidated Statements of Operations for the year ended December 31, 2011. None of these loans are 90 days or more past due or on a nonaccrual status. Interest income on these loans is included in interest income and is not considered part of the change in fair value.
Nonperforming loans include nonaccrual loans and interest-accruing loans contractually past due 90 days or more. Loans are placed on a nonaccrual basis for recognition of interest income when sufficient doubt exists as to the full collection of principal and interest. Generally, loans are to be placed on nonaccrual when principal and interest is contractually past due 90 days, unless the loan is adequately secured and in the process of collection.
The following table presents the aging of loans by class as of December 31, 2011 and December 31, 2010:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company uses the following definitions for risk ratings:
Pass. Loans in this category range from loans that are virtually risk free to those with borderline risk where the borrower has unstable operating history containing losses or adverse trends have weakened its financial condition that have not currently impacted repayment ability but may in the future if not corrected.
Special Mention. Loans in this category have potential weaknesses which currently weaken the asset or inadequately protect the Bank’s credit position and if not immediately corrected will diminish repayment prospects.
Substandard. Loans in this category relate to borrowers with deteriorating financial conditions and exhibit a number of well-defined weaknesses which currently inhibit normal repayment through normal operations. These loans require constant monitoring and supervision by Bank management.
Nonaccrual. Loans in this category exhibit the same weaknesses as substandard loans, however, the weaknesses are more pronounced and these loans are no longer accruing interest.
The following table presents the risk categories of loans by class at December 31, 2011 and December 31, 2010:
The following table sets forth information about our nonaccrual loans, performing restructured loans (TDRs that are not past due or in a nonaccrual status) and impaired loans. The amounts of nonperforming loans at December 31, 2011, 2010 and 2009 and the related interest on nonaccrual loans for the years then ended are shown below:
Impaired loans include all nonaccrual loans as well as certain accruing loans judged to have higher risk of noncompliance with the present contractual repayment schedule for both interest and principal. Unless modified in a trouble debt restructuring, certain homogenous loans, such as residential mortgage and consumer loans, are collectively evaluated for impairment and are, therefore, excluded from impaired loans. The Company’s policy is to charge-off a loan when a loss is highly probable and clearly identified. For consumer loans, the Company follows the guidelines issued by its primary regulator which specifies the number of days of delinquency to charge-off a consumer loan by type of credit. Except for unsecured commercial loans that are generally charged-off when a loan is 90 days past due, the Company does not have a policy to automatically charge-off a commercial loan when it reaches a certain status of delinquency. If a commercial loan is determined to have impairment, the Company will either establish a specific valuation allowance or, if management deems a loss to be highly probable and clearly identified, reduce the recorded investment in that loan by taking a full or partial charge-off. In making the determination that loss is highly probable and clearly identified, management evaluates the type, marketability and availability of the collateral along with any credit enhancements supporting the loan. In determining when to fully or partially charge-off a loan, management considers the prospects for collection of assets, likely time frame for repayment, solvency status of the borrower, the existence of practical or reasonable
collection programs, the existence of shortfalls after attempts to improve collateral position, prospects for near-term improvements in collateral valuations and other considerations identified in its internal loan review and workout processes.
The Company had $3.1 million of letters of credit outstanding related to nonaccrual and impaired loans as of December 31, 2011. The Company had $396,000 in commitments to lend on impaired loans as of December 31, 2011, with $329,000 of that amount committed to loans that are classified as TDRs. At December 31, 2011, the Company had $14.2 million of loans classified as performing restructured loans which included commercial loans of $9.4 million and consumer loans of $4.8 million.
Information about the Company’s impaired loans at or for the years ended December 31, 2011, 2010, and 2009 is as follows:
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2011 and December 31, 2010:
The Company provides several types of loans to its customers, including residential, construction, commercial, and consumer loans. Lending activities are conducted with customers in a wide variety of industries as well as with individuals with a wide variety of credit requirements. Credit risks tend to be geographically concentrated in that the majority of the Company’s customer base lies within the Chicago area. Furthermore, 46% of the Company’s loan portfolio involves loans that are to some degree secured by real estate properties located primarily within the Chicago area as of December 31, 2011, compared to 52% as of December 31, 2010.
Activity in the allowance for loan losses for the years ended December 31, 2011, 2010, and 2009 consisted of the following:
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by class and based on impairment method as of December 31, 2011 and December 31, 2010:
A modified loan is considered a TDR when the borrower is experiencing documented financial difficulty and concessions are made by the Company that would not otherwise be considered for a borrower with similar credit characteristics at the outset of a new loan. The most common types of modifications include interest rate modifications, forbearance on principal and/or interest, partial charge-offs and changes in note structure. All loans modified in a TDR are evaluated for impairment in accordance with the Company’s allowance for loan loss methodology.
For the commercial portfolio, loans modified in a TDR are separately evaluated for impairment at the time of restructuring and at each subsequent reporting date for as long as they are reported as TDRs. The impairment evaluation is generally measured by comparing the recorded investment in the loan to the fair value of the collateral net of estimated costs to sell if the loan is collateral dependent. The Company recognizes a specific valuation allowance equal to the amount of the measured impairment, if applicable.
Commercial and consumer loans modified in a TDR are classified as impaired loans for a minimum of one year. After one year, a loan is no longer included in the balance of impaired loans if the loan was modified to yield a market rate for loans of similar credit risk at the time of restructuring and the loan is performing based on the terms of the restructuring agreement, although the loan continues to be reported as a TDR.
Upon the Company’s adoption of the recent changes to ASC 310-Receivables, loans modified from January 2011 through June 2011 were reanalyzed to determine if those modified loans would be considered a TDR. No additional loans were identified as TDRs and no changes were made to the allowance for loan losses as a result of this analysis.
The following table provides information on loans modified as a TDR during the year ended December 31, 2011. The Pre-Modification Outstanding Recorded Balance is equal to the outstanding balance immediately prior to modification. The Post-Modification Outstanding Recorded Balance is equal to the outstanding balance immediately after modification:
The following table provides information on TDRs that defaulted for the first time during the period indicated and had been modified within the last twelve months.
As of December 31, 2011 and 2010, the Company had extended loans to directors and executive officers of the Bank, the Company and their related interests as detailed in the table below:
In the opinion of management, these loans were made in the normal course of business and on substantially the same terms for comparable transactions with other borrowers and do not involve more than a normal risk of collectability.
5. Premises, Leasehold Improvements and Equipment
Premises, leasehold improvements and equipment at December 31, 2011 and 2010 are summarized as follows:
6. Other Real Estate and Repossessed Assets
A rollforward of other real estate and repossessed assets, for the periods indicated is as follows:
The Company maintained a valuation allowance for losses on other real estate and repossessed assets of $10.7 million at December 31, 2011 and $12.5 million at December 31, 2010.
7. Interest-Bearing Deposits
Interest-bearing deposits at December 31, 2011 and 2010 are summarized as follows:
At December 31, 2011, time deposits in the amount of $100,000 or more totaled $562.3 million compared to $645.4 million at December 31, 2010. Interest expense on time deposits with balances of $100,000 or more was $4.7 million for the year ended December 31, 2011, $7.3 million for the year ended December 31, 2010, and $10.6 million for the year ended December 31, 2009.
The Bank participates in two programs in the Certificate of Deposit Account Registry Service network (“CDARS”). The reciprocal program allows the Bank to accommodate depositors with large cash balances who are seeking the full deposit insurance protection by placing these funds in CDs issued by other banks in the network. Through a matching system, the Bank will receive funds back for certificates of deposit (“CDs”) that it issues for other banks in the network, thus allowing the Bank to retain the full amount of the original deposit. The Bank also participates in the one-way buy program. Through this system, the Bank bids on funds from depositors who are attempting to maximize the return on their deposit while they are continuing to maintain the full FDIC insurance on their deposits. Funds are deposited in the bank with the winning bid.
Brokered CDs are carried net of mark-to-market adjustments when they are the hedged item in a fair value hedging relationship and net of the related broker placement fees of $2.0 million at December 31, 2011 and $1.6 million at December 31, 2010, which are amortized to the maturity date of the related brokered CDs. The
amortization is included in deposit interest expense. As of December 31, 2011, the Company had four brokered CDs with a balance of $60.0 million, that could be called after a lock-out period but before their stated maturity. During 2011 and 2010, the Company did not incur any expenses associated with brokered CDs that were called before their stated maturity.
At December 31, 2011, the scheduled maturities of total time deposits are as follows:
8. Other Borrowings
Other borrowings at December 31, 2011 and 2010 are summarized as follows:
As of December 31, 2011 and 2010, the term repurchase agreements consisted of the following:
Under the terms of the securities sold under agreements to repurchase, if the market value of the pledged securities declines below the repurchase liability, the Bank may be required to provide additional collateral to the counterparty. For overnight repurchase agreements, the Bank maintains control of the pledged securities. However, for the term repurchase agreements, the pledged securities are held by the counterparty.
During 2011, the Company modified the terms of an existing structured repurchase agreement to extend the maturity date and reduce the interest rate. The new instrument was treated as a modification of the old instrument in accordance with ASC Topic 740-Debt. In addition, three structured repurchase agreements were terminated in 2011. The Company incurred a net amount of $3.4 million in early extinguishment of debt expense in 2011 recorded in noninterest expense related to these terminations. These changes were made to shift funding sources to lower cost alternatives. At December 31, 2011, there were no term repurchase agreements eligible to be called.
Information concerning securities sold under agreements to repurchase, including both the overnight and term agreements, for the years ended December 31, 2011, 2010 and 2009 is summarized as follows:
Under the treasury tax and loan note option, the Bank is authorized to accept U.S. Treasury Department deposits of excess funds along with the deposits of customer taxes. These liabilities bear interest at a rate of 0.25% below the average federal funds rate (0.00% at December 31, 2011) and are collateralized by a pledge of various investment securities. This program will no longer be offered as of January 1, 2012.
At December 31, 2011, subject to available collateral, the Bank had total pre-approved overnight federal funds borrowings of $164 million and repurchase agreement lines of $850 million. At December 31, 2010, subject to available collateral, the Bank had total pre-approved overnight federal funds borrowings of $119 million and repurchase agreement lines of $930 million.
9. Income Taxes
The components of the income tax expense (benefit) for the years ended December 31, 2011, 2010 and 2009 are as follows:
During 2011, the Company recorded current income tax expense of $368,000, primarily related to the release of the residual tax effects of changes in the beginning of the year valuation allowance previously
allocated to OCI. These residual tax effects resulted from changes in the deferred tax liability associated with deferred gains on terminated cash flow hedges recorded in OCI. During 2010, the Company recorded income tax expense of $1.2 million.
Income tax expense (benefit) is different from the amounts computed by applying the federal statutory rate of 35% for the years ended December 31, 2011, 2010, and 2009 to income (loss) before income taxes because of the following:
Under U.S. generally accepted accounting principles, a valuation allowance against a net deferred tax asset is required to be recognized if it is more-likely-than-not that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax asset is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions.
In 2008, the Company determined a valuation allowance was necessary, largely based on negative evidence including cumulative losses caused by credit losses in the residential real estate construction portfolio and general uncertainty surrounding future economic and business conditions.
The Company evaluates the need for a deferred tax asset valuation allowance on an ongoing basis, considering both positive and negative evidence. For the year ended December 31, 2011, positive evidence included the Company’s return to profitability, continued improvement in asset quality and credit ratios, the continued reduction in real estate construction and bank and bank holding company loan portfolios that had substantial losses in the past three years and an improving economic environment. Negative evidence included the Company’s cumulative losses from 2009 through 2011, no available taxes paid in open carryback years and no significant tax planning opportunities to accelerate income. Based on the Company’s assessment of all available evidence, management determined that it is more-likely-than-not that the deferred tax asset will be realized. Therefore, at December 31, 2011, the Company released its $73.2 million valuation allowance against the net deferred tax assets resulting in a credit to income tax (benefit) expense.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2011 and 2010 are presented below:
At December 31, 2011, the Company had $104.4 million of Illinois State operating loss carry forwards that will begin to expire in 2023. In addition, the Company had a federal operating loss carry forward of $63.6 million that will begin to expire in 2029, a federal tax credit carry forward of $1.3 million that will begin to expire in 2029 and a $1.4 million alternative minimum tax credit carry forward that can be carried forward indefinitely.
As of December 31, 2011, the Company maintained a reserve for unrecognized tax positions of $37,000, compared to a reserve of $90,000 at December 31, 2010.
The Company is no longer subject to examination by federal tax authorities for the years 2004 and prior because the statute of limitations has expired. The Company, which is located and primarily does business in Illinois, is no longer subject to examination by the Illinois taxing authorities for the years 2007 and prior because the statute of limitations has expired.
10. Notes Payable and Other Advances
Other advances at December 31, 2011 and 2010 consisted of the following:
There were no notes payable outstanding at December 31, 2011 or December 31, 2010.
In 2011, the Company modified the terms of two existing FHLB advances to extend the maturity date and convert the fixed rate to a variable rate. The new instruments were treated as modifications of the old instruments in accordance with ASC Topic 740-Debt. These changes were made to shift funding sources to lower cost alternatives.
The Bank participates in the Federal Reserve Bank’s Borrower In Custody (“BIC”) program. At December 31, 2011 the Bank had pledged $569.2 million of commercial loans as collateral for available $463.3 million borrowing capacity under the BIC program at the FRB. This compares to December 31, 2010 when the Bank had pledged $813.1 million of commercial loans as collateral for available $504.9 million borrowing capacity under the BIC program at the FRB. The Bank had no advances from the FRB at December 31, 2011 or December 31, 2010.
At December 31, 2011, the FHLB advances were collateralized by $782.1 million of investment securities and a blanket lien on $390.8 million of qualified first-mortgage residential, home equity and commercial real estate loans. Based on the value of collateral pledged at December 31, 2011, the Bank had additional borrowing capacity at the FHLB of $277.3 million. In comparison, at December 31, 2010, the FHLB advances were collateralized by $521.6 million of investment securities and a blanket lien on $332.4 million of qualified first-mortgage residential, home equity and commercial real estate loans with additional borrowing capacity of $223.6 million.
11. Junior Subordinated Debentures
The following table summarizes the amount of junior subordinated debentures issued by the Company to TAYC Capital Trust I and TAYC Capital Trust II as of December 31, 2011 and 2010:
In October 2002, the Company formed TAYC Capital Trust I, a wholly-owned subsidiary and a Delaware statutory trust to issue trust preferred securities. TAYC Capital Trust I used the proceeds from the sale of these trust preferred securities, along with proceeds from the purchase of its common equity securities, to invest in 9.75% junior subordinated debentures of the Company. The sole assets of TAYC Capital Trust I are the Company’s junior subordinated debentures. Interest on both the trust preferred securities and junior subordinated debentures is payable quarterly at a rate of 9.75% per year.
In June 2004, the Company formed TAYC Capital Trust II, a wholly-owned subsidiary and a Delaware statutory trust to issue trust preferred securities. TAYC Capital Trust II used proceeds from the sale of these trust preferred securities, along with proceeds from the purchase of its common equity securities, to invest in the floating rate junior subordinated debentures of the Company. The sole assets of TAYC Capital Trust II are the Company’s junior subordinated debentures. The interest rate on both the trust preferred securities and the junior subordinated debentures equals the three-month LIBOR plus 2.68% and re-prices quarterly on the 17th of September, December, March and June. The interest rate on both the trust preferred securities and the junior subordinated debenture was 3.24% and 2.98% at December 31, 2011 and 2010, respectively.
The Company may redeem all or part of each of the junior subordinated debentures at any time, subject to approval by the Federal Reserve Bank, at a redemption price equal to 100% of the aggregate liquidation amount of the debentures plus any accumulated and unpaid distributions thereon to the date of redemption. Each of the trust preferred securities is subject to mandatory redemption when the related junior subordinated debentures are paid at maturity or upon any earlier redemption of the debentures. Each of the trust preferred securities may also be redeemed at any time in the event of unfavorable changes in certain laws or regulations.
The Company may defer the payment of interest on each of the junior subordinated debentures at any time for a period not exceeding 20 consecutive quarters, provided that the deferral period does not extend past the stated maturity. During any such deferral period, distributions on the corresponding trust preferred securities will also be deferred and the Company’s ability to pay dividends on its common shares will be restricted. The Company also has agreed, consistent with its past practice, to continue to provide its regulators notice before the payment of interest on the junior subordinated debentures related to the trust preferred securities. Issuance costs from each issuance of the trust preferred securities, consisting primarily of underwriting discounts and professional fees, were capitalized and are being amortized over 30 years, or through the maturity dates, to interest expense using the straight-line method. At December 31, 2011, unamortized issuance costs related to TAYC Capital Trust I and TAYC Capital Trust II were $2.1 million and $352,000, respectively.
The Company’s obligations with respect to each of the trust preferred securities and the related debentures, in the aggregate, constitute a full, irrevocable and unconditional guarantee on a subordinated basis by the Company of the obligations of each of the Trusts under the respective trust preferred securities.
In accordance with applicable accounting standards, the Company does not consolidate TAYC Capital Trust I and TAYC Capital Trust II. The equity investments in the Trusts of $2.5 million at December 31, 2011 and $2.6 million at December 31, 2010, are reported in other assets on the Consolidated Balance Sheets.
12. Subordinated Notes
The carrying value of subordinated notes at December 31, 2011 and 2010 is as follows:
On September 24, 2008, the Bank issued $60.0 million of 10% subordinated notes. The subordinated notes pay interest quarterly at an annual rate of 10% and will mature on September 29, 2016, but currently can be prepaid at the Bank’s option. The subordinated notes are subordinated unsecured obligations of the Bank and are subordinate to all deposits, purchased funds, and senior indebtedness of the Bank. The notes also contain restrictions on the Bank’s ability to pay dividends to the Company in the event the Bank fails to make any required principal and interest payments. The Company also has agreed, consistent with its past practice, to continue to provide its regulators notice before the payment of any interest on the Bank’s subordinated notes. In addition, for every $1,000 in principal amount of the subordinated notes, investors received a warrant to purchase 15 shares of the Company’s common stock at an exercise price of $10.00 per share, subject to customary anti-dilution adjustments, which represents an aggregate of 900,000 shares of common stock. The warrants will expire on September 29, 2013. The proceeds received from this transaction were allocated to the subordinated notes and the warrants based upon their relative fair values. The discount represents the portion of the proceeds allocated to the warrants and is being amortized as additional interest expense on the subordinated notes over the remaining contractual life of the notes. The fair value allocated to the warrants, totaling $4.7 million at the issuance date of September 24, 2008, net of issuance costs, was credited to surplus in stockholders’ equity on the Company’s Consolidated Balance Sheets. The subordinated notes qualify as Tier 2 capital for regulatory capital purposes.
On May 28, 2010, the Company issued $33.9 million of 8% subordinated notes. The subordinated notes pay interest quarterly at an annual rate of 8% and will mature on May 28, 2020, but may be prepaid at the Company’s option on or after May 28, 2012. The subordinated notes are subordinated unsecured obligations of the Company and are subordinate to the general creditors of the Company. The notes also contain restrictions on the Company’s ability to pay dividends in the event the Company fails to make any required principal and interest payments. The Company also has agreed, consistent with its past practice, to continue to provide its regulators notice before the payment of any of the interest on the subordinated notes. In addition, for every $1,000 in principal amount of the subordinated notes, investors received a warrant to purchase 25 shares of the Company’s common stock at an exercise price of $12.28 per share, representing an aggregate of 848,450 shares of common
stock. The warrants are currently exercisable and will expire on May 28, 2015. The proceeds received from this transaction were allocated to the subordinated notes and the warrants based on their relative fair values. The discount represents the portion of the proceeds allocated to the warrants and is being amortized as additional interest expense on the subordinated notes over the remaining contractual life of the notes. The fair value allocated to the warrants, totaling $4.4 million at the issuance date of May 28 2010, net of issuance costs, was credited to surplus in stockholders’ equity on the Company’s Consolidated Balance Sheets. The subordinated notes qualify as Tier 2 capital for regulatory purposes.
On October 21, 2010, the Company issued $3.6 million of 8% subordinated notes which will pay interest quarterly at an annual rate of 8% and will mature on May 28, 2020, but may be prepaid at the Company’s option on or after May 28, 2012. These notes also contain restrictions on the Company’s ability to pay dividends in the event the Company fails to make any required principal and interest payments. In addition, for every $1,000 in principal amount of the subordinated notes, investors received a warrant to purchase 25 shares of the Company’s common stock at an exercise price of $12.28 per share, representing an aggregate of 89,050 shares of common stock. These warrants are immediately exercisable and will expire on May 28, 2015. The proceeds were allocated between the subordinated notes and the warrants based on their relative fair values. The discount represents the portion of the proceeds allocated to the warrants and is being amortized as additional interest expense on the subordinate notes over the remaining contractual life of the note. The fair value allocated to the warrants, totaling $420,000 at the issuance date of October 21, 2010, net of issuance costs, was credited to surplus in stockholders’ equity on the Company’s Consolidated Balance Sheets. The subordinated notes qualify as Tier 2 capital for regulatory purposes.
13. Employee Benefit Plans
The Company maintains a 401(k) Plan for its employees. Contributions to the 401(k) Plan are made at the discretion of the Board of Directors, with the exception of certain 401(k) matching of employee contributions. The 401(k) Plan allows participants a choice of several equity and fixed income mutual funds. Company common stock is not an investment option for 401(k) participants. For the years ended December 31, 2011, 2010 and 2009, contributions paid to the 401(k) Plan were $1.7 million, $1.4 million, and $1.1 million, respectively.
On May 31, 2008, the Company filed a request to terminate a previously established Profit Sharing/Employee Stock Ownership Plan (“ESOP”). The Company received its final determination letter from the IRS on December 14, 2009 allowing the termination of the ESOP. As of December 31, 2009, the ESOP held 290,133 shares of Company common stock and cash totaling $256,000, for a total value of the ESOP (cash plus value of shares on December 31, 2009) of $3.6 million. Participants became fully vested in their accounts when the request was filed. A final valuation was completed in May 2010, and all participants were notified in writing that they were entitled to take their distribution or rollover their account balances. As of December 31, 2010, all distributions had been made.
The Company also maintains a non-qualified deferred compensation plan for certain key employees that allow participants to defer a portion of base and incentive compensation. The Company also may make contributions and discretionary matching contributions to the plan. The deferrals and Company contributions are held in a rabbi trust for the participants. While the Company maintains ownership of the assets, the participants are able to direct the investment of the assets into several equity and fixed income mutual funds. Company common stock is not an investment option for the participants. The Company records the assets at their fair value in other assets on the Consolidated Balance Sheets. The liability to participants is recorded in other liabilities on the Consolidated Balance Sheets. Total assets and the corresponding liability in the nonqualified deferred compensation plan totaled $2.7 million and $2.6 million at December 31, 2011 and 2010, respectively.
14. Stock-Based Compensation
At the 2011 Annual Meeting held on May 12, 2011, the Company’s stockholders approved the 2011 Incentive Compensation Plan (the “Plan”) which provides for the granting of stock-based compensation awards. The Plan replaced the 2002 Incentive Compensation Plan and increased the total number of shares available for issuance by 1,200,000. Under the Plan, directors, officers and employees selected by the Board of Directors are eligible to receive awards, including incentive stock options, nonqualified stock options, stock appreciation rights, stock awards and performance awards. The Company has only issued nonqualified stock options and restricted stock awards under the Plan. As of December 31, 2011, a total of 1,588,110 shares of common stock were authorized for use in the Plan. The amount of shares available for future grants may increase as any outstanding issuances under the 2002 Plan are either forfeited, terminated or otherwise lapse or expire without the issuance of shares. As of December 31, 2011, 1,600,630 shares were available for future grants, including forfeitures of prior outstanding issuances.
During 2011, the Company recognized $2.6 million of stock-based compensation expense which consisted of $2.2 million related to restricted stock grants and $430,000 related to stock options grants. In comparison, during 2010, the Company recognized $2.2 million of stock-based compensation expense which consisted of $1.6 million for restricted stock grants and $512,000 for stock option grants, while total stock-based compensation expense in 2009 was $2.1 million which consisted of $1.7 million for restricted stock grants and $406,000 for stock option grants.
Stock Options:
The Company is required to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as compensation expense in the Company’s Consolidated Statements of Operations over the requisite service periods using a straight-line method. Since stock-based compensation expense is based on awards ultimately expected to vest, the expense is reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
Generally, stock options are granted with an exercise price equal to the fair market value of the common stock on the date of grant. Since 2006, stock options granted vest over a four year period (vesting at 25% per year) and expire eight years following grant date. Stock options granted prior to 2006 vest over a five year period (vesting at 20% per year) and expire 10 years following the grant date. In either case, upon death, disability, retirement or change of control of the Company (as defined in the Plan) vesting may be accelerated to 100%.
The following is a summary of stock option activity for the year ended December 31, 2011:
As of December 31, 2011, the total compensation cost related to nonvested stock options that have not yet been recognized totaled $671,000 and the weighted average period over which these costs are expected to be recognized is approximately 2.0 years.
Restricted Stock:
Under the Plan, the Company can grant restricted stock awards that vest upon completion of future service requirements or specified performance criteria. The fair value of these awards is equal to the market price of the common stock at the date of grant. The Company recognizes stock-based compensation expense for these awards over the vesting period, using the straight-line method, based upon the number of awards ultimately expected to vest. For grants prior to 2006, the Company recognized compensation expense over the service period of each separately vesting portion of the award, in effect treating each vesting portion as a separate award. Generally, restricted stock awards based upon completion of future service requirements vest 50% at the end of year three, 75% at the end of year four and 100% at the end of year five or upon death, disability, retirement or change of control of the Company (as defined in the Plan). In 2008 the Company granted a restricted stock award to an executive that vested 25% per year over a four year term. If a participant terminates employment prior to the end of the continuous service period, the unearned portion of the stock award is forfeited. The Company may also issue awards that vest upon satisfaction of specified performance criteria. For these types of awards, the final measure of compensation cost is based upon the number of shares that ultimately vest considering the performance criteria.
Under the United States Department of the Treasury’s (“UST”) Troubled Asset Relief Program (“TARP”), restrictions are placed on the top five most highly compensated employees from receiving incentive compensation, except in restricted stock valued at up to one-third of their total compensation. If granted, the restricted stock may not fully vest for at least two years and until the repayment of TARP, although for every 25% of TARP funds repaid, 25% of the restricted stock may become transferable.
The following table provides information regarding nonvested restricted stock:
The fair value of restricted stock awards that vested during 2011 was $2.5 million, compared to $438,000 and $1.3 million during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2011, the total compensation cost related to nonvested restricted stock that has not yet been recognized totaled $2.6 million, and the weighted average period over which these costs are expected to be recognized is approximately 1.6 years.
Valuation Information:
The Company uses the modified Black-Scholes option-pricing model (“Black-Scholes model”) for determining the fair value of stock options issued to employees and directors. The determination of the fair value of stock-based payment awards using the Black-Scholes model is impacted by the Company’s stock price on the date of grant as well as several assumptions used as inputs into the model. The assumptions include the risk-free interest rate at grant date, expected stock price volatility, expected dividend payout, and expected option life.
The risk-free interest rate assumption is based upon observed interest rates for the expected term of the Company’s stock options. The expected volatility input into the model takes into account the historical volatility of the Company’s common stock or the expected term of the option. The expected dividend yield assumption is based upon the Company’s historical dividend payout, if any, determined at the date of grant. In addition, the Company used the methodology outlined in the Securities and Exchange Commission’s Staff Accounting
Bulletin No. 107 in determining the expected life of the awards. This methodology takes into account the vesting periods and the contractual term of the award.
The following are the assumptions used to determine the weighted average fair value of stock option awards, using the Black-Scholes model, for each of the periods indicated:
* There were no grants issued during 2011.
15. Stockholders’ Equity
At both December 31, 2011 and 2010, the Company’s authorized capital stock was 55 million shares, consisting of 45 million shares of common stock, par value $0.01 per share, and 10 million shares of preferred stock, par value $0.01 per share. In September 2008, the Company designated and issued 2.4 million preferred shares as 8% Non-Cumulative Convertible Perpetual Preferred Stock, Series A (“Series A Preferred”) which was exchanged for 7,200,000 shares of common stock in May 2010. In November 2008, the Company designated and issued 104,823 shares of preferred stock as Fixed Rate Cumulative Perpetual Preferred Stock, Series B (“Series B Preferred”). In May 2010, the Company designated and issued 1,276,480 shares of preferred stock as 8% Non-Cumulative, Convertible Perpetual Preferred Stock, Series C (“Series C Preferred”) which was converted to 3,517,887 shares of common stock in December 2011. In October 2010, the Company designated and issued 405,330 preferred shares as Nonvoting, Convertible Preferred Stock, Series D (“Series D Preferred”). In October 2010, the Company also designated and issued 223,520 preferred shares of 8% Nonvoting Non-Cumulative Convertible Perpetual Preferred stock, Series E (“Series E Preferred”) which was converted to 616,020 shares of Non-Voting, Convertible Preferred Stock, Series G (“Series G Preferred”) in December 2011. In March 2011, the Company designated and issued 1,000,000 shares of preferred stock as 8% Non-Cumulative, Nonvoting, Contingent Convertible Preferred Stock, Series F (“Series F Preferred”) and designated 1,350,000 shares of preferred stock as Series G Preferred. The Series F Preferred was immediately converted to 2,280,000 shares of common stock and 220,000 shares of Series G Preferred. In December 2011, the Company issued an additional 616,020 shares of Series G Preferred on conversion of the Series E Preferred. The Company has agreed, consistent with its past practice, to continue to provide its regulators notice before the payment of any dividends on its preferred stock.
Common Stock:
The holders of outstanding shares of common stock and any participating securities (as defined by the certificate of designation) are entitled to receive dividends out of assets legally available at such times and in such amounts as the Company’s Board of Directors may determine. The terms of the Series B Preferred require the Company to obtain consent, under certain circumstances, before paying common dividends. The terms of the junior subordinated debentures and subordinated notes place defined restrictions on the Company’s ability to pay common dividends in the event of deferral of the payment of interest or dividends on those securities. The shares of common stock are neither redeemable nor convertible, and the holders thereof have no preemptive or subscription rights to purchase any securities of the Company. Upon liquidation, dissolution or winding up of the Company, the holders of common stock are entitled to receive, pro rata, the assets of the Company which are legally available for distribution, after payment of all debts and other liabilities and subject to the prior rights of any holders of preferred stock then outstanding. Each outstanding share of common stock is entitled to one vote on all matters submitted to a vote of stockholders.
In November 2011, the Company launched a rights offering that involved the distribution, at no charge, to holders of the Company’s common stock, Series C Preferred, Series D Preferred, Series E Preferred, Series G Preferred and certain warrants to purchase common stock of nontransferable subscription rights to purchase a total of 4,424,778 shares of the Company’s common stock or a nonvoting common stock equivalent. Each subscription right entitled the holder to purchase 0.1671 shares of common stock or a non-voting common stock equivalent at the purchase price of $7.91 per share. The rights offering expired on December 14, 2011. The rights offering was fully subscribed and 4,424,761 shares of common stock were issued with total gross proceeds to the Company of $35.0 million.
Preferred Stock:
The Company’s Third Amended and Restated Certificate of Incorporation authorizes its Board of Directors to issue preferred stock in classes or series and to establish the designations, preferences, qualifications, limitations or restrictions of any class or series with respect to the rate and nature of dividends, the price and terms and conditions on which shares may be redeemed, the terms and conditions for conversion or exchange into any other class or series of the stock, voting rights and other terms.
Series A Preferred: In May 2010, the Company completed an exchange offering in which all of its outstanding shares of Series A Preferred were exchanged for 7,200,000 shares of common stock that included 1,200,000 shares as an inducement to exchange the Series A Preferred for common shares. The $15.8 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series A Preferred and resulted in no net impact on total stockholders’ equity. This non-cash dividend was a deduction in arriving at net loss applicable to common stockholders on the Consolidated Statement of Operations and was considered in the determination of basic and diluted loss per common share. After the payment of the regular quarterly dividend of $1.2 million on April 15, 2010, the Company did not declare or pay any further dividends on the Series A Preferred. This compares to the period ended December 31, 2009, when the Company declared and paid dividends on Series A Preferred in the amount of $4.8 million.
Series B Preferred: In November 2008, as part of the UST TARP Capital Purchase Program, the Company entered into a Letter Agreement and Securities Purchase Agreement (“Purchase Agreement”) with the UST, pursuant to which the Company sold, for an aggregate purchase price of $104.8 million, 104,823 shares of Series B Preferred, with a purchase price and liquidation preference of $1,000 per share, and warrants to purchase 1,462,647 shares of the Company’s common stock.
The total proceeds received of $104.8 million were allocated to the Series B Preferred and the warrants based upon their relative fair values. The fair values allocated to the Series B Preferred and warrants upon issuance were $96.6 million and $8.2 million, respectively. The Series B Preferred is recorded on the Company’s Consolidated Balance Sheets at the aggregate liquidation amount less the discount created by the allocation of a portion of the proceeds to the warrants. At December 31, 2011, the recorded balance of the Series B Preferred was $102.0 million, which is equal to the liquidation amount, net of unamortized discount of $3.6 million plus accumulated but undeclared dividends of $670,000. This compares to December 31, 2010 when the recorded balance of the Series B Preferred was $100.4 million, which was equal to the liquidation amount, net of unamortized discount of $5.1 million plus accumulated but undeclared dividends of $670,000. The discount on the Series B Preferred is being accreted as a dividend yield adjustment over five years, the period that the Company expects the Series B Preferred to remain outstanding. During 2011, the total discount accreted as a non-cash dividend was $1.7 million compared to $1.5 million during 2010. The discount amortization decreased net income applicable to common stockholders and the earnings per common share during 2011 and increased the net loss applicable to common stockholders and the net loss per common share during 2010.
The Series B Preferred qualifies as Tier 1 capital for regulatory capital purposes and pays cumulative compounding dividends at a rate of 5% per year until November 21, 2013, and 9% per year thereafter. During 2011 and 2010, the Company declared and paid dividends on the Series B Preferred in the amount of $5.2 million per year.
The Company’s Third Amended and Restated Certificate of Incorporation, as amended by the certificate of designations for the Series B Preferred (as amended, the “Charter”), provided that the Company may not redeem the Series B Preferred prior to November 21, 2011, except with proceeds from the sale of equity securities of the Company that qualify as Tier 1 capital at the time of issuance. Since November 21, 2011, the Company may redeem shares of the Series B Preferred for the per share liquidation amount of $1,000 per share, plus any accrued and unpaid dividends.
In February 2009, subsequent to the issuance of the Series B Preferred, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. Among other things, the ARRA provided that the Secretary of Treasury, after consultation with the appropriate federal banking agency, will permit any recipient of TARP funds to repay such funds without regard to the source of the funds or any waiting period. Furthermore, if such assistance has been repaid, the Secretary of Treasury shall liquidate any associated warrants at the current market value.
In the event of any voluntary or involuntary liquidation, dissolution or winding up of the affairs of the Company, each holder of Series B Preferred will be entitled to receive the liquidation amount per share and the amount of any accrued and unpaid dividends, whether or not declared to the date of payment, out of the Company’s assets or proceeds available for distribution to stockholders of the Company, subject to the rights of any creditors and before any distribution of such assets or proceeds is made to or set aside for the Company’s common stock stockholders.
Series C Preferred: In December 2011, the Company completed the conversion of all of its outstanding shares of Series C Preferred into 3,517,887 shares of common stock that included 919,249 shares issued in accordance with the amended terms of the stock, which were in addition to the number of shares to be issued upon such a conversion according to the original terms of the stock. The $8.9 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series C Preferred and resulted in no net impact on total stockholders’ equity. This non-cash dividend was a deduction in arriving at net income applicable to common stockholders on the Consolidated Statement of Operations and was considered in the determination of basic and diluted earnings per common share. Excluding the implied noncash dividend, the dividends declared and paid for the period ended December 31, 2011 totaled $1.9 million and were paid in 235,869 shares of common stock. This compares to the period ended December 31, 2010, when the Company declared and paid cash dividends on Series C Preferred in the amount of $1.6 million.
Series D Preferred: In October 2010, the Company issued a total of 405,330 shares of Series D Preferred, in exchange for 405,330 shares of common stock held by certain investors. The Series D Preferred participates in any dividends paid to holders of the Company’s common stock. Each share of Series D Preferred will be automatically converted into one share of common stock immediately on any Widely Dispersed Offering or Conversion Event, (as defined in the Certificate of Designation), establishing the Series D Preferred.
The holders of Series D Preferred are entitled to notice of all stockholder meetings at which all holders of common stock shall be entitled to vote, but the Series D Preferred holders shall not be entitled to vote on any matter presented to the stockholders of the Company unless required by law.
In the event of any reorganization, reclassification, consolidation, merger or sale of the Company, each holder of the Series D Preferred shall be treated the same as each holder of common stock. In the event that holders of common stock have the option to elect the form of consideration to be received, holders of Series D Preferred shall have the same election privileges. In all cases, if any of the securities otherwise receivable are “voting securities” for bank regulatory purposes, each Series D Preferred holder shall have the right to elect to receive “nonvoting securities” in lieu of voting securities.
Series E Preferred: In December 2011, the Company completed the conversion of all of its outstanding Series E Preferred were converted into 616,020 shares of Series G Preferred that included 160,972 shares issued in accordance with the amended terms of such stock, which were in addition to the number of shares to be issued upon such a conversion according to the original terms of the stock. The $1.6 million value attributed to the additional shares was considered an implied noncash dividend to holders of the Series E Preferred and resulted in
no net impact on total stockholders’ equity. This implied noncash dividend was a deduction in arriving at net income applicable to common stockholders on the Consolidated Statement of Operations and was considered in the determination of basic and diluted earnings per common share. Excluding the implied noncash dividend, the dividends declared and paid for the period ended December 31, 2011 totaled $335,000 and were paid in 41,324 shares of Series G Preferred. This compares to the period ended December 31, 2010, when the Company declared and paid cash dividends on Series E Preferred in the amount of $103,000.
Series F Preferred: In connection with a private placement in March 2011, the Company issued 1,000,000 shares of Series F Preferred with a purchase price and liquidation preference of $25.00 per share. After stockholder approval was obtained at a special meeting of the Company’s stockholders held on March 29, 2011, all shares of the Series F Preferred were converted into an aggregate of 2,280,000 shares of the Company’s common stock and 220,000 shares of the Company’s Series G Preferred at a conversion price of $10.00 per share.
Series G Preferred: In connection with a private placement in March 2011, the Company designated for issuance 1,350,000 shares of Series G Preferred. After stockholder approval was obtained at a special meeting of the Company’s stockholders held on March 29, 2011, the shares of Series F Preferred held by Prairie Capital IV, L.P. and Prairie Capital IV QP, L.P. (collectively, the “Prairie Funds”) were converted into 220,000 shares of Series G Preferred at a conversion price of $10.00 per share. In December 2011, the Company completed the conversion of all of its outstanding shares of Series E Preferred into 616,020 shares of Series G Preferred.
The Series G Preferred participates in any dividends paid to holders of the Company’s common stock. Each share of Series G Preferred will be automatically converted into one share of common stock immediately on any Widely Dispersed Offering or Conversion Event (as defined in the Certificate of Designation establishing the Series G Preferred). The holders of Series G Preferred are entitled to notice of all stockholder meetings at which all holders of common stock shall be entitled to vote, but the Series G Preferred holders shall not be entitled to vote on any matter presented to the stockholders of the Company.
In the event of any reorganization, reclassification, consolidation, merger or sale of the Company, each holder of the Series G Preferred shall be treated the same as each holder of common stock. In the event that holders of common stock have the option to elect the form of consideration to be received, holders of Series G Preferred shall have the same election privileges. In all cases, if any of the securities otherwise receivable are “voting securities” for bank regulatory purposes, each Series G Preferred holder shall have the right to elect to receive “nonvoting securities” in lieu of voting securities.
Warrants to Purchase Common Stock:
At December 31, 2011, an aggregate of 3,847,918 warrants were issued and outstanding to purchase shares of the Company’s common stock. The warrants were issued in five different transactions as follows:
On September 29, 2008, the Company issued Financial Investments Corporation (“FIC”) warrants to purchase up to 500,000 shares of the Company’s common stock at an exercise price of $20.00 per share. The FIC warrants are not transferable or assignable after their initial issuance, and are exercisable at any time up to the September 29, 2018 expiration date. As of December 31, 2011, no warrants had been exercised.
In connection with the issuance by the Bank of $60 million of subordinated notes in September 2008, the Company issued detachable warrants to purchase an aggregate amount of 900,000 shares of the Company’s common stock. The exercise price of the warrants is $10.00 and the warrants became exercisable on March 29, 2009 and expire on September 29, 2013. The proceeds from the subordinated notes offering were allocated to the subordinated notes and the warrants based upon their relative fair values. The fair value of the warrants of $4.7 million was credited to surplus resulting in an increase in stockholders’ equity. As of December 31, 2011, no warrants had been exercised.
In connection with the issuance by the Company of $33.9 million of subordinated notes in May 2010, the Company issued detachable warrants to purchase an aggregate amount of 848,450 shares of the Company’s common stock. The exercise price of the warrants is $12.28 and the warrants became exercisable on November 24, 2010 and expire on May 28, 2015. The proceeds from the subordinated notes offering were allocated to the subordinated notes and the warrants based on their relative fair value. The fair value of the warrants totaling $4.4 million at the issuance date of May 2010, net of issuance costs, was credited to surplus in stockholders’ equity resulting in an increase in stockholders’ equity. As of December 31, 2011, no warrants had been exercised.
In connection with the issuance by the Company of $3.6 million of subordinated notes in October 2010, the Company issued detachable warrants to purchase an aggregate amount of 89,050 shares of the Company’s common stock. The exercise price of the warrants is $12.28 and the warrants are exercisable immediately after issuance and expire on May 28, 2015. The proceeds from the subordinated notes offering were allocated to the subordinated notes and the warrants based on their relative fair value. The fair value of the warrants totaling $420,000 at the issuance date of October 21, 2010, net of issuance costs, was credited to surplus in stockholders’ equity resulting in an increase in stockholders’ equity. As of December 31, 2011, no warrants had been exercised.
In connection with the Series B Preferred offering in November 2008, the Company issued to the Treasury a warrant to purchase 1,462,647 shares of the Company’s common stock. This warrant has a 10-year term and was immediately exercisable upon its issuance, with an initial exercise price, subject to anti-dilution adjustments, equal to $10.75 per share of the common stock. The warrant is not subject to any contractual restrictions on transfer. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant. As a result of the issuance of the subscription rights in the Company’s rights offering in November 2011, the TARP warrant required anti-dilution adjustments as defined in the original warrant. This adjustment caused the number of shares that can be purchased under the warrant to increase to 1,510,418 at the reduced exercise price of $10.41. As of December 31, 2011, no warrants had been exercised.
16. Regulatory Disclosures
The Company and the Bank are subject to various capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators, which, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the entity’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and Bank’s 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 Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 Capital to risk-weighted assets and of Tier 1 Capital to average assets (as all terms are defined by regulation). As of
December 31, 2011 and 2010, the Bank was considered “well-capitalized” under the regulatory framework for prompt corrective action. To be categorized “well-capitalized” the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. At December 31, 2011, there were no conditions or events that management believes would have changed the Bank’s status as well-capitalized. During 2011, the Company contributed an additional $25.0 million of capital to the Bank to further strengthen its regulatory capital.
The Company’s and the Bank’s actual and required capital amounts and ratios as of December 31, 2011 and 2010 are presented in the following table:
The Bank is also subject to dividend restrictions set forth by regulatory authorities. Because of the net losses in past periods, as of December 31, 2011, the Bank could not declare and pay dividends to the Company without notifying the appropriate regulatory authorities. Payment of any such dividends would also be subject to the Bank remaining in compliance with all applicable capital ratios.
17. Commitments and Financial Instruments with Off-Balance Sheet Risks
Commitments:
The Company is obligated in accordance with the terms of various long-term non-cancelable operating leases for certain premises (land and building) and office space and equipment, including the Company’s principal offices. The terms of the leases generally require periodic adjustment of the minimum lease payments
based on an increase in the consumer price index. In addition, the Company is obligated to pay the real estate taxes assessed on the properties and certain maintenance costs. Certain of the leases contain renewal options for periods of up to five years. Total rental expense for the Company in connection with these leases for the years ended December 31, 2011, 2010 and 2009 was approximately $5.2 million, $5.2 million, and $4.8 million, respectively. Estimated future minimum rental commitments under all operating leases as of December 31, 2011 are as follows:
Financial Instruments with Off-Balance Sheet Risks:
At times, the Company is party to various financial instruments with off-balance sheet risks. The Company uses these financial instruments in the normal course of business to meet the financing needs of customers. These financial instruments include commitments to extend credit and financial guarantees, such as financial and performance standby letters of credit. When viewed in terms of the maximum exposure, those instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. Credit risk is the possibility that a counterparty to a financial instrument will be unable to perform its contractual obligations. Interest rate risk is the possibility that, due to changes in economic conditions, the Company’s net interest income will be adversely affected.
The Company mitigates its exposure to credit risk through its internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits, and, when deemed necessary, securing collateral. Collateral held varies but may include deposits held in financial institutions; U.S. Treasury securities; other marketable securities; income-producing commercial or multi-family rental properties, vacant land or land under development; accounts receivable; inventories; and property, plant and equipment. The Company manages its exposure to interest rate risk generally by setting variable rates of interest on extensions of credit and administered rates on interest bearing non-maturity deposits and, on a limited basis, by using derivative financial instruments to offset existing interest rate risk of its assets and liabilities.
The following is a summary of the contractual or notional amount of each significant class of financial instrument with off-balance sheet credit risk outstanding. The Company’s maximum exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for commitments to extend credit and financial guarantees is represented by the contractual notional amount of these instruments.
At December 31, 2011 and 2010, the contractual amounts were as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. Many customers do not utilize the total approved commitment amounts. Historically, available commitment amounts are not always drawn. Therefore, the total commitment amounts do not usually represent the actual future funding requirements.
The Company issues financial guarantees in the form of financial and performance standby letters of credit to meet the needs of customers. Financial standby letters of credit are conditional commitments issued by the Company to guarantee the payment of a specified financial obligation of a customer to a third party. Performance standby letters of credit are conditional commitments issued by the Company to make a payment to a specified third party in the event a customer fails to perform under a non-financial contractual obligation. The terms of these financial guarantees primarily range from less than one year to three years. A contingent liability is recognized if it is probable that a liability has been incurred by the Company under a standby letter of credit. The credit risk involved in issuing these letters of credit is essentially the same as that involved in extending loan facilities to customers. Management expects most of the Company’s letters of credit to expire undrawn. Management expects no significant loss from its obligation under these financial guarantees to the extent not already recognized as a liability on the Company’s Consolidated Balance Sheets. At December 31, 2011 and 2010, the Company had established a reserve of $4.4 million and $5.4 million, respectively, for unfunded commitments because it was probable that a liability had been incurred by the Company under standby letters of credit that have not yet been funded. The Company had $4.4 million of letters of credit outstanding related to nonaccrual and impaired loans as of December 31, 2011.
18. Derivative Financial Instruments
The Company uses derivative financial instruments to accommodate customer needs and to assist in interest rate risk management. The Company uses interest rate exchange agreements, callable interest rate exchange agreements and interest rate floors, collars and corridors to manage the interest rate risk associated with its commercial loan portfolio, brokered CDs, cash flows related to FHLB advances and repurchase agreements, and mortgage servicing associated with Cole Taylor Mortgage. The Company also has interest rate lock commitments and forward loan commitments associated with Cole Taylor Mortgage that are considered derivatives. Periodically, the Company will sell options to a bank or dealer for the right to purchase certain securities held within the Bank’s investment portfolios (covered call options).
An interest rate exchange agreement (or swap) is an agreement in which two parties agree to exchange, at specified intervals, interest payment streams calculated on an agreed-upon notional principal amount with at least one stream based on a specified floating-rate index. Under an interest rate floor agreement, in the event a specified floating-rate index decreases below a predetermined interest rate floor level, the Company will receive an amount, from the counterparty, equal to the difference between the floor level and the current floating-rate index computed based on the notional amount. In an interest rate collar agreement, a predetermined floor and ceiling interest rate level are set with the counterparty. If the specified floating-rate index decreases below the interest rate floor level, the Company will receive an amount equal to the difference between the floor level and the current floating-rate index, computed based on the notional amount. If the specified floating-rate index increases above the interest rate ceiling level, the Company will pay an amount equal to the difference between the current floating-rate index and the ceiling level, computed based on the notional amounts. An interest rate corridor is an agreement in which one party pays an upfront premium to a second party in exchange for future interest payments based on a notional principal amount and the level of a floating-rate index relative to the pre-determined lower and upper bounds of the interest rate corridor. The net effect of the interest rate corridor, when combined with a floating-rate liability, is to lock in a fixed funding cost when the floating-rate index is between the lower and upper bounds of the interest rate corridor. For all types of these agreements, the notional amount does not represent the direct credit exposure. The Company is exposed to credit-related losses in the event of non-performance by the counterparty on the interest rate exchange or floor or collar payment, but does not anticipate that any counterparty will fail to meet its payment obligation.
The following tables describe the derivative instruments outstanding as of the dates indicated (dollars in thousands):
Derivative Instruments Designated as Hedges:
The Company had derivative instruments with a notional amount of $106.9 million at December 31, 2011, which were designated as fair value hedges against the interest rate risk inherent in certain of its brokered certificates of deposits (“brokered CDs”). The CD swaps are used to convert the fixed rate paid on the brokered CDs to a variable rate based upon 3-month LIBOR computed on the notional amount. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value of the related hedged brokered CD is reported as an adjustment to the carrying value of the brokered CDs. Total ineffectiveness on the interest rate swaps was $89,000 for the year ended December 31, 2011 and was recorded in noninterest income.
The Company had derivative instruments with a notional amount of $60.0 million at December 31, 2011, which were designated as fair value hedges against the interest rate risk inherent in certain callable brokered CDs. These swaps are used to convert the fixed rate paid on the callable brokered CDs to a variable rate based on 3-month LIBOR computed on the notional amount. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value of the related hedged callable brokered CD is reported as an adjustment to the carrying value of the callable brokered CDs. Total ineffectiveness on these interest rate swaps was $292,000 for the year ended December 31, 2011 and was recorded in noninterest income.
The Company had $155.0 million of notional amount interest rate corridors at December 31, 2011, which were designated as cash flow hedges against certain borrowings. The corridors are used to reduce the variability in the interest paid on borrowings attributable to changes in 1-month LIBOR. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value is recorded in OCI. There was no ineffectiveness on the interest rate corridors for the year ended December 31, 2011.
Non-hedging Derivative Instruments:
In order to accommodate customer borrowing needs, the Company enters into interest rate swap agreements with customers. At the same time, in order to offset the exposure and manage interest rate risk, the Company enters into an interest rate swap with a different counterparty with offsetting terms. These derivative instruments are not designated as accounting hedges and changes in fair value of these instruments, as well as any net cash settlements and upfront customer fees, are recognized in noninterest income as other derivative income or expense. As of December 31, 2011 and 2010, the Company had notional amounts of $413.1 million and $232.3 million, respectively, of interest rate swaps with customers where the Company has agreed to receive a fixed interest rate and pay a variable interest rate. In addition, as of December 31, 2011 and 2010, the Company has offsetting interest rate swaps with other counterparties with a notional amount of $413.1 million and $232.3 million, respectively, in which the Company has agreed to receive a variable interest rate and pay a fixed interest rate.
The Company enters into interest rate swaps as a part of Cole Taylor Mortgage’s servicing business in order to minimize most of the price volatility of the mortgage services rights asset. At December 31, 2011, the Company had a notional amount of $22.5 million of interest rate swaps. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income.
The Company also enters into interest rate lock and forward loan sale commitments as a part of Cole Taylor Mortgage’s origination business. At December 31, 2011, the Company had notional amounts of $370.0 million of interest rate lock commitments and $352.6 million of forward loan sale commitments. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income.
The Company enters into covered call option transactions from time to time that are designed primarily to increase the total return associated with the investment securities portfolio. There were no covered call options outstanding as of December 31, 2011 or December 31, 2010. In 2011, $178,000 of premium related to covered call options was recognized in noninterest income. No covered call options were entered into in 2010 and, therefore, there was no impact on the Company’s Statement of Operations.
Terminated Derivative Instruments:
In January 2009, the Company terminated a $100.0 million notional amount interest rate swap that was not designated as an accounting hedge. The Company discontinued hedge accounting in December 2008 when it determined that this hedge would no longer be effective. The unrealized gain of $6.4 million upon de-designation, which had accumulated in OCI (net of tax), is being amortized to loan interest income over what would have been the life of the hedge. From the date of de-designation to December 31, 2008, the change in fair value, along with net settlements attributed to this period, was recorded in other derivative income in noninterest income and totaled $394,000. This derivative was terminated in January 2009 and the Company received a cash payment $6.6 million, which represented the fair value of the swap at the date of termination. At December 31, 2011 the net settlement had been completely amortized and there is no longer any amount remaining in accumulated OCI. This compares to December 31, 2010 when the Company had $761,000 in accumulated OCI related to previously terminated cash flow hedges. The amount in accumulated OCI represented the net unamortized portion of the deferred gain that had accumulated in OCI when the hedging relationship was terminated. During 2011 and 2010, $1.2 million and $3.2 million of deferred gains from previously terminated cash flow hedges were amortized as a net increase to loan interest income.
Hedges with the notional amount of $145.0 million were terminated in 2011, with net termination fees of $896,000 recognized in noninterest income for the year ended December 31, 2011. These hedges were terminated because the transaction which they hedged was no longer forecast to occur.
19. Fair Value Measurement
On January 1, 2010, the Company elected to account for held for sale residential mortgage loans originated by Cole Taylor Mortgage at fair value under the fair value option in accordance with ASC 825-Financial Instruments. When the Company began to retain mortgage servicing rights (“MSR”) in 2011, an election was made to account for these rights under the fair value option. In addition, any purchased MSRs are accounted for under the fair value option. The Company has not elected the fair value option for any other financial asset or liability.
In accordance with FASB ASC 820, the Company groups financial assets and financial liabilities measured at fair value in three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are defined as follows.
Level 1 - Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3 - Significant unobservable inputs that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate fair values:
Available for sale investment securities:
The Company obtains fair value measurements from an independent pricing service, when available. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current ratings from credit rating agencies and the bond’s terms and conditions, among other things. The fair value measurements are compared to another independent source on a quarterly basis to review for reasonableness. In addition, the Company reviews the third party valuation methodology on a periodic basis. The Company has determined that these valuations are classified in Level 2 of the fair value hierarchy. When the independent pricing service does not have fair value measurements available for a security, the Company has set the fair value to equal the present value of the expected cash flows. The Company has determined that these valuations are classified in Level 3 of the fair value hierarchy.
The Company does not have subprime loans in its mortgage related investment securities portfolio. As of December 31, 2011, the Company had $1.19 billion of mortgage related investment securities which consisted of mortgage-backed securities and collateralized mortgage obligations. Of the total mortgage related investment securities, $1.18 billion, or 99.6%, were issued by government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. In comparison, of the $1.16 billion of mortgage related investment securities at December 31, 2010, $1.15 billion, or 99.4%, were issued by government sponsored enterprises. The mortgage related portfolio also includes $4.9 million of private-label mortgage related securities at December 31, 2011 that has received heightened monitoring because the Company believes the fair values of these securities have been impacted by illiquidity in the market place. While none of these securities contain subprime mortgage loans, the portfolio does include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. While the fair value of these securities has been impacted by market illiquidity, the Company does not modify the fair value determined by the independent pricing service, but takes additional steps to review for other-than-temporary impairment. See Note 3 -”Investment Securities” for additional details of the evaluation of other-than-temporary impairment.
Loans held for sale:
At December 31, 2011, loans held for sale included $186.0 million of residential mortgage loans, that were originated by Cole Taylor Mortgage and for which the Company has elected to account for on a recurring basis under the fair value option.
In prior periods, the Company had certain residential mortgage loans that it acquired in a bulk purchase transaction and nonaccrual commercial loans classified as held for sale. These loans were recorded at the lower of cost or fair value and were recorded at fair value on a nonrecurring basis.
For all residential mortgage loans held for sale, the fair value is based on quoted market prices for similar assets in active markets and is classified in Level 2 of the fair value hierarchy. The fair value of the commercial loans was determined based on the estimated net contracted sales price, less cost to sell and was classified in Level 2 of the fair value hierarchy.
Loans:
The Company does not record loans at their fair value on a recurring basis except for $5.1 million of mortgage loans originated by Cole Taylor Mortgage and later transferred to the Company’s portfolio. The Company evaluates certain loans for impairment when it is probable the payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Once a loan has been determined to be impaired, it is measured to establish the amount of the impairment, if any, based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less cost to sell. If the measure of the impaired loan is less than the recorded investment in the loan, a valuation allowance is established. At December 31, 2011, a portion of the Company’s total impaired loans were evaluated based on the fair value of the collateral. In accordance with fair value measurements, only impaired loans for which an allowance for loan loss has been established based on the fair value of collateral require classification in the fair value hierarchy. As a result, a portion, but not all, of the Company’s impaired loans are classified in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the impaired loan as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management’s assessment of the liquidation value of collateral, the Company classifies the impaired loan as nonrecurring Level 3 in the fair value hierarchy.
Assets held in employee deferred compensation plans:
Assets held in employee deferred compensation plans are recorded at fair value and included in other assets on the Company’s Consolidated Balance Sheets. The assets associated with these plans are primarily invested in mutual funds and classified as Level 1 as the fair value measurement is based upon available quoted prices. The Company also records a liability included in accrued interest, taxes and other liabilities on its Consolidated Balance Sheets for the amount due to employees related to these plans.
Derivatives:
The Company has determined that its derivative instrument valuations, except for the mortgage derivatives which are discussed separately, are classified in Level 2 of the fair value hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings thresholds, mutual puts and guarantees.
Mortgage derivatives:
Mortgage derivatives include interest rate swaps hedging mortgage servicing rights, interest rate lock commitments to originate held for sale residential mortgage loans for individual customers and forward commitments to sell residential mortgage loans to various investors. The fair value of the interest rate swaps used
to hedge mortgage servicing rights is classified in Level 2 of the hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings thresholds, mutual puts and guarantees. The fair value of forward loan sale commitments is based upon quoted prices for similar assets in active market that the Company has the ability to access and is classified in Level 2 of the hierarchy. The Company uses an internal valuation model to estimate the fair value of its interest rate lock commitments which is based upon unobservable inputs that reflects management’s assumptions and specific information about each borrower transaction and is classified in Level 3 of the hierarchy.
Mortgage servicing rights:
The Company records its mortgage servicing rights at fair value in other assets in the Consolidated Balance Sheets. Mortgage servicing rights do not trade in an active market with readily observable prices. Accordingly, the Company determines the fair value of mortgage servicing rights by estimating the fair value of the future cash flows associated with the mortgage loans being serviced. Key economic assumptions used in measuring the fair value of mortgage servicing rights include, but are not limited to, prepayment speeds, discount rates, delinquencies and cost to service. The assumptions used in the model are validated on a regular basis. The fair value is validated on a quarterly basis with a third party. Discrepancies between the internal model and the third party validation are investigated and resolved by an internal committee. Due to the nature of the valuation inputs, mortgage servicing rights are classified in Level 3 of the fair value hierarchy.
Other real estate owned and repossessed assets:
The Company does not record other real estate owned (“OREO”) and repossessed assets at their fair value on a recurring basis. At foreclosure or obtaining possession of the assets, OREO and repossessed assets are recorded at the lower of the amount of the loan balance or the fair value of the collateral, less estimated costs to sell. Generally, the fair value of real estate is determined through the use of a current appraisal and the fair value of other repossessed assets is based upon the estimated net proceeds from the sale or disposition of the underlying collateral. Only assets that are recorded at fair value, less estimated cost to sell, are classified under the fair value hierarchy. When the fair value of the collateral is based upon an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the OREO and repossessed asset as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management’s assessment of liquidation of collateral, the Company classifies the other real estate owned and repossessed assets as nonrecurring Level 3 in the fair value hierarchy.
Assets and Liabilities Measured on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are summarized below:
* The fair value for certain available for sale investment securities for which the Company’s independent pricing service does not have a fair value measurement was previously included in Level 2 of the fair value hierarchy. This disclosure has been modified to reflect these securities in Level 3.
The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 and 2010 (including the change in fair value) for investment securities on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:
The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 and 2010 (including the change in fair value) for mortgage derivative instruments measured on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:
The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 (including the change in fair value) for mortgage servicing rights measured on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:
Assets Measured on a Nonrecurring Basis
Assets measured at fair value on a nonrecurring basis are summarized below. The Company may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis. These assets generally consist of loans considered impaired that may require periodic adjustment to the lower of cost or fair value.
At December 31, 2011, the Company had $16.0 million of impaired loans and $28.8 million of OREO and repossessed assets measured at fair value on a nonrecurring basis and classified in Level 3 in the fair value hierarchy. The change in Level 3 carrying value of impaired loans during the year ended December 31, 2011 represents payments or net chargeoffs of $23.8 million, four additional impaired loans with fair value of $14.4 million and the related charge to earnings of $1.9 million to reduce these loans to fair value. The change in Level 3 OREO and repossessed assets during the year ended December 31, 2011 included $13.1 million of new additions, $4.1 million of transfers from Level 2 and $9.6 million of sales/settlements and writedowns.
At December 31, 2010, the Company had $25.4 million of impaired loans and $21.1 million of OREO and repossessed assets measured at fair value on a nonrecurring basis and classified in Level 3 in the fair value hierarchy. The change in Level 3 carrying value of impaired loans represents sales, payments or net chargeoffs of $11.4 million, nine additional impaired loans with fair value of $21.2 million and the related charge to earnings of $32.0 million to reduce these loans to fair value. The change in Level 3 OREO and repossessed assets during the year ended December 31, 2010 included $25.2 million of additions, $14.5 million of sales/settlements and writedowns.
Fair Value of Financial Instruments
The Company is required to provide certain disclosures of the estimated fair value of its financial instruments. A portion of the Company’s assets and liabilities are considered financial instruments. Many of the Company’s financial instruments, however, lack an available, or readily determinable, trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. The Company can use significant estimations and present value calculations for the purposes of estimating fair values. Accordingly, fair values are based on various factors relative to current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment and, therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect these estimated values.
The methods and assumptions used to determine fair values for each significant class of financial instruments are presented below:
Cash and Cash Equivalents:
The carrying amount of cash, due from banks, interest-bearing deposits with banks or other financial institutions, federal funds sold, and securities purchased under agreement to resell with original maturities less than 90 days approximate fair value since their maturities are short-term.
Investment Securities:
The fair value measurements of investment securities consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current ratings from credit rating agencies and the bond’s terms and conditions, among other things.
Loans Held For Sale:
For residential mortgage loans held for sale, the fair value has been determined based on quoted market prices for similar assets in active markets. For commercial loans held for sale, the fair value has been determined based upon the estimated net contracted sales prices, less cost to sell.
Loans:
The fair values of loans have been estimated by the present value of future cash flows, using current rates at which similar loans would be made to borrowers with the same remaining maturities, less a valuation adjustment for general portfolio risks. This method of estimating fair value does not incorporate the exit price concept of fair value prescribed by ASC “Fair Value Measurements and Disclosures, (Topic 820).” Certain loans are accounted
for at fair value when it is probable the payment of interest and principal will not be made in accordance with the contractual terms and impairment exists. In these cases, the fair value is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less cost to sell.
Investment in FHLB and FRB Stock:
The fair value of investments in FHLB and Federal Reserve Bank stock equals its book value as these stocks can only be sold back to the FHLB, Federal Reserve Bank, or other member banks at their par value per share.
Accrued Interest Receivable:
The carrying amount of accrued interest receivable approximates fair value since its maturity is short-term.
Derivative Financial Instruments:
The carrying amount and fair value of derivative financial instruments, such as interest rate swaps, floors, collars, and corridors are based on independent valuation models, which use widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral posting thresholds, mutual puts and guarantees.
The Company also has derivative financial instruments associated with Cole Taylor Mortgage including forward loan sale and interest rate lock commitments. The fair value of the forward loan sale commitments is based on quoted market prices for similar assets in active markets. The fair value of interest rate lock commitments is determined based on an internal valuation model using management assumptions and rate and pricing information from each loan commitment transaction. On the Company’s Consolidated Balance Sheets, instruments that have a positive fair value are included in other assets and those instruments that have a negative fair value are included in accrued interest, taxes and other liabilities.
Other Assets:
Financial instruments in other assets consist of assets in the Company’s nonqualified deferred compensation plan. The carrying value of these assets approximates their fair value and is based upon quoted market prices.
Deposit Liabilities:
Deposit liabilities with stated maturities have been valued at the present value of future cash flows using rates which approximate current market rates for similar instruments unless this calculation results in a present value which is less than the book value of the reflected deposit, in which case the book value would be utilized as an estimate of fair value. Fair values of deposits without stated maturities equal the respective amounts due on demand.
Other Borrowings:
The carrying amount of overnight securities sold under agreements to repurchase, federal funds purchased, and the U.S. Treasury tax and loan note option, approximates fair value, as the maturities of these borrowings are short-term. Securities sold under agreements to repurchase with original maturities over one year have been valued at the present values of future cash flows using rates which approximate current market rates for instruments of like maturities.
Notes Payable and Other Advances:
Notes payable and other advances have been valued at the present value of estimated future cash flows using rates which approximate current market rates for instruments of like maturities.
Accrued Interest Payable:
The carrying amount of accrued interest payable approximates fair value since its maturity is short-term.
Junior Subordinated Debentures:
The fair value of the fixed rate junior subordinated debentures issued to TAYC Capital Trust I is computed based upon the publicly quoted market prices of the underlying trust preferred securities issued by the Trust. The fair value of the floating rate junior subordinated debentures issued to TAYC Capital Trust II has been valued at the present value of estimated future cash flows using current market rates and credit spreads for an instrument with a like maturity.
Subordinated Notes:
The subordinated notes issued by the Bank in 2008 and by the Company in 2010, have been valued at the present value of estimated future cash flows using current market rates and credit spreads for an instrument with a like maturity.
Off-Balance Sheet Financial Instruments:
The fair value of commercial loan commitments to extend credit is not material as they are predominantly floating rate, subject to material adverse change clauses, cancelable and not readily marketable. The carrying value and the fair value of standby letters of credit represent the unamortized portion of the fee paid by the customer. A reserve for unfunded commitments is established if it is probable that a liability has been incurred by the Company under a standby letter of credit or a loan commitment that has not yet been funded.
The estimated fair values of the Company’s financial instruments are as follows:
The remaining balance sheet assets and liabilities of the Company are not considered financial instruments and have not been valued differently than is required under historical cost accounting. Since assets and liabilities that are not financial instruments are excluded above, the difference between total financial assets and financial liabilities does not, nor is it intended to, represent the market value of the Company. Furthermore, the estimated fair value information may not be comparable between financial institutions due to the wide range of valuation techniques permitted, and assumptions necessitated, in the absence of an available trading market.
20. Litigation
The Company is, from time to time, a party to litigation arising in the normal course of business. Management knows of no threatened or pending legal actions against the Company that are likely to have a material adverse impact on its business, financial condition, liquidity or operating results.
21. Parent Company Only Financial Statements
Summarized financial information of Taylor Capital Group, Inc. is as follows:
BALANCE SHEETS
(in thousands)
STATEMENTS OF OPERATIONS
(in thousands)
STATEMENTS OF CASH FLOWS
(in thousands)
22. Other Comprehensive Income (Loss)
The following table presents other comprehensive income (loss) for the years ended December 31, 2011, 2010, and 2009:
The tax effects of changes in the beginning of the year deferred tax asset valuation allowance solely attributable to identifiable events recorded in OCI, primarily changes in unrealized gains on the available for sale investment portfolio, were allocated to OCI in accordance with U.S. generally accepted accounting principles.
In 2011, certain interest rate corridors were terminated with net termination fees of $896,000 reclassified out of OCI and recognized in noninterest income.
23. Earnings Per Share
Earnings per share are calculated using the two-class method. The calculation of basic earnings per share requires an allocation of earnings to all securities that participate in dividends with common shares, such as unvested restricted stock and preferred participating stock, to the extent that each security may share in the entity’s earnings. Basic earnings per share are calculated by dividing undistributed earnings allocated to common stock by the weighted average number of common shares outstanding. Dilutive earnings per share considers the dilutive effect of common stock equivalents, including stock options, warrants to purchase shares of common stock, and preferred stock that can be converted into shares of common stock. Dilutive earnings per share are calculated by dividing undistributed earnings allocated to common stockholders by the sum of the weighted average number of common shares outstanding and the weighted average number of common stock equivalents outstanding, provided those common stock equivalents are dilutive. Potentially dilutive common stock equivalents are excluded from the calculation of diluted earnings per share in periods in which the effect would reduce the loss per share or increase the income per share (i.e., when the common stock equivalents are antidilutive.) To the extent there is an undistributed loss for the period, that loss is allocated entirely to the weighted average number of common shares as the participating security holders have no contractual obligation to share in losses.
For the year ended December 31, 2011, common stock equivalents included in the calculation of diluted earnings per share were 25,002 stock options outstanding to purchase shares of common stock. Weighted-average common stock equivalents that were considered antidilutive and were not included in the calculation of diluted earnings per share at December 31, 2011 were 615,031 stock options outstanding to purchase shares of common stock, 3,805,513 warrants to purchase shares of common stock and 2,598,427 shares of convertible Series C Preferred and Series F Preferred.
Due to the net loss for the years ended December 31, 2010 and 2009, all common stock equivalents were considered antidilutive and were not included in the computation of basic or diluted earnings per share. At December 31, 2010, actual common stock equivalents consisted of 910,103 stock options outstanding to purchase shares of common stock, 3,800,147 warrants to purchase shares of common stock, convertible Series C preferred stock which could be converted into 2,598,697 shares of common, convertible Series D preferred stock which could be converted into 405,330 shares of common stock and convertible Series E preferred stock which could be converted into 455,049 shares of common stock. At December 31, 2009, actual common stock equivalents consisted of 813,099 stock options outstanding to purchase shares of common stock, 2,862,647 warrants to purchase shares of common stock, and the convertible Series A preferred stock which could be converted into 6,000,000 shares of common stock.
The following table provides earnings per share calculation details for the years ended December 31, 2011, 2010 and 2009:
* Diluted earnings per share are calculated by dividing undistributed earnings allocated to common shares by the total diluted weighted-average number of common shares outstanding.
24. Segment Reporting
The Company has identified two segments for purposes of financial reporting: Banking and Mortgage Banking. In addition, the Company utilizes an Other category. These segments were determined based on the products and services provided or the type of customers served and are consistent with the information that is used by the Company’s key decision makers to make operating decisions and to assess the Company’s performance.
The Banking operating segment includes commercial banking, asset based lending, retail banking and all other functions that support those units. The Mortgage Banking operating segment originates mortgage loans for sale to investors and for the Company’s portfolio through its retail and broker channels. This segment also services residential mortgage loans for various investors and for loans owned by the Company. The Other segment includes subordinated debt expense, certain parent company activities and residual income tax expense, representing the difference between the actual amount incurred and the amount allocated to operating segments. The income tax benefit due to the reversal of the Company’s net deferred tax asset valuation allowance is included in the Other segment.
The accounting policies of the individual operating segments are generally the same as those of the Company described in Note 1-Summary of Significant Accounting and Reporting Policies. Segment results are presented based on our management accounting practices. The information presented in our segment reporting is based on internal allocations, which involve management judgment. The application and development of management reporting methodologies is a dynamic process and is subject to periodic adjustments and enhancements.
The following table presents financial information from the Company’s operating segments for the periods ended December 31, 2011 and December 31, 2010. There are no results presented for the period ended December 31, 2009 as Cole Taylor Mortgage was first established in January 2010.
The Other category includes subordinated debt expense, certain parent company activities and residual income tax expense, representing the difference between the actual amount incurred and the amount allocated to operating segments. The income tax benefit due to the reversal of the Company’s net deferred tax asset valuation allowance is included in the Other category.
25. Subsequent Events
Events subsequent to the balance sheet date of December 31, 2011 have been evaluated for potential recognition or disclosure in these financial statements that would provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing the financial statements. The Company has determined that there was no additional evidence about conditions that existed at the date of the balance sheet or any new nonrecognized subsequent event that would need to be disclosed to keep the financial statements from being misleading through the date these financial statements were filed.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2011.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the criteria established in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2011.
KPMG LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Corporation included in this annual report on Form 10-K, has issued an attestation report on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2011. The report, which expresses an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2011, is included under the heading “Report of Independent Registered Public Accounting Firm.”
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter-ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors of Taylor Capital Group, Inc.:
We have audited Taylor Capital Group, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Taylor Capital Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on Taylor Capital Group, Inc.’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Taylor Capital Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Taylor Capital Group, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011, and our report dated March 9, 2012 expressed an unqualified opinion on those consolidated financial statements.
Chicago, Illinois
March 9, 2012
Item 9B.
Item 9B. Other Information
None.
TAYLOR CAPITAL GROUP, INC.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Information required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days of our fiscal year-end.
Item 11.
Item 11. Executive Compensation
Information required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days of our fiscal year-end.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days of our fiscal year-end.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days of our fiscal year-end.
Item 14.
Item 14. Principal Accountant Fees and Services
Information required by this Item is incorporated herein by reference to our definitive Proxy Statement for the 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days of our fiscal year-end.
TAYLOR CAPITAL GROUP, INC.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a)(1) Financial Statements
See Part II-Item 8. Financial Statements and Supplementary Data
(a)(2) Financial Statement Schedules
Schedules have been omitted because the information required to be shown in the schedules is not applicable or is included elsewhere in our financial statements or accompanying notes.
(a)(3) Exhibits:
EXHIBIT INDEX
+ Management contract or compensatory plan or arrangement required to be filed as an Exhibit to this Form 10-K.
* Filed herewith
** As provided in Rule 406T of Regulation S-T, this information shall not be deemed “filed” for purposes of Section 11 and 12 of the Securities Act and Section 18 of the Exchange Act, or otherwise subject to liability under those sections.
(b) Exhibits
See Item 15(a)(3) above.
(c) Financial Statement Schedules
See Item 15(a)(2) above.
TAYLOR CAPITAL GROUP, INC.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 9th day of March 2012.
TAYLOR CAPITAL GROUP, INC.
/S/ MARK A. HOPPE
Mark A. Hoppe
President and Chief Executive Officer
(Principal Executive Officer)
/S/ RANDALL T. CONTE
Randall T. Conte
Chief Operating and Chief Financial Officer
(Principal Financial Officer)
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and the dates indicated.