ITEM 1. BUSINESS
General
Baylake Corp., a Wisconsin corporation organized in 1976, ("Baylake" or the "Registrant"), is a registered bank holding company under the Federal Bank Holding Company Act of 1956. Registrant was organized primarily to acquire and hold the stock of Baylake Bank ("Bank"), and to enter into such other closely related business activities as may be approved from time to time.
Baylake Bank
The Bank is a Wisconsin State Bank originally chartered in 1876. At December 31, 1997, the Bank had total assets of $450.1 million. It is a member of the Federal Reserve System and its deposits are insured, subject to regulatory limits, by the FDIC. It provides general banking and trust department services to commercial, industrial and individual accounts in a five county area composed of Door, Kewaunee, Manitowoc, Brown and Waupaca Counties. The Bank offers a full range of financial services, including demand deposit accounts, various savings account plans, certificates of deposit, individual retirement accounts, real estate mortgage loans, consumer and business loans, agricultural loans, safe deposit boxes, collection services, transfer agency services, a trust department, insurance agency, discount brokerage, financial planning, conference facilities and access to TYME Corporation's electronic funds transfer system. The Bank maintains a number of divisions each headed by a vice president, including a Retail Division, Commercial/Loan Division and Non-Bank Division to facilitate the provision of customer services, and three supportive divisions, the Administrative Division, Accounting Division and Operations Division.
The Bank has the following 100%-owned subsidiaries: Baylake Investments, Inc., Bank of Sturgeon Bay Building Corporation, Cornerstone Financial, Inc., Karsten Resources, Inc. and Baylake Insurance Agency, Inc.. Baylake Investments, Inc. was formed to manage certain bank assets available for investment. Bank of Sturgeon Bay Building Corporation owns the main office building, conference center facilities and underlying property of the Bank. Cornerstone Financial, Inc. manages Bank of Sturgeon Bay Building Corporation's conference center facilities. Karsten Resources, Inc. manages hotel and restaurant facilities, acquired as a result of a loan default. Baylake Insurance Agency, Inc. offers various types of insurance products to the general public as an independent agent. The Bank also owns a 49.6% interest in United Financial Services, Inc. ("UFS"), a data processing services company. Unaffiliated third parties own a 50.4% interest in UFS. The revenues generated by these subsidiaries and UFS amount in aggregate to less than 5% of the Bank's total income.
The Bank offers short-term and long-term loans on a secured and unsecured basis for business and personal purposes. They make real estate, commercial/industrial, agricultural and consumer loans. The Bank focuses lending activities on individuals and small businesses in its market area. Lending has been exclusively within the industrial and consumer community within their market areas. The Bank's market area consists of primarily Door County, Wisconsin. Sturgeon Bay is the county seat and major industrial and retail area of Door County. The Bank is the largest commercial bank in Door County. The Bank operates seven branch offices (two of which are seasonal) in Door County, in addition to its main office in downtown Sturgeon Bay.
The resident population of Door County is approximately 27,250 (according to the 1990 census) with 9,100 living in the City of Sturgeon Bay. The major industries of Door County include shipbuilding, tourism, metal products manufacturing, electrical components manufacturing, and industrial oven fabrication. Most industry is centered in the Sturgeon Bay area. The rest of Door County is primarily involved in agriculture (mostly dairy farming and the production of cherries and apples), and tourism. The tourist business of Door County is seasonal, with the season beginning in early spring and continuing until late fall. The seasonal nature of the tourist business imposes increased demands for loans shortly before and during the tourist season and causes reduced deposits shortly before and during the early part of the tourist season, although the financial needs of those involved in the delivery of tourist related services is a year around concern.
The Bank's market area consists also of Kewaunee County, Wisconsin and adjacent portions of Manitowoc County. The Bank owns and operates three branch offices, in addition to its main office in downtown Kewaunee. The resident population of Kewaunee County is approximately 20,000 according to the 1990 census, with 2,750 people living in Kewaunee and 3,353 in Algoma. The Kewaunee County industrial base is diverse with over half of the business associated with food and related products, fabricated metals, and lumber and wood furniture and fixtures. Most industry is centered in the Kewaunee and Algoma area. The rest of Kewaunee County is primarily involved in agriculture (mainly dairy production). Tourism also contributes to the local economy.
The Bank additionally has three locations in Brown County consisting of two permanent locations located on the Northeast side of Green Bay and one leased facility located on the Northwest side of Green Bay. The area offers a wide and diversified manufacturing and service industry mix and is a leading area for growth in Wisconsin.
The Bank's market area also consists of two locations in Waupaca county (acquired through the Four Seasons acquisition which is further referenced in Item 7. of Management's Discussion and Analysis of Financial Condition and Results of Operations under General) and is located approximately 35 miles west of Green Bay.
The major industries center around the production of food and related products, lumber and wood furniture and fixtures. Tourism also contributes to the local economy.
Lending and Investments
The Bank offers short-term and long-term loans on a secured and unsecured basis for business and personal purposes. They make real estate, commercial/industrial, agricultural and consumer loans. The Bank focuses lending activities on individuals and small businesses in its market area. Lending has been exclusively within the State of Wisconsin. The Bank does not conduct any substantial business with foreign obligors. The markets served by the Bank include a wide variety of types of businesses; therefore, the Registrant does not believe it is unduly exposed to the problems in any particular industry group. However, any general weakness in the economy of Door and Kewaunee County areas ( as a result, for example, of a decline in its manufacturing and tourism industries or otherwise) could have a material effect on the business and operations of the Registrant.
The Bank's total outstanding loans as of December 31, 1997 amounted to approximately $293.4 million, consisting of 79.3% residential, commercial, agricultural and construction real estate loans, 13.9% commercial and industrial loans, 4.6% installment and 2.2% agricultural loans.
The Registrant maintains a portfolio of other investments, primarily consisting of U.S. Treasury securities, U.S. Government agency securities, mortgage-backed securities, and obligations of states and their political subdivisions. The Registrant attempts to balance its portfolio to manage interest rate risks, maximize tax advantages and meet its liquidity needs while endeavoring to maximize investment income.
Deposits
The Bank offers a broad range of depository products, including non-interest bearing demand deposits, interest-bearing demand deposits, various savings and money market accounts and certificates of deposit. Deposits at the Bank are insured by the FDIC up to statutory limits. At December 31, 1997, the Bank's total deposits amounted to $346.0 million, including interest bearing deposits of $301.8 million and non-interest bearing deposits of $44.2 million.
Other Customer Services and Products
Other services and products offered by the Bank and subsidiaries include safety deposit box services, personal and corporate trust services, conference center facilities, an insurance agency and discount brokerage services offering stocks, bonds, annuities, mutual funds and other investment products.
Competition
The Bank competes with other financial institutions and businesses in both attracting and retaining deposits and making loans. The Bank encounters direct competition in its Door County market area from one other commercial bank as well as from two savings and loans associations and one credit union which maintain offices in Door County. The Bank encounters direct competition in its Kewaunee County market area from four other commercial banks as well as one savings and loan association and one credit union. In spite of such competition, the Bank has maintained their position within the market areas, holding better than half of all commercial bank deposits in the combined market area as of December 31, 1997. Although no assurance can be given that they will continue to do so, the Bank has been able to maintain their prominence in the market areas, even though certain competitors have considerably more financial and other resources than do the Registrant.
Regulation and Supervision
The banking industry is highly regulated by both federal and state regulatory authorities. Regulation includes, among other things, capital and reserve requirements, dividend limitations, limitations on products and services offered, geographical limits, consumer credit regulations, community reinvestment requirements and restrictions on transactions with affiliated parties. Financial institution regulation has been the subject of significant legislation in recent years, may be the subject of further significant legislation in the future, and is not within the control of Baylake. This regulation substantially affects the business and financial results of all financial institutions and holding companies, including Baylake and its subsidiaries. As an example, Baylake is subject to the capital and leverage guidelines of the Federal Reserve Board, which require that Baylake's capital to asset ratio meet certain minimum standards. For a discussion of the Federal Reserve Board's guidelines and the Registrant's applicable ratios, see the section entitled "Capital Resources" under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation.
The Bank is incorporated under the banking laws of Wisconsin, and its deposits are insured by the FDIC. It is therefore subject to supervision and regulation by the Wisconsin Commissioner of Banking (the "Commissioner"), the Federal Reserve Bank ("FRB") and the FDIC. As a registered bank holding company under the Bank Holding Company Act, Baylake is subject to review and regulation by the FRB (their primary regulator). Baylake is also subject to review and examination by the Commissioner under Wisconsin law.
In addition to general requirements that banks retain specified levels of capital and otherwise conduct their business in a safe and sound manner, Wisconsin law requires that dividends of Wisconsin banks declared and paid without approval of the Commissioner be paid out of current earnings or, no more than once
within the immediate preceding two years, out of undivided profits in the event there have been insufficient net profits. Any other dividends require the prior written consent of the Commissioner. As a result of extraordinary dividends declared to enable the purchase of Four Seasons, the Bank is required to get written consent from the FRB prior to paying dividends. The Bank is in compliance with all applicable capital requirements and may pay dividends to Baylake, pending written approval.
Current federal law provides that adequately managed bank holding companies from any state may acquire banks and bank holding companies located in any other state, subject to certain conditions. Beginning on June 1, 1997, banks may create interstate branching networks in states that do not "opt out" of interstate branching. Prior to that date, banks could create interstate branching networks in states that "opted in" to interstate branching early. Wisconsin law generally permits establishment of full service bank branch offices statewide.
Employees
At December 31, 1997, the Registrant and its subsidiary, had 190 full-time equivalent employees.
Statistical Information
The following statistical information is presented in accordance with the Securities and Exchange Commission's Guide 3, "Statistical Disclosure by Bank Holding Companies." Reference numbers relate to Guide 3.
I. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL
A. Three-year comparison of Consolidated Average Balance Sheet (in thousands)
I. B. INTEREST RATES AND INTEREST DIFFERENTIAL
The tables below show for the periods indicated the daily average amount outstanding for major categories of the interest-earning assets and interest-bearing liabilities, the interest earned or paid and the average yields thereon (in thousands of dollars).
The table below shows the net interest earnings and the net yield on interest-earning assets for the periods indicated (in thousands of dollars).
Interest on tax exempt income, (i.e., interest earned on state and municipal obligations) are figured on a federal tax- equivalent basis using a tax rate of 34%.
I. C. The following table sets forth for the periods indicated a summary of the changes in interest earned and interest paid resulting from changes in volume and changes in rates (in thousands).
(1) When a change in interest is due both to rate changes and volume this analysis has been made on a fifty-fifty basis.
II. INVESTMENT PORTFOLIO
A. The carrying value of investment securities for those held to maturity (at amortized cost) and available for sale (fair market value) as of December 31, 1997, 1996 and 1995 are summarized as follows (in thousands of dollars)
The Registrant does not hold investment securities of any issuer (other than securities of the U.S. Government or its agencies) whose book value exceeds ten percent of its stockholders equity.
II. B. The following table shows the maturities of investment securities as of December 31, 1997 and weighted average yields of investment securities (in thousands). The weighted average yields by maturity range was computed by annualizing the purchase yield income on the securities within such maturity range.
Weighted average yield on state and political subdivisions has been computed on a fully taxable equivalent basis using a tax rate of 34%.
III. LOAN PORTFOLIO
A. Types of Loans
The following table sets forth the comparison of the loan portfolio at December 31st of each of the past five years (in thousands of dollars).
2. As of December 31, 1997, there existed potential problem loans totaling $695,833 which are additionally disclosed within the category "Risk Element".
The following table indicates management's assessment of potential loss at year end 1997.
Commercial loans comprised $449,715 or 64.6% of the total loans categorized as problem loans. The other types of loans comprising this amount were consumer loans totaling $171,431 or 24.7% and mortgage loans totaling $74,687 or 10.7%.
3. The Bank's loan portfolio is diversified by types of borrowers and industry groups within the Door, Kewaunee, Brown and Waupaca county market area. Significant loan concentrations are considered to exist for a financial entity when such amounts are loaned to borrowers engaged in similar activities as would cause them to be similarly impacted by economic or other conditions. At December 31, 1997, there existed the following industry group concentrations in the Registrant's loans which exceed 10% of total loans:
Tourism related loans:
Lodging Business $50.3 million or 17.1% ---------------------- Total tourism loans $50.3 million or 17.1%
III. LOAN PORTFOLIO
B. Maturity and Sensitivities of Loans to Changes in Interest Rates
The following table shows the amount of loans outstanding (in thousands) as of December 31, 1997 which, based on remaining schedule repayments of principal, are due in the periods indicated. Also, the amounts due after one year are classified according to the sensitivity to change in interest rates.
C. Risk Elements
1. The following table shows at December 31, the aggregate amounts of loans (in thousands) which are non-accrual, troubled with debt restructurings and accruing loans past 90 days or more as to principal or interest payments.
If the non-accrual loans had been current throughout their terms, interest income would have been approximately $202,000; $472,000; $74,000; $117,000; and $175,000 for 1997, 1996, 1995, 1994 and 1993 respectively. Interest income which is recorded only as received, amounted to $180,000; $154,000; $34,000; $58,000; and $101,000 for 1997, 1996, 1995, 1994 and 1993 respectively for these non-accrual loans.
Loans are placed in non-accrual status when they are contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectibility of principal or interest on loans, it is the practice of management to place such loans on a non-accrual status immediately rather than waiting until the loans become 90 days past due. When interest accruals are discontinued, interest credited to income is reversed. If collectibility is in doubt, cash receipts on nonaccrual loans are used to reduce principal rather than recorded as interest income.
IV. SUMMARY OF LOAN LOSS EXPERIENCE
A. The following table summarizes the daily average loan balances at the end of each period; changes in allowance for possible loan losses arising from loans charged off and recoveries on loans previously charged off, by loan category; and addition to the allowance which have been charged to operating expenses (in thousands).
The factors which influence management's judgment in determining the additions to the loan valuation reserve are as follows:
1. The ratio of loan valuation reserves to the total loans should approximate 1.25% according to Baylake management.
2. The percentage of recoveries of loans previously charged off in relation to the ratio
in (1) above.
3. The charged off loans to total loan loss experience.
4. The economic stability within the market area and its impact on the loan portfolio.
B. Allocation of Allowance for Loan Losses
For each period ended December 31, the loan valuation reserve has been allocated to the following categories in amounts deemed reasonably necessary to provide for the possibility of losses being incurred within each category. The table also sets forth the percentage of loans in each category to total loans (in thousands).
V. DEPOSITS
The average deposits are summarized below for the periods indicated (in thousands).
Maturities of time certificates of deposit of $100,000 or more outstanding at December 31 are summarized as follows (in thousands).
VI. RETURN ON EQUITY AND ASSETS
The ratio of consolidated net income to average stockholders' equity and to average total assets and other ratios are as follows:
VII. Short-Term Borrowings
A. The following table shows outstanding amounts of short-term borrowings, together with the weighted average interest rates thereon, at December 31, of each of the past three years (in thousands of dollars).
B. The following table shows the maximum amounts outstanding of short term borrowings at any month-end during each reported period (in thousands of dollars).
C. The following table shows for the periods indicated the daily average amount outstanding for the categories of short-term borrowings, the interest paid and the weighted average rates thereon (in thousands of dollars).
VIII. Long Term Debt
A. The following table shows outstanding amounts of long term debt, together with the weighted average interest rates thereon, at December 31, of each of the past three years (in thousands of dollars). Long term debt consists of a land contract requiring annual principal payments of $53,000 plus interest calculated at prime + 1/4% and a supplier contract for $14,000 with a five year term and payments monthly.
B. The following table shows the maximum amounts outstanding of long term debt at any month-end during each reported period (in thousands of dollars).
C. The following table shows for the periods indicated the daily average amount outstanding for the categories of long term debt, the interest paid and the weighted average rates thereon (in thousands of dollars).
ITEM 2.
ITEM 2. PROPERTIES
Registrant directly owns no real properties of any kind. However, Bank owns fifteen branches and leases the main office building from its subsidiary the Bank of Sturgeon Bay Building Corporation. In addition, the Bank leases office space from an unrelated third party for a facility in Green Bay.
The main office building located in Sturgeon Bay serves as headquarters for Registrant as well as the main banking office of Bank. The main office also accommodates the expanded business of the Bank, primarily an insurance agency and financial services. The sixteen branches owned or leased by Bank are conveniently located throughout the market area served by Bank, including counties of Door, Kewaunee, Brown, Manitowoc, and Waupaca. All properties are in good condition and considered adequate for present and near term requirements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no legal proceedings pending involving the Registrant or its subsidiaries which management believes to be material.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year 1997.
Executive Officers of the Registrant
The following is a list of names of the executive officers of the Registrant and position within the Registrant.
Thomas L. Herlache Chairman, President, CEO and Director of Baylake Corp
Richard A. Braun Vice Chairman, Executive Vice President and Director of Baylake Corp
Paul C. Wickmann Vice President
Daniel F. Maggle Secretary
Steven D. Jennerjohn Treasurer
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS
Historically, trading in shares of Baylake Common Stock has been limited. Since mid-1993, Baylake Common Stock has been listed on the OTC Bulletin Board (Trading symbol:BYLKBB), an electronic interdealer quotation system providing real-time quotations on over 4,000 eligible securities. Previously, Baylake Common Stock was listed on the NASDAQ Pink Sheets. Trading in Baylake Common Stock has been conducted principally by certain brokerage and investment firms with offices in Door County, Wisconsin which have provided price quotations, and have assisted individual holders of Baylake Common Stock who wish to sell their shares. In addition, since May 1993, prices for Baylake Common Stock have generally been reported daily in The Milwaukee Journal Sentinel based on information provided by a local brokerage firm.
The following table summarizes high and low bid prices and cash dividends paid for the Baylake Common Stock for the periods indicated. Bid prices are computed from those obtained from two brokerage firms, and, since May 1993 from bid prices reported in The Milwaukee Journal Sentinel. The reported high and low prices represent interdealer bid prices, without retail mark-ups, mark-downs or commission, and may not necessarily represent actual transactions.
Baylake had approximately 1,552 shareholders of record at March 24, 1998. Baylake paid a special dividend of $.25 per share cash dividend in December 1997.
Dividends on Baylake Common Stock have historically been paid in cash on a quarterly basis in March, June, September and January, and Baylake expects to continue this practice for the foreseeable future. The holders of Baylake Common Stock are entitled to receive such dividends when and as declared by Baylake's Board of
Directors. The ability of Baylake to pay dividends is dependent upon receipt by Baylake of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state chartered banks, generally limit the payment of dividends on bank stock to the bank's undivided profits after all payments of all necessary expenses, provided that the bank's surplus equals or exceeds its capital. In determining the payment of cash dividends, the Board of Directors of Baylake considers the earnings, capital and debt servicing requirements, financial ratio guidelines issued by the FRB and other banking regulators, financial conditions of Baylake and the Bank, and other relevant factors.
Baylake has maintained a dividend reinvestment plan which enabled participating shareholders to elect to purchase shares of Baylake Common Stock in lieu of receiving cash dividends. Such shares may be newly issued securities or acquired in the market, and were purchased on behalf of participating shareholders at their then fair market value.
Effective April 1, 1997, Baylake suspended its dividend reinvestment plan as a result of certain short-term compliance costs. As a result, shareholders received cash dividends for the remainder of 1997. Effective with the March 15, 1998 dividend payment Baylake reinstated the dividend reinvestment plan, consequently, shareholders in the dividend reinvestment plan who so elected were able to purchase shares or partial shares of stock in lieu of receiving cash dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) All data, except dividends per share, have been restated to give effect to the Registrant's acquisition of Kewaunee County Banc-Shares, Inc. on August 31, 1994, in a transaction accounted for using the pooling of interest methods of accounting.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
General
The following sets forth management's discussion and analysis of the consolidated financial condition and results of operations of the Baylake
Corp. ("Baylake" or the "Registrant"), which may not be otherwise apparent from the consolidated financial statements included in this report. This discussion and analysis should be read in conjunction with those financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report for a more complete understanding of the following discussion and analysis.
On August 31, 1994, the Registrant completed the acquisition of Kewaunee County Banc-Shares, Inc. ("KCB"), the holding company for Baylake Bank- Kewaunee ("BBK"). The Registrant acquired all of the outstanding shares of KCB in exchange for 574,756 shares of the Registrant's common stock. The acquisition was structured as a merger of KCB with a newly-formed subsidiary of the Registrant and accounted for using the pooling-of-interests method of accounting; therefore, results of prior periods have been restated.
On July 1, 1996, the Registrant consummated its acquisition of Four Seasons of Wis., Inc. ("Four Seasons"), in a cash transaction totaling $13.875 million. The acquisition was accounted for using the purchase method of accounting, therefore it would affect future operations.
Results of Operations
Net income in 1997 was $5.3 million, a 12.1% increase from the $4.70 million earned in 1996. Net income for 1996 showed a 1.3% increase over 1995 earnings. Basic operating earnings per share increased to $2.15 per share in 1997 compared with $1.92 in 1996, an increase of 12.0%. Basic operating earnings per share in 1996 showed a 1.6% increase over 1995 results of $1.89 per share. On a diluted operated earnings per share basis, the Registrant recorded $2.14 per share in 1997, compared to $1.90 and $1.88 per share in 1996 and 1995, respectively.
The presentation of basic and diluted earnings per share on the consolidated statements of income is in accordance with the Registrant's adoption of STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 128 (SFAS 128) "Earnings per Share". Under the provisions of SFAS 128, primary and fully diluted earnings per share reporting were replaced with basic and diluted earnings per share.
Net income for 1997 includes amortization expense of goodwill related to the purchase of Four Seasons. This expense reduced after-tax net income in 1997 by $326,000 or earnings per share by $.13. Net income for 1996 reflected amortization expense of $144,000 related to the Four Seasons acquisition. Those charges in 1996 reduced after-tax earnings per share by $.06.
Net interest income for 1997 improved $2.0 million or 13.7% over 1996 levels. Net interest income for 1996 improved $524,000 or 3.7% over 1995 levels. In a relatively stable interest environment, interest income increased 17.3% while interest expense increased 21.7%.
Other income showed an increase of $617,000 or 17.9%. The primary factors increasing other income were securities gains and gains on sales of loans into the secondary market.
Non-interest expense increased $1.3 million or 11.4% over 1996 levels. Factors contributing to the increase were increased personnel expenses and
occupancy expense.
For 1997, return on average assets declined to 1.29% compared with 1.34% in 1996 and 1.56% recorded in 1995. This ratio declined as a result of the various factors discussed above combined with average asset growth of 15.9% in 1997.
Return on average stockholders' equity in 1997 showed an increase at 13.14% compared to 12.39% in 1996 and a decrease compared to 13.43% in 1995. The increase in 1997 compared to 1996 occurred as a result of increased net income and the factors discussed above.
Cash dividends declared in 1997 increased 31.2% to $1.22 per share compared to $.93 in 1996. This compares to a decrease of 18.4% in 1996 dividends as compared to 1995.
Net Interest Income
Net interest income is the largest component of the Registrant's operating income (net interest income plus other non-interest income), accounting for 81.4% of 1997 total operating income, as compared to 82.0% in 1996 and 85.3% in 1995. Net interest income represents the difference between interest earned on loans, investments and other earning assets, and the interest expense associated with the deposits and borrowings that fund them. Interest fluctuations together with changes in the volume and types of earnings and interest-bearing liabilities combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of interest earned. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable.
Net interest income on a tax-equivalent basis reached $17.9 million in 1997, an increase of 13.9% from $15.7 million in 1996 (and $15.0 million in 1995). The improvement in 1997 net interest income of $2.2 million was due in part to a 18.3% increase in the volume of average earning assets, offset by a 17.8% increase in average interest-bearing liabilities. The benefit from the increase in earning assets and the increase in noninterest bearing deposits were offset, in part, by an increase in interest-bearing liabilities, a decline in the yield on earning assets and an increase in the cost of interest paying liabilities. As a result, interest income increased 17.3%, while interest expense for 1997 increased 21.7%.
Average loans outstanding grew from $233.5 million in 1996 to $276.6 million in 1997, an increase of 18.5%. The increase in loan volumes also was a significant contributing factor to the increase in interest income. Average loans outstanding increased from $201.8 million in 1995 to $233.5 million in 1996, an increase of 15.7%. The mix of average loans to average total assets declined slightly from 67.6% in 1995 to 66.3% in 1996 and increased to 67.8% in 1997. The relationship of greater loan composition in the asset mix has provided a source of higher yielding assets, which has contributed to an increase in net interest income.
Interest rate spread is the difference between the tax-equivalent rate earned
on average earning assets and the rate paid on average interest-bearing liabilities. The interest rate spread decreased 24 basis points in 1997 to 4.12% from 4.36% in 1996, as the average yield on earning assets decreased 9 basis points while the average cost paid on interest-bearing liabilities increased 15 basis over the same period. The decrease in interest rate spread followed a decline of 20 basis points in 1996 compared to a spread of 4.56% in 1995. The decrease in the Registrant's earning assets yield reflects stable loan yields, resulting from increased competition, less frequent repricing of variable rate loans due to a stable interest rate environment on average and an increased percentage of the Registrant's assets represented by loans. Increased investment interest income resulting from an increased investment portfolio combined with lower yields on the investment portfolio have contributed to the decline in interest rate spread. Yields on interest-paying liabilities increased 15 basis points as a result of two factors. First, increased competition for retail deposits and new product offerings increased yields on interest bearing deposits by 7 basis points from 4.37% to 4.44% in 1997 compared to 1996. Second, as a result of an effort intended to increase interest-earning assets and thus reduce the percentage of equity to total assets (known as leveraging) Bank was able to acquire additional funding, primarily from the Federal Home Loan Bank (FHLB) of Chicago. This effort increased the percentage of short-term borrowings as a percentage of interest-bearing liabilities to 8.6% in 1997 compared to 3.7% in 1996. Yields on these borrowings increased 10 basis points in 1997 adding to the rates paid on interest-bearing liabilities.
Net interest margin is tax-equivalent net interest income expressed as a percentage of average earning assets. The net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds to fund a portion of earning assets. As a result, the level of funds available without interest cost (demand deposits and equity capital) is an important factor affecting an increasing net interest margin.
The net interest margin for 1997 was 4.77% compared to 4.97% in 1996. The decline in net interest margin was primarily the result of the 24 basis point decline in the interest rate spread offset by an increase in the average earning assets to average asset ratio. The impact from competition as it relates to the commercial loan portfolio had a negative affect on the change in net interest margin. The free funds ratio, or the level of non-interest-bearing funds that support earning assets, declined to 21.4% from 22.6% in 1996, which caused a reduction in net interest margin.
The net interest margin for 1996 was 4.97% as compared to 5.38% in 1995 as interest rate spread declined during that period. The decrease in 1996 occurred primarily as the result of the 20 basis point decline in the interest rate spread and a reduction in the average earning assets to average ratio. Increased competition especially as it relates to the commercial loan portfolio negatively affected net interest margin.
The ratio of average earning assets to average total assets measures management's ability to employ overall assets for the production of interest income. This ratio was 91.6% in 1997 compared with 89.6% in 1996 and 93.4% in 1995. The ratio improved in 1997 as a result of efforts to increase interest earning assets using such sources of FHLB and increased loan demand.
Competition in the financial services industry will also affect net interest margin. Spreads will be a focus of management's attention, as the Registrant constantly seeks to attract lower cost core deposits, service the needs of the customer, and provide attractively priced products. Competition for high quality assets will also affect asset yields. Net interest income is vital to the Registrant's earnings performance, since net interest income is the largest component of operating income. Growth in net interest income primarily is the result of growth in the level of earning asset volumes and changes in asset mix. Interest rate spread management through asset and liability pricing and increased levels of non-interest-bearing sources of funds also aid in improving net interest income. Management will continue its focus on maintaining an appropriate mix of quality earning assets as well as seeking to achieve appropriate growth in volumes.
Changes in the levels of market interest rates also affect net interest income, but are less directly under the control of the Registrant. Although a rather stable rate environment has been experienced, management believes that a gradual increase in interest rates will not adversely affect the earning capacity of the Registrant. Past experience has shown that, although the Registrant remains in a short-term negative interest rate sensitivity gap, deposits tend not to be repriced as quickly as loans in a rising rate scenario and are repriced more frequently in a falling interest rate environment. More discussion on this subject is referenced in the section titled "Interest Rate Sensitivity".
Provision for Loan Losses
Provision for loan losses in 1997 at $1,115,000 compares to a provision of $400,000 for 1996 and $250,000 for 1995. Net charge-offs in 1997 were $127,000 compared with net charge-offs of $244,000 in 1996 and $167,000 in 1995. Net charge-offs as a percentage of average loans is a key measure of asset quality. Net charge-offs to average loans were .05% in 1997 compared with .10% in 1996 and .08% in 1995. The provision was increased as a result of higher average loan growth experienced compared to an allowance for loan loss levels to average loan ratios that has declined in recent years. Additionally entry into new markets has allowed management the opportunity to re-evaluate the methodology used in providing adequate provision for potential loan losses. Management's determination of the provision for loan losses is based on several factors. Factors considered include evaluation of the loan portfolio, current domestic conditions, loan volume, loan growth, loan portfolio composition, levels of non-performing loans, trends in past due loans, and the evaluation of various problem loans for loss potential. Net charge-offs to average loans remain comparatively low in spite of above average loan growth due to higher underwriting standards and improved collection efforts.
Non-Interest Income
Total non-interest income for 1997, excluding securities transactions, was $363,000 more than 1996, or a 10.6% increase. In 1996, total non-interest income was $836,000 more than 1995, or a 32.4% increase. Trust service fees, loan servicing fees, gains from sales of loans and service charges continue to be the primary components of non-interest income.
Trust fees decreased $120,000 or 19.6% in 1997 compared to 1996, primarily as a result of a reduction in trust estate business. This compared to an increase of $217,000 or 55.1% in 1996 compared to 1995, due to increased trust business and the timing of certain billable business.
Loan servicing fees increased $57,000 or 8.5% to $731,000 in 1997. $58,000 of the increase stemmed from income derived from mortgage servicing rights activity. The adoption of STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 122 (SFAS 122) "Accounting for Mortgage Servicing Rights" occurred in 1996. This followed an increase of $169,000 or 33.5% in 1996 as compared to 1995 following the implementation of SFAS 122 which accounted for $134,000 of the increase. Additional income was realized as a result of a larger portfolio of commercial loan business sold on the secondary market and serviced by Registrant.
Gains on sales on loans in the secondary market increased $466,000 to $678,000 in 1997 primarily as a result of increased commercial loan business and a favorable rate environment in which to take gains. The business sold consisted of the guarantee portion of loans partially guaranteed by the Small Business Administration (SBA) and sold with servicing rights retained by Registrant.
Service charges on deposit accounts showed an improvement of $101,000 or 13.5% over 1996 results accounting for much of the improvement in fee income generated for other services to customers.
Included in 1997 other income are revenues of $116,000 stemming from the operation of Karsten Resources, Inc. This compares to revenues of $277,000 reported in 1996. The operation of Karsten Resources, Inc. was sold in the latter part of 1997 with a gain on sale of assets of $17,000 realized.
Non-Interest Expense
Non-interest expense in 1997 increased $1.3 million or 11.4% compared to 1996 results primarily as a result of increased personnel, occupancy and data processing expense. This followed a $1.4 million or 14.1% rise in 1996 as compared to 1995.
Salaries and employee benefits expense is the largest component of non-interest expense and totaled $7.0 million in 1997, an increase of $733,000 or 11.7% as compared to 1996 results. The increase in 1997 primarily results from additional staffing increases, increased benefit costs, and normal salary increases. Salary and employee benefits expense in 1996 totaled $6.3 million, an increase of $879,000 or 16.3% over 1995 results. This increase resulted from additional staffing, a result of expansion into the Green Bay market and Waupaca County market (stemming from the Four Seasons acquisition) and normal salary increases.
Bonuses arising from the Registrant's Pay-For-Performance Program amounted to $390,000 in 1997 compared to $373,000 in 1996, an increase of 4.6%. This program is designed to reward various divisions if certain goals are met in achieving improvement in income; bonuses increased due to an increased salary base structure and certain goals on return on equity being achieved.
The Registrant's 401(k) profit sharing plan covering all employees who qualify as to age and length of service showed an increase of $46,000 or 12.2% over 1996 levels. Expenses in the same category were up $36,000 or 10.6% in 1996 compared to 1995 as the Registrant increased contributions from combination discretionary/matching plan of 5% to 10% in 1995 to meet industry standards.
The number of full-time equivalent employees increased to 190 in 1997 compared to 185 in 1996, an increase of 2.7%. Employee levels in 1996 increased to 185 from 157 in 1995, an increase of 17.8%. This increase primarily resulted from the Registrant gearing up for entry into the Green Bay market with emphasis on personnel time spent on acclimation to the Bank and its products and calling programs. As the Registrant expands to take advantage of business opportunities and the related revenues, management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to occur in future years.
Net occupancy expense for 1997 showed an increase of $298,000 or 34.3% compared to 1996. This increase followed an increase of $180,000 or 26.1% in 1996. This expense has resulted from expansion costs in the development of the Green Bay region and two new branches completed in 1997 for the Door County market area (Egg Harbor and West Side locations) resulting in additional depreciation expense, real estate tax expense, and other occupancy costs.
Equipment expense showed an increase of $5,000 or .6% compared to 1996. This followed an increase of $230,000 or 36.4% in 1996. These resulted primarily from depreciation relating to past increased capital expenditures for equipment which were made to enhance the Registrant's technological capabilities and additional equipment added as a result of the Green Bay expansion efforts.
Data processing expense in 1997 increased $88,000 or 17.0% due to moderate volume increases and technology enhancements. This followed a decrease of $11,000 or 1.6% in 1996 compared to 1995. Management estimates that data processing expense should show relatively flat increases with only adjustments related to any volume increase incurred by Registrant.
Other real estate expenses are netted against income received in the determination of net other real estate owned expense (income). As a result the Registrant has shown varied results. Other real estate owned expenses showed a net loss of $30,000 in 1997 as a result of a loss on sale of approximately $17,000, a result of a sale of a commercial property disposed of in 1997. Other real estate owned expenses showed net income of $188,000 in 1996 as a result of gains on sale of approximately $96,000 resulting from three commercial properties disposed of in 1996. Additionally a gain of $155,000 was recognized as a result of disposal of additional lot sales of Idlewild Valley, a former subsidiary of the Bank whose value was written off in 1988. This compares to net income of $84,000 in 1995.
Other operating expenses in 1997 were $66,000 less than in 1996 or a 2.3% decrease. Included in 1997 expenses was amortization of goodwill related to the Four Seasons acquisition of $328,000 in 1997. This compares to an increase of $221,000 or 8.6% in 1996 compared to 1995. Primarily affecting
this change was amortization expense goodwill amounting to $144,000 in 1996.
Supplies expense shows a decrease of $47,000, or 13.0% 1997 as compared to 1996 primarily as a result of branch startup costs that existed in 1996. This compares to an increase of $99,000 in 1996 as related to 1995.
Payments to regulatory agencies increased $28,000 to $41,000 for 1997. These charges related to debt service assessment related to Financing Corporation (FICO). A risk classification rating of 1A (rating assigned to well capitalized institutions) allowed Bank to experience no Federal Deposit Insurance Corporation (FDIC) assessments in 1997.
Operating costs for Karsten Resources, Inc. of $180,000 are included as part of other operating expenses for 1997. This compares to costs of $328,000 included as a part of other operating expenses for 1996.
Other items comprising other operating expense shows an increase of $114,000 or a 5.1% increase in 1997 compared to 1996. Additional marketing and advertising expense of $20,000 in 1997 account for some of this increase. These costs were primarily the result of the Bank's expansion efforts. Director fees and other related costs show an increase of $38,000 in 1997 due to additional regional boards being established in the year for purposes of keeping involvement in the communities served by Bank and allow various levels of decision-making to be made in the regions formed. The overhead ratio, which is computed by subtracting non-interest income from non-interest expense and dividing by average total assets was 2.08% for 1997 compared to 2.22% for 1996. Registrant continues its commitment to deliver quality service and products for its customer base.
Income Taxes
Income tax expense for the Registrant in 1997 was $2.0 million, an increase of $88,000 or 4.5% compared to 1996. This followed a decrease of $210,000 or 9.8% in 1996 compared to 1995. The higher tax expense in 1997 reflected the Registrant's increase in before tax earnings offset by an increase in tax exempt interest income. Conversely, 1996 income tax expense was lower due to an decrease in before tax earnings and a decrease in tax exempt interest income.
The Registrant's effective tax rate (income tax expense divided by income before taxes) was 27.8% in 1997 compared with 29.2% in 1996 and 31.6% in 1995. Of the 27.8% effective rate for 1997 the federal effective tax rate was 25.9% while the Wisconsin state tax effective rate was 1.9%.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been recognized to offset the related deferred tax assets due to the uncertainty of realizing tax benefits of a portion of loan loss and mortgage servicing differences.
Income taxes are provided for the tax effects of transactions reported in the financial statements and consists of taxes currently due plus deferred taxes related primarily to differences between the basis of the allowance for loan
losses, deferred loan origination fees, deferred compensation, mortgage loan servicing, market value adjustments of securities, and depreciation for financial and income tax reporting in accordance with SFAS 109. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.
Balance Sheet Analysis
Loans
Total loans outstanding grew to $293.4 million at December 31, 1997, a 12.5% increase from the end of 1996. This follows a 24.1% increase at December 31, 1996 over 1995 year end.
The commercial, financial, and agricultural loan classification primarily consists of commercial loans to small business. Loans of this type are in a broad range of industries and include service, retail, wholesale and manufacturing concerns. Agricultural loans are made principally to farmers engaged in dairy, cherry and apple production. Borrowers are primarily concentrated in Door and Kewaunee Counties, Wisconsin. The credit risk related to commercial loans made by the Registrant's subsidiaries is largely influenced by general economic conditions (especially those applicable to the Door County market area) and the resulting impact on a borrower's operations.
Commercial loans and commercial real estate loans (including construction loans) totaled $179.9 million at year end 1997 and comprised 61.2% of the loan portfolio compared with 62.2% of the portfolio at the end of 1996. Loans in these classifications grew $17.7 million or 10.9% during 1997.
The following table sets forth loan composition (net of unearned income) at December 31:
Real estate loans (including construction loans) secured by non-residential real estate properties involve borrower characteristics similar to those for commercial loans. Because of their similarities, we have combined them with commercial loans for purposes of analysis and discussion.
An active credit risk management process is used for commercial loans to ensure that sound and consistent credit decisions are made. Credit risk is controlled in part by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers' outstanding loans and commitments. Borrower relationships are formally reviewed on an ongoing basis. Further analyses by customer, industry, and location are performed to monitor trends, financial performance and concentrations.
The Registrant's loan portfolio is diversified by types of borrowers and industry groups with the Door and Kewaunee County market areas. Significant loan concentrations are considered to exist for a financial entity when such amounts are loans to a multiple of borrowers engaged in similar activities which cause them to be similarly impacted by economic or other conditions. At December 31, 1997, there existed the following industry group concentrations in the Registrant's loans which exceeded 10% of total loans:
Tourism related loans:
Lodging business $50.3 million or 17.1% --------------------- Total tourism loans $50.3 million or 17.1%
The Registrant has a significant loan concentration because of tourism based loans. The Registrant must serve the credit needs of its market, with one of the key industries being tourism. Being a community bank, however, the Registrant must also meet the other needs of its market area. For that reason the Registrant realizes that the economic conditions of its market area directly impact the Registrant's performance levels. Any general weakness in the Door or Kewaunee County areas could have a material effect on the business and operations of the Registrant, although management believes that it is not unduly exposed to problems in any particular industry group.
Real estate residential mortgage loans totaled $100.6 million at the end of 1997 and comprised 34.3% of the loan portfolio at the end of 1997. Loans in this category grew $17.2 million or 20.7% during 1997. Residential real estate loans consist of conventional home mortgages, adjustable indexed interest rate mortgage loans, home equity lines, and secondary home mortgages. Loans are primarily for properties within the Door and Kewaunee County markets. Residential real estate loans generally contain a limit for the maximum loan to collateral value of 75% to 80%. Private mortgage insurance may be required when the loan to value exceeds these limits. Residential real estate loans are written normally with a one and three year
balloon feature.
In 1997, Registrant offered adjustable indexed interest mortgage loans based upon market demands. At year end 1997, those loans totaled $30.1 million dollars. Adjustable indexed interest rate mortgage loans contain an interest rate adjustment provision tied to the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of one year, plus an additional mark-up of 2.75% (the "index") which varies with the mortgage loan product. Interest rates on indexed mortgage loans are adjusted, up or down, on predetermined dates fixed by contract, in relation to and based on the index or market interest rates as of a predetermined time prior to the adjustment date.
Adjustable indexed interest rate mortgage loans have an initial period, ranging from one or three years, during which the interest rate is fixed, with adjustments permitted thereafter, subject to annual and lifetime interest rate caps which vary with the product. Annual limits on interest rate increases are 2% while aggregate lifetime interest rate increases over the term of the loan are currently at 6% above the original mortgage loan interest rate.
The Registrant also participates in a secondary fixed rate mortgage program under the Federal Home Loan Mortgage Corporation (FHLMC) guidelines. These loans are sold on the secondary market and the Registrant retains servicing rights. At December 31, 1997, these loans totaled $36.3 million.
Additionally in the last quarter of 1997, Registrant offered fixed rate mortgage through participation in secondary fixed rate mortgage programs under private investors. These loans are sold on the secondary market with servicing rights sold retained by buyer.
Installment loans to individuals totaled $13.5 million or 4.6% of the total loan portfolio at December 31, 1997 compared to $15.2 million or 5.9% at the end of 1996. Installment loans include short-term installment loans, direct and indirect automobile loans, recreational vehicle loans, credit card loans, and other personal loans. Individual borrowers may be required to provide related collateral or a satisfactory endorsement or guaranty from another party, depending upon the specific type of loan and the creditworthiness of the borrower. Loans are made to individual borrowers located in Door and Kewaunee Counties. Credit risks for these types of loans is generally influenced by general economic conditions (especially in the Door and Kewaunee County market areas), the characteristics of individual borrowers and the nature of the loan collateral. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers as well as taking the appropriate collateral and guaranty positions on such loans.
Critical factors in the overall management of credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, adequate allowance for possible loan losses, and conservative non-accrual and charge-off policies.
Allowance for Possible Loan Losses
At December 31, 1997 the allowance for possible loan losses of $3.9 million represented 1.32% of total loans, up from 1.11% at December 31, 1996. Loans grew at a rate of 12.5% from December 31, 1996 to year end 1997, while the allowance grew at a higher rate. Also, net charge-offs decreased in 1997 as compared to 1996. As loans have grown, management did not believe there existed any trends indicating any undue portfolio risk.
At December 31, 1996, the allowance for possible loan losses of $2.9 million represented 1.11% of total loans compared with 1.25% at the end of 1995.
Commercial, agricultural and other loans net charge-offs represented 37.8% of the total net charge-offs as compared with 27.0% of total net charge-offs in 1996. There existed no real estate mortgage loan net charge-offs in 1997 as compared to 40.6% of the total net charge-offs in 1996. Installment loan net charge-offs in 1996 were 62.2% of the total net charge-offs as compared with 32.4% of total net charge-offs in 1996. In the commercial sector, one charge-off contributed to the increase. The remaining commercial loan charge-offs during 1997 were offset for the most part by their eventual recoveries in 1997. The majority of charge-offs in the installment loan sector occurred as a result of automobile loans. Nine charge-offs totaling $59,000 were made in 1997 with minimal recoveries occurring. Credit card loans showed net charge-offs of $19,000 in 1997 compared to net charge-offs of $30,000 in 1996. Although the Bank has experienced higher interest returns on approximately $1.3 million in credit card balances, credit card loans are inherently risky in nature. The Bank continues to work with the credit card issuer to solicit quality loan accounts based on designated criteria and actively pursue collection efforts in a more timely fashion. Loans charged-off are subject to continuous review and specific efforts are taken to achieve maximum recovery of principal and accrued interest.
Management regularly reviews the adequacy of the allowance for possible loan losses to ensure that the allowance is sufficient to absorb potential losses arising from the credit granting process. Factors considered include the levels of non-performing loans, other real estate, trends in past due loans, loan portfolio growth, changes in loan portfolio composition, historical net charge-offs, present and prospective financial condition of borrowers, general and local economic conditions, specific industry conditions and other regulatory or legal issues that could affect the Registrant's loss potential.
Management believes that the balance of the allowance for possible loan losses as of December 31, 1997 is sufficient to absorb potential loan losses.
Non-Performing Loans, Potential Problem Loans and Other Real Estate
Management remains committed to a philosophy that encourages early identification of non-accrual and problem loans. The philosophy is embodied through the monitoring and reviewing of credit policies and procedures to ensure that all problem loans are identified quickly and the risk of loss is minimized.
Non-performing loans remain a leading indicator of future loan loss potential. Non-performing loans are defined as non-accrual loans, guaranteed
loans 90 days or more past due but still accruing, and restructured loans. Loans are placed in non-accrual status when contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collectibility of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. Previously accrued and uncollected interest on such loans is reversed and income is recorded only to the extent that interest payments are subsequently received on a cash basis and a determination has been made that the loan's principal is collectible. If the collectibility of principal is doubtful, payments received are applied to loan principal.
Restructuring loans involve the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes.
Non-performing loans at December 31, 1997 were $4.7 million, the same that existed at December 31, 1996. Non-accrual loans represent $1.7 million of this total. Approximately $1.2 million of this total consists of three non-accrual commercial real estate credits which are experiencing cashflow problems. Management believes that collateral is sufficient in the event of default. Troubled debt restructured loans represent $2.9 million of non-performing loans. Approximately $1.9 million of this total consists of one commercial real estate credit which has been granted various concessions and has been experiencing cashflow problems. This credit was current at December 31, 1997. Other commercial credits totaling $646,000 represented by five customers make up the balance remaining. These credits also have experienced cashflow difficulties but are current at year end 1997. Management believes that collateral is sufficient in those loans classified as troubled debt in event of default. As a result the ratio of non-performing loans to total loans at the end of 1997 was 1.6% compared to 1.8% at 1996 year end. The Registrant's allowance for possible loan losses balance was 83.3% of total non-performing loans at December 31, 1997 compared to 61.9% at year end 1996.
Potential problem loans are performing loans in which there is doubt that the borrower will be able to comply with loan repayment terms. Management's decision to place loans in this category does not necessarily mean that the Registrant expects to take losses on such loans, but that management needs to be more vigilant in its efforts to oversee the loan and recognize that a higher degree risk is associated with these nonperforming loans. At December 31, 1997, potential problem loans amounted to a total of $696,000 compared to $1.4 million at year end 1996. $180,000 of the 1997 problem loans stems from vacant commercial property which has been listed for sale. $208,000 of the problem loans stem from three commercial credits who are currently experiencing cashflow concerns. Various commercial loans totaling $62,000, mortgage loans totaling $75,000 and consumer loans totaling $171,000 make up the remaining totals. With the exceptions noted above, potential problem loans are not concentrated in a particular industry but rather cover a diverse range of businesses.
The placement of performing loans in the potential problem loan category indicated management's willingness to more closely monitor the financial condition of the borrower and collateral positions of the Registrant or will
strengthen the loans with additional collateral if significant losses from credits are expected in this category.
Other real estate owned which represents property to which the Registrant has acquired through foreclosure or in satisfaction of debt, consisted of no real estate property at year end 1997. This compared to one commercial real estate property totaling $110,000 at year end 1996. Management actively seeks to ensure that properties held are administered to minimize any risk of loss.
Net cost of operation of other real estate for 1997, 1996, and 1995 consists of the following:
Other properties taken in as a result of foreclosure or surrender include a restaurant and hotel facility that existed as a subsidiary of Bank named Karsten Resources, Inc. This subsidiary was sold in the last quarter of 1997. Results of operation which are included in other income and other operating expense consists of 1997 other income of $99,000 and gain on sale of fixed assets of $17,000; other operating expenses of $180,000 and a net loss after tax of $42,000.
Investment Portfolio
The investment portfolio is intended to provide the Registrant with adequate liquidity, flexibility in asset/liability management and, lastly, its earning potential.
Investment securities are classified as held to maturity or available for sale. The Registrant has determined at year end 1997 that all of its taxable issues, including U.S. Treasury, U.S. Agency securities and municipal bond securities purchased in 1997 were to be classified as available for sale. In addition, Bank had determined that its non-taxable issues such as municipal issues and non-taxable local municipals were classified as available for sale. In the case of the Baylake Bank's non-taxable issues and municipal bond investments purchased prior to 1996, they were determined to be held to
maturity. This determination was made because the Bank wanted to retain the municipal bond issues due to their higher after-tax yields, and local non-taxable issues due to their lessened marketability. Held to maturity securities are those securities which the Registrant has both the intent and ability to hold until maturity. Under this classification, securities are stated at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income. Gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. At December 31, 1997, securities held to maturity had an aggregate market value of approximately $12.4 million compared with amortized cost of $11.9 million.
Investment securities classified as available for sale are those securities which the Registrant has determined might be sold to manage interest rates or in response to changes in interest rates or other economic factors. While the Registrant has no current intention of selling those securities, they may not be held to maturity. Investment securities available for sale at December 31, 1997 and 1996 are carried at market value. Adjustments up or down to market value at December 31, 1997 and 1996 are recorded as a separate component of equity, net of tax. Premium amortization and discount accretion are recognized as adjustments to interest income. Realized gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold using the specific identification method. At December 31, 1997, securities available for sale had a market and carrying value of $103.0 million compared with amortized cost of $101.0 million. The reserve for market adjustment of securities, net of tax, and reflected in the stockholders' equity section stood at $1.3 million at December 31, 1997.
At December 31, 1997 and 1996, the Registrant's investment portfolio did not contain, other than U.S. treasury and federal agencies, securities of any single issuer that were payable from and secured by the same source of revenue of taxing authority where the aggregate book value of such securities exceed 10% of stockholders' equity.
Investment securities averaged $99.6 million in 1997 compared with $83.8 million in 1996. The average balance of securities increased primarily as a result of the additional funding created from the leveraging strategy employed by the Registrant in the latter part of 1997. In 1997, taxable securities comprised approximately 67.0% of the total average investments compared to 70.0% in 1996. Tax-exempt securities on average for 1997 accounted for 33.0% of the total average investments compared to 30.0% in 1996.
Deposits
Average total deposits in 1997 were $332.7 million, an increase of 11.8% over 1996. This follows a 16.6% increase in 1996 over 1995, partially the result of the acquisition of Four Seasons.
Non-interest bearing demand deposits in 1997 averaged $41.5 million, up 11.5% from $37.2 million in 1996. This $4.3 million increase is partially attributable to improvement in the seasonal increases in these funds throughout the year along with an emphasis of attracting new customer relationships and selling more services to existing customers. December 31,
1997 non-interest bearing demand deposits were $44.2 million compared with $43.1 million at year end 1996.
Interest bearing deposits generally consist of interest-bearing checking, savings deposits, money market accounts, individual retirement accounts (IRAs) and certificates of deposit (CDs). In 1997 interest bearing deposits averaged $291.2 million compared with $260.4 million, an increase of 11.8%. Within the category of interest bearing deposits, savings deposits (including money market accounts) increased an average of $498,000 or .6%. During the same period, time deposits (including CDs and IRAs) grew an average of $28.0 million or 20.6%. Time deposits over $100,000 increased by $14.3 million on average primarily in public fund time deposits. These were priced within the framework of Registrant's rate structure and did not materially increase the average rates on deposit liabilities. Increased competition for consumer loan deposits and customer awareness of interest rates continues to limit the Registrant's core deposit growth in these types of deposit.
Additional emphasis will be placed on generating additional core deposits in 1998 through competitive pricing of deposit products and through the branch delivery systems that have already been established. The Registrant will also attempt to attract and retain core deposit accounts through new product offerings and customer service.
Short-Term Borrowings
Short-term borrowings consist of federal funds purchased, securities sold under agreements to repurchase, and borrowings from the Federal Home Loan Bank. Average 1997 short-term borrowings were $29.5 million compared with $11.8 million during 1996. This increase of $17.7 million or 150.2% occurred as a result of higher than expected loan demand, increased investment balances and the Registrant's effort to more effectively leverage capital.
Average short-term borrowings increased $7.4 million or 167.4% in 1996 from 1995 as a result of increased loan demand and additional funding required as a result of the acquisition of Four Seasons.
Federal funds are purchased from money center banks and correspondent banks at prevailing overnight interest rates. Securities are sold to bank customers under repurchase agreements at prevailing market rates. The balances in federal funds purchased show the most fluctuation as we saw an increase in average short-term borrowings of $11.0 million, as a result of increased lines established during 1997. During 1997 the Registrant acquired an additional funding source with the establishment of a relationship with the Federal Home Loan Bank. Borrowings with the Federal Home Loan Bank are secured by one to four family residential mortgages allowing the Registrant to use it for additional funding purposes. On average, $6.8 million was borrowed with the Federal Home Loan Bank in 1997.
Long-Term Debt
The largest component of long-term debt of $383,000 consists of a land contract requiring annual principal payments of $53,000 plus interest
calculated at prime + 1/4%. The land contract is debt used for the purchase of one of the properties in the Green Bay region for branch location.
Liquidity
Liquidity refers to the ability of the Registrant or its subsidiary bank to generate adequate amounts of cash to meet its needs for cash. The Registrant and the Bank have different liquidity considerations.
The Bank meets their cash flow needs by having funding sources available to them to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity at the Bank is derived from deposit growth, maturing loans, the maturity of the investment portfolio, access to other funding sources, marketability of certain of their assets and strong capital positions.
Maturing investments has been a primary source of liquidity at the Bank. This changed in 1997, as the Registrant implemented a capital leveraging strategy. As part of this strategy employed by the Registrant, $50.3 million in investments were purchased in 1997. This resulted in a net cash of $18.9 million used in investing activities for 1997. At December 31, 1997, the carrying or book value of investment securities maturing within one year amounted to $21.4 million or 18.6% of the total investment securities portfolio. This compares to the 23.4% level for investment securities with one year or less maturities as of December 31, 1996. Within the investing activities of the cashflow statement, sales and maturities of investment securities during 1997 totaled $31.4 million. At the end of 1997, the investment portfolio contained $65.8 million of U.S. Treasury and federal agency backed securities, representing 57.3% of the total investment portfolio. These securities tend to be highly marketable and had a market value above amortized cost at year end 1997 amounting to $1.0 million.
Deposit growth is another source of liquidity for the Bank. As a financing activity reflected in 1997 Consolidated Statements of Cash Flows, deposits provided $18.8 million in net cash inflow during 1997. The Registrant's overall average deposit base grew $35.1 million or 11.8% during 1997. Deposit growth, especially in the area of core deposits, is the most stable source of liquidity for the Bank.
Federal funds sold averaged $17,000 in 1997 compared to $943,000 in 1996. Funds provided from the maturity of these assets typically are used as funding sources for seasonal loan growth, which generally have higher yields. Being short-term and liquid by nature, federal funds sold generally provide a yield lower than other earning assets. The Bank has a strategy of maintaining a sufficient level of liquidity to accommodate fluctuations in funding sources and will at times take advantage of specific opportunities to temporarily invest excess funds at narrower than normal rate spreads while still generating additional interest revenue. At December 31, 1997, the Bank had no federal funds sold.
The scheduled maturity of loans can provide a source of additional liquidity. The Bank has $81.3 million of loans maturing within one year, or 27.7% of total loans.
Within the classification of short-term borrowings at year end 1997, federal funds and securities sold under agreements to repurchase totaled $20.6 million compared with $23.8 million at the end of 1996. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Federal Home Loan Bank was also established during 1997 as another source of funds. Borrowings from Federal Home Loan Bank stood at $36.0 million at year end 1997.
The Bank's liquidity resources were sufficient in 1997 to fund the growth in loans, maintain a stable investment portfolio, increase the volume of interest earning assets and meet other cash needs when necessary.
Management expects that deposit growth will continue to be the primary funding source of the Bank's liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities, and a strong capital position. Although federal funds purchased and borrowings from the Federal Home Loan Bank provided a sizable portion of funds provided in 1997, management expects deposit growth to be a more reliable funding source in the future as a result of branch expansion efforts and marketing efforts to attract and retain core deposits. Shorter-term liquidity needs will mainly be derived from growth in short-term borrowings, maturing federal funds sold and portfolio investments, loan maturities and access to other funding sources.
The Registrant's (rather than of Bank's) primary sources of funds are dividends and interest, and proceeds from the issuance of equity. The Registrant manages its liquidity position in order to provide funds necessary to pay dividends to its shareholders. Dividends received from Bank totaled $3.0 million in 1997 and will continue to be the Registrant's main source of long-term liquidity. The dividends from the Bank were sufficient to pay cash dividends to the Registrant's shareholders of $3.0 million in 1996.
Management believes that, in the current economic environment, the Registrant's and the Bank's liquidity position are adequate. To management's knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material increase or decrease in the Banks or the Registrant's liquidity.
Interest Rate Sensitivity
Interest rate risk is the exposure to a bank's earnings and capital arising from changes in future interest rates. All banks assume interest rate risk as an integral part of normal banking operations. Management of interest rate risks includes four components: policy statements, risk limits, risk measurement and reporting procedures. A primary objective of asset/liability management is the control and monitoring of interest rate risk. The Registrant's bank uses an Asset/Liability Committee (ALCO) to manage risks associated with changing interest rates, changing asset and liability mixes, and their impact on earnings. The sensitivity of net interest income to market rate changes is evaluated monthly by the ALCO committee.
Interest rate sensitivity analysis can be performed in several different ways. The traditional method of measuring interest sensitivity is called "gap" analysis. The mismatch between asset and liability repricing characteristics in specific time intervals is referred to as "interest rate sensitivity gap." If more liabilities than assets reprice in a given time interval a liability gap position exists. In general, liability sensitive gap positions in a declining interest rate environment increases net interest income. Alternatively asset sensitive positions, where assets reprice more quickly than liabilities, negatively impact the net interest income in a declining rate environment. In the event of an increasing rate environment, opposite results would occur in that a liability sensitivity gap position would decrease net interest income and an asset sensitivity gap position would increase net interest income. The sensitivity of net interest income to changing interest rates can be reduced by matching the repricing characteristics of assets and liabilities.
The following table entitled "Asset and Liability Maturity Repricing Schedule" indicates that the Registrant is liability sensitive, although management believes that a range of plus or minus 15% within a one year pricing schedule is acceptable. The analysis considers regular savings, money market deposits and NOW accounts to be rate sensitive within three months. All other earning categories including loans and investments as well as other paying liability categories such as time deposits are scheduled according to their contractual maturities. Additionally, the Registrant considers its savings and NOW accounts to be core deposits and relatively non-price sensitive, as it believes it could make repricing adjustments for these types of accounts in smaller increments without a material decrease in balances. Although the analysis indicates a result above the 15% one year maturity gap for repricing, management considers these core deposits such as savings and NOW accounts to be more long-term in repricing characteristics.
ASSET AND LIABILITY MATURITY REPRICING SCHEDULE
Capital Resources
Stockholders' equity at December 31, 1997 increased $2.6 million or 6.7% to $41.9 million, compared with $39.2 million at 1996 year end. This increase includes a positive change of $707,000 to capital in 1997 due to the use of STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 115. Without the effect of this net change stockholders' equity would have increased $1.9 million or 5.0% for 1997 over 1996, which compares to an increase of $2.5 million or 7.0% for 1996 over 1995. With the SFAS 115 adjustment included in 1996 capital, capital increased $2.9 million or 8.2% compared to 1995 year end.
The Registrant's capital base (before SFAS 115 change) increased primarily due to the retention of earnings. Although not used for a portion of 1997, the Registrant's dividend reinvestment plan typically provides capital improvement, as the holders of approximately 28% of Registrant's Common Stock participate in the plan. The dividend reinvestment plan although suspended during a part of 1997 and early 1998 was reinstated for the March 1998 dividend for those shareholders who elected to participate.
Cash dividends paid in 1997 were $1.22 per share compared with $.93 in 1996, including a special dividend of $.25 paid in December 1997. The Registrant provided a 4.3% increase in normal dividends per share in 1997 over 1996 as a result of above average earnings and strong capital position.
In 1997, the Registrant's Board of Directors authorized management to repurchase up to 7,000 shares of the Registrant's common stock each calendar quarter in the market. The shares repurchased would be used to fill its needs for the dividend reinvestment program, any future benefit plans, and the employee stock purchase program currently being developed. Shares repurchased are held as treasury stock and, accordingly, are accounted for as a reduction of stockholders' equity. The Registrant purchased 14,000 of its common shares in 1997.
The adequacy of the Registrant's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. Management is confident that because of current capital levels and projected earnings levels, capital levels are more than adequate to meet the ongoing and future concerns of the Registrant.
The Federal Reserve Board has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to total assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory -and possible additional
discretionary- actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements.
At December 31, 1997, the most recent notification from the Federal Reserve Board categorized the corporation as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's category.
To be well capitalized under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
The following table presents the Registrant's capital ratios as of December 31, for each of the following two years.
Registrant's Ratios:
Management believes that a strong capital position is necessary to take advantages of opportunities for profitable expansion of product and market share, and to provide depositor and investor confidence. The Registrant's capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for a superior return on the capital employed.
Management actively review capital strategies for the Registrant to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements.
Year 2000
The Registrant has begun an initial assessment of the Year 2000 issue. This issue relates to systems designed to use two digits rather than four to define the particular year. The assessment completed thus far includes an awareness, inventory of systems affected by the issue and a preliminary analysis of corrective actions to be taken.
Accounting Developments
Effective December 31, 1997, the Registrant adopted SFAS No. 128, "Earnings per Share." The statement specifies the computation, presentation, and disclosure requirements for earnings per share for entities with publicly held common stock. All reported prior period earnings per share information has been restated with SFAS No. 128.
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 130, "Reporting Comprehensive Income." This statement establishes standards for reporting and display of comprehensive income in a full set of general- purpose financial statements. The Registrant will be required to adopt this statement as of January 1, 1998. If the Registrant had adopted this statement as of January 1, 1996, comprehensive income for the years ended December 31, 1997 and 1996, would have been $6.0 million and $5.2 million, respectively.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement requires certain disclosures about an entity's operating segments in annual and interim financial reports. It also requires certain related disclosures about products and services, geographic areas, and major customers. The segment and other information disclosures are required for the year ended December 31, 1998. The segments that will be disclosed have not yet been determined.
Item 7 A.
Item 7 A. Quantitative and Qualitative Disclosures About Market Risk.
The Registrant's financial performance is impacted by interest rate risk and credit risk, among other factors. Registrant does not use derivatives to mitigate its interest rate risk, or credit risk. Registrant instead puts reliance on loan review and the provision of an adequate loan loss reserve as explained in "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Interest rate risk is the exposure to a bank's earnings and capital arising from changes in future interest rates. This risk is evaluated quarterly by the Registrant's Asset/Liability Committee (ALCO). Their responsibility involves the management of risks associated with changing interest rates, changing mix involving assets and liabilities, and the subsequent impact on earnings. The ALCO committee operates under the advisory policy guidelines on interest rate sensitivity approved the Board of Directors. The sensitivity of net interest income to market rate changes is evaluated regularly by the Registrant to determine the effectiveness of interest rate risk management.
In order to limit exposure to interest rate risk, the Registrant has developed strategies to manage its liquidity, shorten the effective maturities of certain interest-earning assets, and increase the effective maturities of certain interest-bearing liabilities. Registrant has focused on the establishment of Adjustable rate mortgages (ARM's) in its residential lending productline; the concerted efforts made to attract and sell core deposit products through use of Registrant's branching and delivery systems and marketing efforts; and the use of other available sources of funding to provide longer term funding possibilities.
Interest rate sensitivity analysis is used to measure the Registrant's interest rate risk by computing changes in the Registrant's pretax income calculated using flat rates over a 12 month period. The resulting income is then compared to a future earnings simulation based on a +/- 100 basis point parallel rate shock. The difference in income calculated represents the Registrant's earnings sensitivity to a +/- 100 basis point parallel rate shock. The table below illustrates these amounts at December 31, 1997, which are within the limits established by the Registrant:
HYPOTHETICAL CHANGE IMPACT TO 1998 IN INTEREST RATES PRETAX NET INCOME
100 basis point shock up (5.2%) 100 basis point shock down 2.5%
These results are based solely on immediate and sustained parallel changes in market rates and do not reflect the earnings sensitivity that may arise from such factors as the change in spread between key market rates and the shape of the yield curve. The above results also are considered to be conservative estimates due to the fact that no management action is factored into the analysis to deal with potential income variances.
Another component of interest rate risk, fair value at risk, is determined by the Registrant through the technique of simulating the fair value of equity in changing rate environments. This involves determining the present value of all contractual asset and liability cash flows based on market rates of interest provided by independent broker quotations and other public sources. The net result of all these balance sheet items determine the fair value of equity. The fair value of equity resulting from the current flat rate scenario is compared to the fair value of equity using discount rates +/- 100 basis points from flat rates to determine the fair value of equity at risk. Currently, fair value of equity at risk is less than 3.0% of the market value of the Registrant as of December 31, 1997.
PART II - OTHER INFORMATION
ITEM 8.
ITEM 8. Other Information
Bank has received approval to open two additional branches in 1998. The first branch will be opened up in the town of Ledgeview, located in the southeast portion of the Green Bay region. This facility will offer a full range of retail and deposit services and is anticipated to be completed in the early third quarter of 1998. Costs to complete facility are estimated at $950,000. The second branch will be opened up in the city of Waupaca. This facility will offer a full range of retail and deposit services and is anticipated to be completed in the late third quarter to early fourth quarter of 1998. Costs to complete facility are estimated to be $1.1 million.
Baylake Corp has reinstated the Dividend Reinvestment Plan with the quarterly dividend payment made March 16, 1998. Participating shareholders who so elected, purchased shares of Baylake Common Stock in lieu of receiving cash dividends.
ITEM 9.
ITEM 9. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Registrant's Consolidated Financial Statements and notes to related thereto are set forth on the following pages.
ITEM 10.
ITEM 10. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED FINANCIAL STATEMENTS and REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
For the Years Ended December 31, 1997, 1996, and 1995
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
Page ----
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS 1
FINANCIAL STATEMENTS
Consolidated Balance Sheets 2 - 3
Consolidated Statements of Income 4
Consolidated Statements of Changes in Stockholder Equity 5 - 6
Consolidated Statements of Cash Flows 7 - 8
Notes to Consolidated Financial Statements 9 - 36
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors Baylake Corp. Sturgeon Bay, Wisconsin
We have audited the accompanying consolidated balance sheets of Baylake Corp. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, changes in stockholder equity, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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 financial statements referred to above present fairly the consolidated financial position of Baylake Corp. and subsidiaries at December 31, 1997 and 1996, and the results of its operations and cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
Madison, Wisconsin January 22, 1998 SMITH & GESTELAND, LLP
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED BALANCE SHEETS December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER EQUITY For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER EQUITY (Continued) For the Years Ended December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements of Baylake Corp. (the company) include the accounts of the company, its wholly-owned subsidiaries, Baylake Bank and Kewaunee County Banc-Shares, Inc. and their wholly-owned subsidiaries; Bank of Sturgeon Bay Building Corporation, Cornerstone Financial, Inc., Baylake Investments, Inc., Baylake Insurance Agency, Inc., Karsten Resources, Inc., and Lufter Insurance Agency, Inc. All significant intercompany items and transactions have been eliminated.
Baylake Bank owns a 49% interest in United Financial Services, Inc., a data processing service. The investment in this entity is carried under the equity method of accounting and the pro rata share of its income (loss) is included in other revenue. Amounts paid to United Financial Services, Inc. for data processing services for the banks were $599,000, $531,000, and $464,000 in 1997, 1996, and 1954, respectively. At December 31, 1997 and 1996, Baylake Bank had loans of $696,000 and $424,000, respectively, to United Financial Services, Inc.
The bank grants commercial, mortgage, and installment loans to customers substantially all of whom are located in Door, Brown, Kewaunee, and Waupaca Counties of Wisconsin. Although the bank has a diversified portfolio, a substantial portion of their debtors' ability to honor their contracts is dependent upon the economic condition of the local industrial businesses, and commercial, agricultural and tourism industries.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
For comparability, certain 1996 and 1995 amounts have been reclassified to confirm with classification adopted in 1997.
Investment securities classified as held to maturity are those securities which the bank has both the intent and the ability to hold until maturity. Under this classification, securities are stated at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income. Gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Investment securities classified as available for sale are those securities which the bank has determined might be sold to manage interest rate risk or in response to changes in interest rates or other economic factors. While the company has no current intention of selling these securities, they may not be held to maturity.
Investment securities available for sale are carried at market value. Adjustments up or down to market value are recorded as a separate component of equity, net of tax. Premium amortization and discount accretion are recognized as adjustments to interest income. Realized gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
Loans are stated at face value, net of deferred loan origination fees (net of costs) and the allowance for loan losses. Interest on loans is calculated using the simple interest method on daily balances of the principal amount outstanding or an amortized method.
Loan origination fees and related costs are deferred and the net deferred revenue is amortized over the term of the loans using the effective interest rate method.
The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current domestic and international economic conditions, volume, growth and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income.
The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collectibility is in doubt, cash receipts on nonaccrual loans are used to reduce principal rather than recorded as interest income.
Depreciable assets are stated at cost less accumulated depreciation. Depreciation is charged to operating expense over the estimated useful lives of the assets, using the straight-line and accelerated methods.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Other real estate, which is included in other assets, comprises properties acquired through a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. These properties are carried at the lower of cost or fair value, minus estimated costs to sell, based on appraised value at the date acquired. Loan losses arising from the acquisition of such property are charged against the allowance for loan losses. An allowance for losses on other real estate is maintained for subsequent valuation adjustments on a specific property basis.
The company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25) and related interpretations in accounting for its stock-based compensation plans. In 1995, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" which is effective for fiscal years beginning after December 15, 1995. Under SFAS No. 123, companies may elect to recognize stock-based compensation expense based on the fair value of the awards or continue to account for stock-based compensation under APB No. 25. The company has elected to continue to apply the provisions of APB No. 25 with the disclosure requirements of SFAS No. 123 in Note 17.
Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of the allowance for loan losses, deferred loan origination fees, deferred compensation, mortgage loan servicing, market value adjustments of securities, and depreciation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.
The company and its subsidiaries file a consolidated federal income tax return. The subsidiaries provide for income taxes on a separate-return basis, and remit to the company amounts determined to be currently payable, if any.
Earnings per share are based on the weighted average number of shares outstanding during each year.
For purposes of the statement of cash flows, the company considers cash and due from banks as cash and cash equivalents.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Effective January 1, 1997, the company adopted SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 125 requires that after a transfer of financial assets, an entity must recognize the financial and servicing assets controlled and liabilities incurred and derecognize financial assets and liabilities in which control is surrendered or when debt is extinguished. The impact on the company's consolidated financial position and results of operations was not material.
In December 1996, the FASB issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125." SFAS No. 127 deferred the effective date of SFAS No. 125 related to transfers of financial assets occurring after December 31, 1997, specifically, such transfers involving repurchase agreements, securities lending, and similar transactions. The company will adopt SFAS No. 127 as required. The adoption of SFAS No. 127 is not expected to have a material impact on the company's consolidated statement of position or results of operations.
Effective December 31, 1997, the company adopted SFAS No. 128, "Earnings Per Share." The statement specifies the computation, presentation, and disclosure requirements for earnings per share for entities with publicly held common stock. All reported prior period earnings per share information has been restated in accordance with SFAS No. 128.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." This statement establishes standards for reporting and display of comprehensive income in a full set of general-purpose financial statements. The company will be required to adopt this statement as of January 1, 1998. If the company had adopted this statement as of January 1, 1996, comprehensive income for the years ended December 31, 1997 and 1996, would have been $5,977,000 and $5,165,000, respectively.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement requires certain disclosures about an entity's operating segments in annual and interim financial reports. It also requires certain related disclosures about products and services, geographic areas, and major customers. The segment and other information disclosures are required for the year ended December 31, 1998. The segments that will be disclosed have not yet been determined.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS
The subsidiary banks are required to maintain average reserve balances by the Federal Reserve Bank. The average amount of those reserve balances for the year ended December 31, 1997, was approximately $3,797,000.
NOTE 3 - INVESTMENT SECURITIES
The amortized cost and estimated market values of investments are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - INVESTMENT SECURITIES (continued)
A security that had been designated as held to maturity, having an amortized cost basis of $500,000, was called by the issuer in 1995 with a call premium being received.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - INVESTMENT SECURITIES (continued)
The amortized cost and estimated market value of investments at December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Securities pledged to secure public and trust deposits and borrowed funds had a carrying value of $8,181,000 at December 31, 1997, and a carrying value of $7,447,000 at December 31, 1996.
NOTE 4 - LOANS
Major classifications of loans are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - LOANS (continued)
Loans having a carrying value of $65,958,000 are pledged as collateral for borrowings from the Federal Home Loan Bank at December 31, 1997.
Certain directors and officers of the company and the subsidiary banks, including their immediate families, companies in which they are principal owners, and trusts in which they are involved, were loan customers of the subsidiaries during 1997 and 1996. Such loans were made in the ordinary course of business at normal credit terms, including interest rate and collateralization, and do not represent more than a normal risk of collection. The aggregate dollar amount of these loans was $8,471,000 and $7,612,000 at December 31, 1997 and 1996, respectively. During 1997, $9,044,000 of new loans were made and repayments totalled $8,088,000.
Loans on which the accrual of interest has been discontinued or reduced amounted to $1,720,000 and $3,677,000 at December 31, 1997 and 1996, respectively. If these loans had been current throughout their terms, interest income for the nonaccrual period would have approximated $202,000 and $472,000 for 1997 and 1996, respectively. Interest income which has been recorded amounted to $180,000 and $154,000 for 1997 and 1996, respectively, for these nonaccrual loans.
Changes in the allowance for loan losses were as follows:
The provision for credit losses charged to expense is based upon the bank's credit loss experience and an evaluation of potential losses in the current loan portfolio, including the evaluation of impaired loans under SFAS 114. A loan is considered to be impaired when, based upon current information and events, it is probable that the bank will be unable to collect all amounts due according to the contractual terms of the loan.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - LOANS (continued)
The following is a summary of activity in investment in loans that have declined in value and related interest income and allowance for credit losses accounts:
NOTE 5 - BANK PREMISES AND EQUIPMENT
BAYLAKE CORP. AND SUBSIDIARIES
Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 - OTHER REAL ESTATE
Other real estate ($229,000 in 1997, $339,000 in 1996, and $378,000 in 1995, net of an allowance for other real estate losses of $229,000 in 1997, $229,000 in 1996, and $378,000 in 1995) is included in other assets.
Net cost of operation of other real estate is summarized below:
NOTE 7 - SHORT-TERM BORROWINGS
Short-term borrowings consisted of the following at December 31:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7 - SHORT-TERM BORROWINGS (continued)
The average outstanding balance of total short-term borrowings amounted to $29,500,000 in 1997 and $11,791,000 in 1996. The weighted-average interest rate on these borrowings was 5.7% for 1997 and 5.4% for 1996. The average outstanding balance is determined on a daily average basis and the weighted-average interest rate is calculated by dividing the actual interest paid on all short-term borrowings by the average balance for the year.
The maximum amount outstanding at any month end was $56,649,000 during 1997 and $32,288,000 during 1996.
NOTE 8 - LONG-TERM DEBT
Long-term debt consists of the following at December 31,
NOTE 9 - DIVIDENDS AND CAPITAL RESTRICTIONS
Cash dividends per share to outside shareholders were $1.22, $.93, and $1.14 in 1997, 1996, and 1995, respectively.
As of December 31, 1997, undistributed earnings of the subsidiaries, included in consolidated retained earnings, available for distribution to the company as dividends without prior approval of regulatory authorities was $9,921,000.
BAYLAKE CORP. AND SUBSIDIARIES
Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9 - DIVIDENDS AND CAPITAL RESTRICTIONS (continued)
Federal banking regulatory agencies have established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to total assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements.
At December 31, 1997, the most recent notification from the Federal Reserve Board categorized the corporation as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the corporation's category.
To be well capitalized under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
The corporation's risk-based capital and leverage ratios are as follows (amounts in thousands):
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9 - DIVIDENDS AND CAPITAL RESTRICTIONS (continued)
NOTE 10 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees.
The bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contract or notional amount of those instruments. The bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK (continued)
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. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the bank upon extension of credit is based on management's credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
Standby letters of credit and financial guarantees written are conditional commitments issued by the bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The guarantees expire in decreasing amounts through 1999, with the majority expiring within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The bank does not require collateral as support for the commitments. Collateral is obtained based on loan policies upon use of a commitment by a customer.
NOTE 11 - ACQUISITIONS
On July 1, 1996, the company acquired all of the common stock of Four Seasons of Wis., Inc. (Four Seasons) for a cash price of $13,875,000. Subsequent to the purchase, Four Seasons was liquidated and the net assets were contributed to Baylake Bank. Four Seasons was a one-bank holding company with two locations in Waupaca County, Wisconsin. The acquisition was accounted for under the purchase method of accounting. The excess of the purchase price over the fair value of the net identifiable assets acquired of $4,900,000 has been recorded as goodwill and is being amortized on a straight-line basis over 15 years.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11 - ACQUISITIONS (continued)
The following unaudited proforma financial information presents the combined results of operations of the company and Four Seasons as if the acquisition had occurred as of the beginning of each of the periods presented.
NOTE 12 - PENSION PLAN
The subsidiaries have 401(k) Profit Sharing Plans covering all employees who qualify as to age and length of service. The employer contributions paid and expensed under all plans for 1997, 1996, and 1995, totaled $423,000, $377,000, and $341,000, respectively.
Certain officers and directors of the company and its subsidiaries are covered by nonqualified deferred compensation plans. Payments to be made under these plans are accrued over the anticipated years of service of the individuals covered. Amounts charged to expense were $142,000 in 1997, $136,000 in 1996, and $193,000 in 1995.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - INCOME TAX EXPENSE
The following is a summary of the components of the provisions for income taxes and deferred income taxes, and a reconciliation of the U.S. statutory income tax rate to the effective income tax rate.
Provision for income taxes:
Income tax expense associated with realized securities gains was $115,000, $15,000, $2,000 for 1997, 1996, and 1995, respectively.
Provisions for deferred income taxes:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - INCOME TAX EXPENSE (continued)
The provision for income taxes differs from the amount of income tax determined by applying the statutory federal income tax rate to pretax income as a result of the following differences:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - INCOME TAX EXPENSE (continued)
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been recognized to offset the related deferred tax assets due to the uncertainty of realizing tax benefits of a portion of loan loss and mortgage servicing differences. The following is a summary of the significant components of the company's deferred tax assets and liabilities as of December 31, 1997 and 1996:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - EARNINGS AND DIVIDENDS PER SHARE
Earnings and dividends per share are based on the weighted average number of shares outstanding for the year. A reconciliation of the basic and diluted earnings per share amounts is as follows:
There is no difference between basic and diluted income available to common stockholders.
See Note 17 for information on additional stock options issued subsequent to year end. These shares would not have changed materially the calculation of the number of common shares or potential common shares outstanding at the end of the period if the transaction had occurred before December 31, 1997.
NOTE 15 - OTHER INCOME
Other income is comprised of no amounts which are individually greater than 1% of total interest income and total other income.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - OTHER OPERATING EXPENSES
NOTE 17 - STOCK OPTION PLAN
The company has a non-qualified stock option plan under which certain officers and key salaried employees may purchase shares of the company's stock at an established exercise price. Unless earlier terminated, these options will expire ten years from the date of grant. The options become exercisable 20% per year, commencing one year from date of grant.
Activity in the plan is summarized as follows:
In January 1998, options to purchase an additional 42,000 shares were granted. The exercise price was established at 100% of the fair market value of the stock on the date of grant, or $28.75 per share.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - STOCK OPTION PLAN (continued)
The options outstanding at December 31, 1997 were:
Options exercisable at December 31, 1996 and 1995 were 33,200 17,600, respectively. The weighted average exercise price for options exercisable at December 31, 1996 and 1995 was $24.73 and $19.93, respectively.
In October, 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation." This standard establishes financial accounting and reporting standards for stock-based employee compensation plans.
SFAS 123 defines a fair value based method of accounting for employee stock option or similar equity instruments. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award using an option-pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, expected dividends and the risk-free interest rate over the expected life of the option. The resulting compensation cost is recognized over the service period, which is usually the vesting period.
Compensation cost can also be measured and accounted for using the intrinsic value based method of accounting prescribed in Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees." Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount paid to acquire the stock.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - STOCK OPTION PLAN (continued)
The largest difference between SFAS 123 and APB 25 as it relates to the company is the amount of compensation cost attributable to the company's stock option plan. Under APB 25 no compensation cost is recognized for the stock option plan because the exercise price is equal to the quoted market price at the date of grant and therefore there is no intrinsic value. SFAS 123 compensation cost would equal the calculated fair value of the options granted.
As permitted by SFAS 123, the company continues to measure compensation cost for the stock option plan using the accounting method prescribed by APB 25.
Had compensation cost for the company's options granted after January 1, 1995, been determined according to SFAS 123, the company's net income and earnings per share would have been reduced to the following proforma amounts:
The fair value of each option grant was estimated as of the date of grant using the Black-Scholes option pricing method. The resulting compensation cost was amortized over the vesting period.
The grant date fair values and assumptions used to determine such values are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Provided below is the information required by STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107). These amounts represent estimates of fair values at a point in time. Significant estimates regarding economic conditions, loss experience, risk characteristics associated with particular financial instruments and other factors were used for the purposes of this disclosure. These estimates are subjective in nature and involve matters of judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could have a material impact on the amounts estimated.
Many of the company's financial instruments lack an available trading market. Furthermore, most of the financial instruments are intended to be held to maturity. Therefore, it is not probable that the fair values shown will be realized in a current transaction.
The estimated fair values disclosed do not reflect the value of assets and liabilities that are not considered financial instruments. In addition, the significant value of long-term relationships with depositors and other customers are not reflected.
A. CASH AND DUE FROM BANKS
These instruments are, by definition, short-term and do not present any unanticipated credit issues. Therefore, the carrying amount is a reasonable estimate of fair value.
B. INVESTMENT SECURITIES
The estimated fair values of securities are provided in Note 3 to the financial statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)
C. LOANS
The carrying amount (total outstandings excluding unearned income and reserve for loan losses) and estimated fair value of loans outstanding at December 31, 1997, are $293,438,000 and $293,120,000 and for December 31, 1996, are $260,854,000 and $260,013,000. In order to determine the fair values for loans, the loan portfolio was segmented based on loan type, credit quality and repricing characteristics. For certain variable rate loans with no significant credit concerns and frequent repricings, estimated fair values are based on the carrying values. The fair values of other loans are estimated using discounted cash flow analyses. The discount rates used in these analyses are generally based on origination rates for similar loans of comparable credit quality. However, where appropriate, adjustments have been made so as to more accurately reflect market rates. Maturity estimates are based on historical experience with prepayments and current economic and lending conditions.
D. DEPOSITS
The carrying amount and estimated fair value of deposits outstanding at December 31, 1997, are $345,976,000 and $345,989,000, and for December 31, 1996, are $327,165,000 and $325,628,000. Under SFAS 107, the fair value of deposits with no stated maturity is equal to the amount payable on demand. Therefore, the fair value estimates for these products do not reflect the benefits that the company receives from the low-cost, long-term funding they provide. These benefits are significant. The estimated fair values of fixed rate time deposits are based on discounted cash flow analyses. The discount rates used in these analyses are based on market rates currently offered for deposits of similar remaining maturities. Because of the repricing characteristics and the competitive nature of the company's rates offered on variable rate time deposits, carrying amount is a reasonable estimate of the fair value.
E. SHORT-TERM BORROWINGS
Short-term borrowings reprice frequently and therefore the carrying amount is a reasonable estimate of fair value.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)
F. COMMITMENTS TO EXTEND CREDIT, STANDBY LETTERS OF CREDIT, AND LETTERS OF CREDIT
Pricing of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, and compensating balance and other covenants or requirements. Loan commitments generally have fixed expiration dates, are variable rate and contain termination and other clauses which provide for relief from funding in the event that there is a significant deterioration in the credit quality of the customer. Many loan commitments are expected to, and typically do, expire without being drawn upon. The carrying amounts are reasonable estimates of the fair value of these financial instruments. Carrying amounts are comprised of the unamortized fee income and, where necessary, reserves for any expected credit losses from these financial instruments.
NOTE 19 - COMMITMENTS
In December 1997, the board of directors authorized the repurchase of 7,000 shares of stock in early 1998 to be used for the dividend reinvestment plan. The authorized purchase price is $29.25 per share.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
BAYLAKE CORP. (Parent Company Only) CONDENSED BALANCE SHEETS December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (continued)
BAYLAKE CORP. (Parent Company Only) CONDENSED STATEMENTS OF INCOME For the Years Ended December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (continued) BAYLAKE CORP. (Parent Company Only) CONDENSED STATEMENT OF CASH FLOWS For the Years Ended December 31
PART III
The following items are incorporated by reference to the Registrant's Proxy Statement to be filed pursuant to Regulation 14A for its 1998 Annual Meeting of Shareholders (the "1998" Proxy Statement").
Item 11.
Item 11. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information in response to this item is incorporated herein by reference to "Baylake Corp. - Management" and "Election of Directors" and "Compliance with Section 16(a) of the Exchange Act" under "Matters to be Considered at the Baylake Annual Meeting" in the 1998 Proxy Statement.
Item 12.
Item 12. EXECUTIVE COMPENSATION
Information in response to this item is incorporated herein by reference to "Director Fees and Benefits", "Executive Compensation", "Board of Directors/Compensation Committee Report on Management Compensation", "Compensation Committee Interlocks and Insider Participation" and "Performance Graph" under "Matters to be Considered at the Baylake Annual Meeting" in the 1998 Proxy Statement.
Item 13.
Item 13. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to this item is incorporated herein by reference to "Matters to be Considered at the Baylake Annual Meeting - Ownership of Baylake Common" in the 1998 Proxy Statement.
Item 14.
Item 14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this item is incorporated herein by reference to "Matters to be Considered at Baylake Annual Meeting - Election of certain directors whose terms will expire."
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) See "Table of Contents" immediately following Item 9. (b) See the following "Exhibit Index". (c) No reports on Form 8-K.
BAYLAKE CORP. (the "Registrant")
EXHIBIT INDEX TO 1997 ANNUAL REPORT ON FORM 10-K
* Excluding schedules and exhibits, which are identified in such document. The Registrant agrees to furnish supplementally a copy of any omitted schedule or exhibit to the Commission upon request.
** Designated management contracts or compensatory plans or arrangements filed as exhibits.
CONSENT OF SMITH & GESTELAND
We consent to incorporation by reference in the Registration Statement No. 333-45995 on Form S-3, and in Registration Statement No. 33-43880 on Form S-3, and the Registration Statement No. 33-77498 on Form S-8 of Baylake Corp. of our report dated January 22, 1998 relating to the consolidated balance sheets of Baylake and its subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, changes in stockholder equity and cash flows for each of the years ended December 31, 1997, 1996, and 1995, which report appears in Baylake=s Annual Report on Form 10-K for the year ended December 31, 1997, and the reference to our firm under the heading AExperts@ in the Prospectus forming part of the Registration Statements.
SMITH & GESTELAND, LLP Madison, Wisconsin SMITH & GESTELAND, LLP March 27, 1998
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.
BAYLAKE CORP.
By: Steven D. Jennerjohn ------------------------- Steven D. Jennerjohn Treasurer
Date: March 17, 1998 -------------------------
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS that each person whose signature appears below constitutes and appoints Thomas L. Herlache, Steven D. Jennerjohn and Daniel F. Maggle, and each of them, his true lawful attorneys-in-fact and agents, with full power of substitution and resubstitution for him and his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, the Securities and Exchange Commission and any state securities commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities and Exchange Act of 1934, this reports has been signed by the following persons in the capacities and on these dates indicated.*
Thomas L. Herlache L. George Evenson ------------------------- --------------------------- Thomas L. Herlache L. George Evenson, Director President, Chief Executive Officer and Director (Principal Executive Officer)
Steven D. Jennerjohn Glenn Miller ------------------------- --------------------------- Steven D. Jennerjohn Glenn Miller, Director Treasurer (Principal Financial and Accounting Officer)
Ruth Nelson ----------------------------- --------------------------- Ronald D. Berg, Director Ruth Nelson, Director
Marie Bertschinger William Parsons ---------------------------- ---------------------------- Marie Bertschinger, Director William C. Parsons, Director
George Delveaux, Jr. Richard A. Braun ------------------------------ --------------------------- George Delveaux, Jr., Director Richard A. Braun, Director
John W. Bunda Joseph Morgan --------------------------- --------------------------- John W. Bunda, Director Joseph Morgan, Director
John D. Collins --------------------------- John D. Collins, Director
*Each of the above signatures is affixed as of March 17, 1998.