ITEM 1. BUSINESS
D&N Financial Corporation ("D&N" or the "Company") is a financial services holding company organized under the laws of the state of Delaware. The Company's principal subsidiary is D&N Bank (the "Bank"), a federally chartered stock savings bank headquartered in Hancock, Michigan.
The Bank was founded in 1889 and operated as a state-chartered mutual savings and loan association until February 1984, when it converted to a federal charter. In 1985, the Bank converted to a stock association, and in 1986, converted to a federal savings bank. The Bank adopted a holding company structure in July 1988. With total assets of $1.82 billion at December 31, 1997, D&N is one of the largest savings institutions headquartered in Michigan.
D&N's primary business consists of attracting deposits from the general public and making real estate loans, business loans, and consumer loans and other types of investments. The Company conducts its business through a network of 37 full-service community banking offices, including its main office in Hancock, Michigan, seven savings agency offices which provide depository services and four mortgage banking offices. The Bank's deposits are insured up to the maximum extent permitted by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is a member of the Federal Home Loan Bank ("FHLB") of Indianapolis, which is one of the 12 regional banks comprising the FHLB System. The Bank is subject to supervision by the Office of Thrift Supervision, Department of the Treasury ("OTS") and by the FDIC.
The executive office of the Company is located at 400 Quincy Street, Hancock, Michigan 49930, telephone (906) 482-2700.
Like many financial institutions, the operations of the Company's subsidiary are materially affected by general economic conditions, the monetary and fiscal policies of the federal government and the policies of the various regulatory authorities, including the OTS, the FDIC and the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Its results of operations are largely dependent upon its net interest income which is the difference between the interest it receives on its loans and investment securities, and the interest it pays on its liabilities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Asset/Liability Management."
FORWARD LOOKING STATEMENTS
When used in this Form 10-K or future filings by the Company with the Securities and Exchange Commission, in the Company's press releases or
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other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "would be", "will allow", "intends to", "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project", or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995.
The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national economic conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities and competitive and regulatory factors, could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from those anticipated or projected.
The Company does not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
LENDING ACTIVITIES
GENERAL. The Bank, has concentrated its lending activities on first mortgage conventional loans secured by residential and commercial real estate and both installment and revolving consumer and business loans. Approximately $411.9 million or 50% of the Bank's total loans, excluding loans held for sale, secured by real estate as of December 31, 1997, permit periodic interest rate adjustments.
LOAN PORTFOLIO COMPOSITION. The following table sets forth information concerning the composition of D&N's loan portfolio in dollar amounts and percentages, by type of loan.
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LOAN MATURITIES. The following schedule illustrates the maturity structure of the Company's loan portfolio at December 31, 1997. Loans are shown as maturing in the period in which payment is due. This schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.
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The total amount of loans, excluding loans held for sale, due after December 31, 1998 which have fixed interest rates is $403.8 million, while the amount of loans due after such date having floating or adjustable rates is $771.3 million.
LOAN ORIGINATIONS, PURCHASES AND SALES. Federally chartered savings institutions, like the Bank, have general authority to make real estate loans throughout the United States. D&N has originated residential mortgage loans secured by property both within and outside the State of Michigan. D&N has also purchased residential mortgage loans secured by property located in various states. In addition, the Company has originated income producing property loans secured by real estate located in the State of Michigan and has purchased such loans secured by property located in Michigan and elsewhere. Since 1990, the Bank has chosen to focus the activities of its community banking offices on loan originations in their market areas. At December 31, 1997, 73% of D&N's real estate loans receivable (excluding government agency insured or guaranteed mortgage-backed and derivative products) were secured by real estate located in Michigan.
The following table presents information regarding the geographic location of the properties securing D&N's residential mortgage and income producing property loans at December 31, 1997. See "- Classified Assets, Loan Delinquencies and Defaults" for a discussion of other real estate owned.
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Residential loan originations are attributable to direct marketing efforts of the Bank and of the Bank's subsidiary, D&N Mortgage Corporation, as well as to referrals from real estate brokers and builders. Income producing property loans are originated through the Bank's direct marketing efforts and through referrals by existing customers. In 1997, total loan originations increased $120.2 million, or 24% as a result of a significant increase in consumer lending activity. Consumer loan originations alone increased $52.1 million, or 19%.
D&N Bank has sold loans and loan participations in the secondary market, generally without recourse. Loans held for sale are recorded at the lower of cost or market value. At December 31, 1997, the Bank had $5.3 million of net loans held for sale consisting of 15 and 30 year fixed rate loans. These sales have provided additional funds for loan originations and investments and also generated income. The Bank generally continues, after the sale, to service the loans and loan participations sold. Loan sales are made on a yield basis with a portion of the difference between the yield to the purchaser and the amount paid by the borrower constituting servicing income to D&N. On occasion, the Bank also purchased mortgage loan servicing rights from others in order to maintain its loan servicing portfolio economies of scale.
The weighted average servicing fee for loans serviced for others was .31% at December 31, 1997. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Noninterest Income." At
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December 31, 1997, D&N serviced for others approximately $519 million in loans and loan participations. See also Note A of Notes to Consolidated Financial Statements "Summary of Significant Accounting Policies - Mortgage Servicing Rights".
The Bank's investment in mortgage servicing rights ("MSRs") totaled $2.1 million at December 31, 1997. The following table details the value of the Bank's investment in MSRs.
The following table shows origination, purchase, sale and repayment activities of D&N Bank, including mortgage-backed securities, for the periods indicated.
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(1) Includes sales of CMO residuals which were carried at the lower of cost or market.
Outstanding loan commitments of the Bank at December 31, 1997 amounted to $38.6 million for one- to four-family residential real estate loans and $40.1 million for commercial real estate loans. See "Regulation - Federal Savings Association Regulation."
RESIDENTIAL MORTGAGE LOANS. At December 31, 1997, the Bank had $717.4 million in residential mortgage loans representing 55.1% of the Bank's total loan portfolio. This amount represents a 16.8% increase in the dollar value of the residential loan portfolio. However, it also represents a 3.1% decrease in the percentage of the Bank's portfolio consisting of residential real estate loans as the Bank shifted its focus to emphasize the origination of consumer loans.
The original contractual loan payment period for residential loans originated by D&N Bank normally ranges from 15 to 30 years. Because borrowers may refinance or prepay their loans, however, such loans often remain outstanding for a substantially shorter period of time.
Prior to 1992, most of the Bank's residential mortgage loans were originated by its mortgage banking subsidiary. The mortgage banking subsidiary originated loans in southeastern Michigan, Illinois, Arizona, Texas and North Carolina. The Bank now originates loans primarily in its Michigan market area through its community banking and mortgage banking offices. Substantially all of the residential loans being originated by the Bank are in a form which permits their sale in the secondary market.
The Bank's first mortgages customarily include "due-on-sale" clauses, which are provisions giving the Bank the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid. In general, the Bank enforces due-on-sale clauses in its first mortgages.
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In the case of conventional mortgage loans intended for sale, the Bank's policy is to lend a maximum of 95% of the appraised value of single-family residences. The Bank generally does not lend more than 90% of the appraised value of the property on those loans it intends to hold. Private mortgage insurance is required if the loan amount exceeds 80% of the appraised value, in an amount sufficient to reduce the Bank's exposure to 75% or less of the appraised value of the property. Property securing real estate loans made by the Bank is appraised by independent appraisers selected by the Bank and whose appraisals are reviewed by D&N personnel or other independent appraisers.
Loans up to the maximum limits for single family homes of the Federal Home Loan Mortgage Corporation ("FHLMC") and the Federal National Mortgage Association ("FNMA") may be approved by qualified loan officers of the Bank. The Bank's Residential Loan Committee has single-family lending authority up to $500,000, if two members approve. Loans in excess of $500,000 must be approved by the Bank's Loan Committee (comprised of Messrs. Butvilas, Krupka, Janson, West and Sliwinski). Loans in excess of $2 million must also be approved by the Bank's Board of Directors.
Title, fire and casualty insurance as well as surveys are generally required on all mortgage loans.
D&N Bank also offers a variety of Adjustable Rate Mortgages, ("ARM") loans which offer adjustable rates of interest, payments, loan balances or terms to maturity which vary according to specified indices. The Bank's ARMs generally have a loan term of 30 years with rate adjustments every year or every three years during the term of the loan. ARMs currently originated by the Bank contain a 2% limit as to the maximum amount of change in the interest rate at any adjustment period and a 6% limit over the life of the loan. The Bank generally originates ARMs to hold in its portfolio. At December 31, 1997, residential ARMs totaled $328 million, or 47% of the Bank's total residential one- to four-family mortgage loan portfolio. Of this total ARM portfolio, $197 million or 60% were purchased from others. Due to consumer demand, residential loans originated during 1997 were predominately fixed rate loans.
Despite the benefits of ARMs to the Bank's asset/liability management program, such loans also pose potential additional risks, primarily because as interest rates rise, the underlying payment by the borrower rises, increasing the potential for default. At the same time, marketability of the underlying property may be adversely affected by higher interest rates.
MORTGAGE-BACKED SECURITIES. The Bank on occasion purchases mortgage-backed securities to supplement residential loan production. The types of securities purchased are based upon the Bank's asset/liability management strategy and balance sheet objectives. In 1997, the Company
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purchased $107.5 million of fixed rate Collateralized Mortgage Obligations ("CMO") with expected average lives of 2.7 to 4.3 years. CMOs are securitiesderived by reallocating cash flows from mortgage pass-through securities or pools of mortgage loans held by a trust. The CMO securities purchased by the Bank in 1997 are backed by pass-through securities of either FHLMC, FNMA or Government National Mortgage Association ("GNMA").
The Bank has in the past invested in interest only strip securities ("IOs") and principal only strip securities ("POs") as part of its asset/liability management strategy. At December 31, 1997, D&N had IOs with a book value and a market value of $1.4 million, and had no POs at that date.
The following table sets forth information concerning the composition of D&N's mortgage-backed securities portfolio in dollar amounts and percentages, by type of security. See also Note F of Notes to Consolidated Financial Statements.
INCOME PRODUCING PROPERTY LOANS. The Bank has historically originated and purchased both permanent and, to a substantially lesser extent, construction loans secured by income producing property and land development loans. Essentially all permanent income producing property loans originated by the Bank to date have been secured by real property located in Michigan.
To a substantially lesser extent, the Bank has also purchased income producing property loans and participation interests in these loans outside of Michigan. These loans may be in the form of mortgage-backed securities, may have fixed or variable interest rates and most have been outstanding for three to twelve years. At December 31, 1997, $16.5 million of D&N's portfolio of income producing property loans were purchased loans.
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The following table shows the composition of the Bank's income producing property and land development loans at December 31, 1997. See "Non- Performing Assets and Risk Elements."
CONSUMER LENDING. Federal regulations permit federal savings institutions to make secured and unsecured consumer loans, together with investments in commercial paper and corporate debt securities, in an amount up to 35% of the institution's assets. In addition, a federal savings institution has lending authority above the 35% category for certain consumer loans, such as home equity loans, property improvement loans, mobile home loans and deposit account secured loans.
Consumer loans originated by the Bank are offered at fixed and adjustable rates of interest. The underwriting standards employed by the Bank for consumer loans include a determination of the applicant's payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant's monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount.
The Bank has established programs to originate consumer loans including automobile loans, home improvement loans, home equity loans, student loans under various guaranteed student loan programs, loans to depositors secured by pledges of their deposit accounts and unsecured loans. Although consumer loans involve a higher level of risk than one- to four-family
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residential mortgage loans, they generally carry higher yields and have shorter terms to maturity. The Bank has increased its origination of consumer loans during the past several years, and is continuing to emphasize these types of loans. At December 31, 1997, consumer loans totaled $449.6 million or 35% of the Bank's loan portfolio, an increase of $110.3 million or 33% from December 31, 1996.
During 1997, net consumer loan charge-offs were $1,276,000 compared to $926,000 in 1996, $642,000 in 1995, $411,000 in 1994 and $354,000 in 1993.
Indirect loan originations totaled $172.3 million in 1997. Indirect receivables amounted to $235.2 million at December 31, 1997 and make up 53% of the consumer loan portfolio. Indirect loans are underwritten according to the same guidelines as direct loans, and the maximum dollar exposure to any one dealer is typically limited to $5 million.
Home equity loans and home equity credit lines are extended at fixed or variable rates of interest and normally do not exceed 80% of the property's appraised value less the amount owing, if any, on a first mortgage. Home equity loans are repaid according to fixed monthly payments over a maximum term of ten years. Home equity credit lines require a monthly interest payment based upon the outstanding balance. Home equity credit lines generally have five-year terms at which time the Bank may require payment in full or renew the loan for another five-year term. Amounts repaid are available for subsequent borrowing, subject to satisfactory loan performance.
Home improvement loans are generally treated as home equity loans with a first or second mortgage lien securing the loan. A small number of home improvement loans are written as unsecured loans.
The Bank has increased its emphasis in recent years on unsecured loans. These loans are underwritten according to strict guidelines, and loan officers generally have lower approval limits for unsecured loans than for secured loans.
D&N Bank is subject to various state and federal limitations on the maximum rates of interest it may charge on consumer and certain other loans. These limitations have not had a significant effect on D&N's consumer loan activities.
LOANS TO ONE BORROWER
Under federal law, the aggregate amount of loans that the Bank is permitted to make to any one borrower is generally limited to 15% of unimpaired capital and surplus. At December 31, 1997, the Bank's loans to
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one borrower limit was approximately $19.8 million. See "Regulation - Federal Regulation". At December 31, 1997, the Bank had no loans to one borrower in excess of its lending limit.
CLASSIFIED ASSETS, LOAN DELINQUENCIES AND DEFAULTS
The Bank's collection procedures provide that when a residential mortgage loan is 15 days past due, the borrower is contacted by mail and payment is requested. For loans secured by income producing property, the borrower is contacted by telephone when the loan is 15 days past due. If the delinquency continues, subsequent efforts are made by telephone and mail to contact the delinquent borrower. In certain instances, the Bank may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his financial affairs. If the loan continues in a delinquent status for 90 days or more, the Bank generally initiates foreclosure proceedings.
The process of non-judicial foreclosure in Michigan takes approximately six weeks. A sheriff's sale is then held at which the Bank normally bids for the purchase of the property. A conditional sheriff's deed is then awarded to the highest bidder, usually the Bank, and the customer is given six months (or in certain circumstances, one year) to redeem the conditional deed by repaying the bid amount in full. During this redemption period, the borrower may occupy and use the property as he sees fit. If he fails to redeem the sheriff's deed, then the Bank acquires clear title to the real estate and subsequently sells it to recover its investment. In most cases, it is not economical to obtain a deficiency judgment against the borrower if residential property is sold for less than the unpaid balance of the loan.
The following table sets forth information concerning delinquent mortgage and other loans at December 31, 1997. The amounts presented represent the total remaining principal balances of the related loans (before reserves for losses), rather than the actual payment amounts which are overdue.
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Federal regulations provide for the classification of loans and other assets such as debt and equity securities considered to be of lesser credit quality as "substandard," "doubtful" or "loss" assets. The regulation requires insured institutions to classify their own assets and to establish prudent general allowances for loan losses for assets classified "substandard" or "doubtful." For the portion of assets classified as "loss", an institution is required to either establish specific allowances for loan losses for assets of 100% of the amount classified or charge off such amount. The OTS may require the establishment of a general allowance for losses based on assets classified as "substandard" and "doubtful" or based on the general credit quality of the asset portfolio of an institution. At December 31, 1997, $8.5 million of the Bank's assets were classified as "substandard", none of such assets were classified as "doubtful" or as "loss". The Bank's classification of assets is consistent with OTS examination classifications.
Hotels and motels account for $3.4 million of classified assets and apartments account for $2.0 million. The balance of classified assets consists of loans and real estate owned of various income producing properties, land, residential real estate and consumer loans. Classified assets amounting to $2.0 million, or 10% of total classified assets, are secured by real estate located in the state of California.
NONPERFORMING ASSETS AND RISK ELEMENTS
Nonperforming assets, including other real estate owned, decreased to $5.3 million at December 31, 1997 compared to $8.1 million at December 31, 1996. The ratio of nonperforming assets to total assets was 0.29% at December 31, 1997 compared to 0.55% at December 31, 1996. Allowances for losses represented 199% of nonperforming assets at December 31, 1997.
Loans are placed on nonaccrual status when the collection of principal and/or interest becomes doubtful. In addition, residential mortgage loans and income producing property loans are placed on nonaccrual status when the loan becomes 90 days or more contractually delinquent. All consumer loans more than 90 days delinquent are charged against the consumer loan allowance for loan losses. For 1997, the Bank would have recorded interest income of $369,000 if nonaccrual and restructured loans had performed in accordance with their original terms. The Bank recognized $52,000 of interest income on these loans in 1997.
The following table sets forth the amounts and categories of risk elements in the Bank's loan portfolio:
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OTHER REAL ESTATE OWNED
Other real estate owned, net of reserves, totaled $1.5 million at December 31, 1997, the same as at December 31, 1996. Other real estate owned consisted of single family homes, multi-family dwelling units and commercial real estate. At foreclosure, real estate is recorded at estimated fair value less disposal costs. Any difference between estimated fair value and the loan balance is charged to the allowance for loan losses.
The largest asset in other real estate owned is a residential property located in Indiana. This asset had a carrying value of approximately $314,000 at December 31, 1997.
OTHER LOANS OF CONCERN
In addition to nonperforming assets, the Bank has other loans of concern aggregating $14.1 million. These are loans which are currently performing but which demonstrate a specific weakness or weaknesses which, if not corrected, could cause failure of the borrower and default. These loans are closely monitored by management, and as the weaknesses are corrected, may be reclassified as acceptable loans.
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Included in other loans of concern at December 31, 1997, are two income producing property loans located in California and one in Michigan totaling $4.8 million that have all paid as agreed but, for various reasons, indicate potential payment concerns.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established at levels considered appropriate based on management's judgment of potential losses in residential, income producing and consumer loan portfolios. The loan portfolios are reviewed at least quarterly for changes in performance, collateral value and overall quality. Allocated allowances are established for problem loans with expected losses, and in addition, allowances are established for unidentified potential losses. Regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based upon their judgment of the information available to them at the time of their examination. A $1.4 million provision for potential loan losses was made in 1997, compared to $1.1 million in 1996 and $2.4 million in 1995. Management's judgment in determining the level of the allowance for loan losses is influenced by several factors during the quarterly reviews. These factors include, but are not limited to, past loan performance and loss experience, current economic and market conditions, collateral location and market values, industry and geographic concentrations and delinquency statistics and ratios. Management also considers the different levels of risk between income producing property loans, installment loans and one- to four-family residential loans. In addition, management considers the level of nonperforming assets and classified assets, the level of lending activity and the overall size of the loan portfolio.
Income-producing property charge-offs were primarily due to writedowns of loans to estimated fair value. Consumer loan charge-offs increased somewhat, but charge-off ratios decreased as the consumer loan portfolio grew at a faster rate. See "Lending Activities" and "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The following table sets forth an analysis of the Bank's allowance for loan losses:
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The following table summarizes the allocation of the allowance for loan losses by major categories at the dates indicated:
INVESTMENT ACTIVITIES
As a member of the FHLB System, the Bank must maintain minimum levels of liquid assets specified by federal regulations which vary from time to time. See "Regulation -- Federal Home Loan Bank System." Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to return on loans.
Historically, the Bank has maintained liquid assets above the minimum requirements imposed by federal regulations and at a level believed adequate to meet requirements of normal daily activities, repayment of maturing debt and potential deposit outflows. Cash flow is regularly reviewed and updated to maintain adequate liquidity. For the month of December 1997, the Bank's average liquidity ratio (liquid assets as a percentage of net withdrawable deposits and current borrowings) was 13.9%, which was in excess of regulatory requirements.
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The following table sets forth information concerning the Bank's investment securities at the dates indicated. See also Note E of Notes to Consolidated Financial Statements for additional information regarding the contractual maturities and weighted average yields of the Bank's investment securities.
The book value and market value of investment securities at December 31, 1997, by maturity ranges, were as follows:
SOURCE OF FUNDS
GENERAL. Deposits are an important source of the Bank's funds for use in lending and for other general business purposes. In addition to deposits, the Bank derives funds from loan repayments, advances from the FHLB of Indianapolis, other borrowings, reverse repurchase agreements, and at times has derived funds from loan and securities sales. Scheduled loan repayments are a relatively stable source of funds, while loan prepayments and deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used to compensate for reductions in normal sources of funds, such as deposit inflows at less than
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projected levels or deposit outflows, or to support expanded activities. Historically, the Bank has borrowed primarily from the FHLB of Indianapolis, through institutional reverse repurchase agreements and, to a lesser extent, from other sources.
DEPOSIT ACTIVITIES. The Bank attracts both short-term and long-term deposits from the general public by offering a wide assortment of accounts and rates. In recent years, market conditions have required the Company to rely increasingly on short-term accounts that are more responsive to market interest rates. The Bank offers regular savings accounts, checking accounts, various money market accounts, fixed interest rate certificates with varying maturities, negotiated rate certificates of deposit of $100,000 or above ("Jumbo CDs") and individual retirement accounts.
The composition of the Bank's deposits at the end of recent periods is set forth in Note J of Notes to Consolidated Financial Statements. At December 31, 1997, the Company had no brokered deposits. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." In addition, the Bank believes that, based on its experience over the past five years, its savings accounts are stable sources of deposits.
The variety of deposit accounts offered by the Bank has allowed it to be competitive in obtaining funds and has allowed it to respond with flexibility (by paying rates of interest more closely approximating market rates of interest) to, although not eliminate the threat of, disintermediation (the flow of funds away
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from depository institutions such as savings institutions into direct investment vehicles such as government and corporate securities). In addition, the Bank has become much more subject to short-term fluctuations in deposit flows. The ability of the Bank to attract and maintain deposits, and its cost of funds, have been, and will continue to be, significantly affected by money market conditions.
The following table sets forth the deposit flows at D&N Bank during the periods indicated.
The following table sets forth the change in dollar amount of deposits in the various types of deposit programs offered by the Bank for the periods indicated.
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The following table shows rate and maturity information for the Bank's deposits as of December 31, 1997.
The following table shows the scheduled maturities of certificates of deposit of $100,000 or greater as of December 31, 1997.
BORROWINGS. The FHLB of Indianapolis functions as a central reserve bank, providing credit for savings institutions within its assigned region. As a member of the FHLB of Indianapolis, D&N Bank is required to own capital stock in the FHLB of Indianapolis and is authorized to apply for advances on the security of such stock and certain of its residential mortgage loans and
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other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. See "Regulation -- Federal Home Loan Bank System." FHLB advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. The FHLB of Indianapolis prescribes the acceptable uses to which the advances pursuant to each program may be made as well as limitations on the size of advances. Depending on the program limitations, the amount of advances are generally based on the FHLB of Indianapolis' assessment of the institution's creditworthiness. The FHLB of Indianapolis is required to review its credit limitations and standards at least once every six months. The Bank utilizes borrowings, in part, to fund increases in loan demand.
The Bank has entered into reverse repurchase agreements with major investment bankers utilizing government securities or various mortgage instruments as collateral. These reverse repurchase agreements are generally utilized in connection with the Bank's investments. See "Investment Activities" and "Management's Discussion and Analysis of Financial Condition and Results of Operations".
The following table sets forth the maximum month-end and average balance of FHLB advances, securities sold under agreements to repurchase and other borrowings as of the dates indicated:
The following table sets forth certain information as to the Bank's FHLB advances, securities sold under agreements to repurchase and other borrowings at the dates indicated. See also Note L of Notes to Consolidated Financial Statements.
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The following table sets forth the Bank's maturity and rate structure of FHLB advances as of December 31, 1997.
(1) Includes variable rate advances which adjust quarterly.
SERVICE CORPORATION ACTIVITIES
The Bank is permitted to invest an amount equal to 2% of its assets (excluding those of its subsidiaries) in its service corporations. Up to an additional 1% of assets may be invested in service corporations provided that such amount is used for certain types of community development projects. In addition, federal regulations permit institutions to make specified types of loans to such subsidiaries (other than special-purpose finance subsidiaries) in which the institution owns more than 10% of the stock, in an aggregate amount not exceeding 50% of the institution's total capital as defined below.
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As of December 31, 1997, the Bank's investment in stock of and loans to its subsidiaries (other than its special-purpose finance subsidiary and its Real Estate Investment Trust) was in compliance with the regulations and totaled $5.6 million. A federal institution may also invest up to 30% of its assets in special-purpose finance subsidiaries established and operated in accordance with federal regulations. The Bank's investment in its special purpose finance subsidiary, D&N Funding I Corp., was in compliance with these regulations at December 31, 1997. Federal law imposes special capitalization requirements on savings institutions such as the Bank which are engaged in activities through a subsidiary that are not permissible for national banks. See "Regulation -- Regulatory Capital Requirements." The following is a description of the Bank's service corporations.
D&N Enterprises, Inc. ("Enterprises") was formed in 1972 for the purpose of developing real estate through joint venture arrangements. At December 31, 1997, the Company had a $300,000 investment in Enterprises and loans totaling approximately $1.5 million to the subsidiary.
Enterprises entered into the Northside Joint Venture in March 1989 to acquire and develop commercial sites in Shelby Township, Michigan. Enterprises is in the process of marketing this property in its entirety.
D&N Holdings, Inc. ("Holdings") was formed in 1985 and is involved in the sale of mortgage life insurance through its investment in Minnesota Mutual Life Insurance Company ("MIMLIC") and also offers insurance products and annuity contracts through Quincy Insurance Agency, Inc., a subsidiary of Holdings formed in 1995. In Michigan, MIMLIC's mortgage life insurance policies are marketed and sold primarily through Michigan savings institutions. At December 31, 1997, D&N Bank's investment in Holdings totaled approximately $200,000.
MORTGAGE BANKING. On May 1, 1984, D&N Bank established a mortgage banking operation through a subsidiary, D&N Mortgage Corporation ("DNMC"). This subsidiary was relatively dormant from 1992 until 1995. Since restarting operations, D&N Mortgage Corporation has originated loans mainly for the Bank's portfolio. D&N Mortgage Corporation currently has four origination offices located in Michigan's lower peninsula in the cities of Grand Rapids, Hastings, West Bloomfield and St. Joseph. At December 31, 1997, the Bank had $2.4 million invested in this subsidiary.
FINANCE SUBSIDIARY. In 1986, D&N Bank incorporated a special-purpose finance subsidiary, D&N Funding I Corp. ("Funding"). Funding was established solely for the purpose of issuing collateralized mortgage obligations ("CMOs"). In August 1986, Funding pledged $61.5 million in principal amount of FHLMC participation certificates to collateralize the issuance and sale of the CMOs from which the Bank received $56.4 million in net proceeds. The CMOs were sold through a third party conduit and were secured by the pledge of the
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participation certificates. D&N Bank reinvested the proceeds from the sale of the CMOs in residential and commercial mortgage loans.
NEW BANK SUBSIDIARY
D&N Capital Corporation ("D&N Capital") is a Delaware corporation incorporated on March 18, 1997 for the purpose of acquiring and holding real estate assets and is a Real Estate Investment Trust ("REIT"). All shares of common stock of D&N Capital are owned by D&N Bank.
On July 17,1997, D&N Capital sold 1.21 million shares of its 9.0% noncumulative preferred stock, Series A with a liquidation preference of $25.00 per share (totaling $30,250,000). The Series A Preferred Shares are generally not redeemable prior to July 1, 2002. On or after July 1, 2002, the Series A Preferred Shares may be redeemed for cash at the option of the Bank, in whole or in part, at a redemption price of $25.00 per share. As part of this transaction, D&N Capital received $28,719,000 in net proceeds, after offering costs of $1,531,000. The net proceeds, along with the proceeds received from the sale of D&N Capital common stock to D&N Bank, were used to purchase $60,524,000 of mortgage loans from D&N Bank. The interest on these loans is being used to fund the dividends on D&N Capital's preferred and common stock.
The preferred shares are treated as Tier-1 Capital by the Bank, and are traded on Nasdaq as DNFCP. During 1997, D&N Capital declared and paid preferred dividends totaling $1,217,563.
COMPETITION
At December 31, 1997, the Bank ranked second among all savings institutions headquartered in the State of Michigan with respect to total assets.
D&N Bank experiences substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits are the ability to offer attractive rates, the availability of convenient office locations and the range and quality of services offered.
Direct competition for deposits comes from other savings institutions, credit unions and commercial banks. Additional significant competition for deposits comes from money market mutual funds and corporate and government securities. The primary factors in competing for loans are interest rates, loan origination fees and the range of services offered. Competition for origination of real estate loans and consumer loans normally comes from other
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savings institutions, credit unions, commercial banks, mortgage bankers, mortgage brokers and insurance companies.
The deposit programs of savings institutions such as the Bank compete with government securities, money market mutual funds and other investment alternatives. Legislative and regulatory action has increased competition between savings institutions and other financial institutions, such as commercial banks, by expanding the ranges of financial services that may be offered by savings institutions such as interest bearing checking accounts, trust services and consumer loan products, while reducing or eliminating the difference between savings institutions and commercial banks with respect to long-term lending authority, taxation and maximum rates of interest that may be paid on savings deposits.
EMPLOYEES
At December 31, 1997, the Bank had 513 employees, including 94 part-time employees. Management considers its relations with its employees to be satisfactory. The Bank's employees are not represented by any collective bargaining group.
The Bank currently maintains a comprehensive employee benefit program providing, among other benefits, a 401(k) plan with an Employee Stock Ownership Program, hospitalization and major medical insurance, paid sick leave, long-term disability insurance and life insurance.
EXECUTIVE OFFICERS
The following information as to the business experience during the past five years is supplied with respect to executive officers of the Company or its wholly owned subsidiary, other than the Chief Executive Officer, who do not serve on the Company's Board of Directors. Executive officers are elected annually to serve until their successors are elected or until they resign or are removed by the Board of Directors. There are no arrangements or understandings between the persons named and any other person pursuant to which such officers were elected.
George J. Butvilas, age 52. Joining D&N as President in May 1990, Mr. Butvilas was named Chief Executive Officer of the Bank in 1991 and Chief Executive Officer of the Company in 1992. He brought with him over 16 years experience as a commercial and community banker. Mr. Butvilas was formerly Executive Vice President and Director of Boulevard Bancorp, Inc. of Chicago, Illinois.
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Frank R. Donnelly, age 57, is Senior Vice President/Commercial Lending of the Bank. He has been employed by the Bank in various capacities since 1965 and is presently responsible for the business and commercial real estate loan development for the Bank.
Daniel D. Greenlee, age 45, is Senior Vice President/Controller of the Bank. He has been with D&N Bank in various capacities since 1984 and is presently responsible for the accounting, financial and regulatory reporting, financial analysis, tax and risk management functions of the Bank.
Kenneth R. Janson, age 46, is Executive Vice President/Chief Financial Officer and Treasurer of the Company and the Bank. Prior to joining the Bank in May 1988 as Vice President/Financial Analysis, he was affiliated with various universities, the last six years as Associate Professor of Accounting at Michigan Technological University. Mr. Janson is responsible for directing the Bank's accounting, investment and investor relations functions.
Robert J. Krupka, age 36, is Senior Vice President/Chief Credit Officer of the Bank. Prior to joining D&N Bank in March 1997, he was Commercial Loan Officer and Credit Manager with Old Kent Bank. Mr. Krupka is responsible for the commercial loan credit analysis and operations functions.
Peter L. Lemmer, age 40, is Senior Vice President/General Counsel of the Company and the Bank. Prior to joining D&N Bank in October 1990, he held various positions involving legal services, the last five years as Senior Vice President/Compliance and Vice President, Associate General Counsel/Compliance Officer with Cal America Savings, later known as Columbus Savings, and American Federal Bank, respectively. Mr. Lemmer is responsible for the legal and regulatory functions of the Bank.
Donald W. Schulze, age 47, is Senior Vice President/Human Resources of the Bank. He has been with D&N Bank in various capacities since 1986 and is presently responsible for the training and development, facilities management and human resources functions of the Bank.
Alfred J. Sliwinski, age 51, is Executive Vice President/Community Banking. He has been employed by D&N Bank in various community banking capacities since May 1977 and is presently responsible for the community banking function of the Bank.
Richard E. West, age 51, is Executive Vice President/Wholesale Lending. Prior to joining D&N Bank in January 1990, he was Servicing Manager for 20 years with Rothschild Financial Corporation and Valley National Bank of Arizona. Mr. West is responsible for directing the loan servicing, residential lending, consumer lending, bank operations and information systems functions of the Bank.
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REGULATION
GENERAL
The Bank is a federally chartered savings bank, the deposits of which are federally insured and backed by the full faith and credit of the United States Government. Accordingly, the Bank is subject to broad federal regulation and oversight extending to all operations. The Bank is a member of FHLB of Indianapolis and is subject to certain limited regulation by the Federal Reserve Board. As the savings and loan holding company of the Bank, the Company also is subject to federal regulation and oversight. The purpose of the regulation of the Company and other holding companies is to protect subsidiary savings institutions. The Bank is a member of the Savings Association Insurance Fund ("SAIF"), and the deposits of the Bank are insured by the FDIC. As a result, the FDIC has certain regulatory and examination authority over the Bank. Certain of these regulatory requirements and restrictions are discussed below or elsewhere in this document.
FEDERAL REGULATION
The OTS has extensive authority over the operations of savings institutions. As part of this authority, the Bank is required to file periodic reports with the OTS and is subject to periodic examinations by the OTS and the FDIC. The last regular OTS examination of the Bank was as of June 30, 1997. Under agency scheduling guidelines, it is likely that another examination will be initiated in the near future. When these examinations are conducted by the OTS or the FDIC, the examiners may require the Bank to provide for higher general or specific loan loss reserves.
The Bank's general permissible lending limit for loans-to-one-borrower is equal to the greater of $500,000 or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus). At December 31, 1997, the Bank's lending limit under this restriction was $19.8 million. The Bank is in compliance with the loans-to-one-borrower limitation.
. INSURANCE OF ACCOUNTS AND REGULATION BY THE FDIC
The Bank is a member of the SAIF, which is administered by the FDIC. Savings deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC- insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a
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serious risk to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition.
The FDIC's deposit insurance premiums are assessed through a risk- based system under which all insured institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Under the system, institutions classified as well capitalized (i.e., a core capital ratio of at least 5%, a ratio of Tier 1 or core capital to risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (i.e., core or Tier 1 risk-based capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions will be made by the FDIC for each semi-annual assessment period.
The FDIC is authorized to increase assessment rates, on a semiannual basis, if it determines that the reserve ratio of the SAIF will be less than the designated reserve ratio of 1.25% of SAIF insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. In addition, the FDIC may impose special assessments on SAIF members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC.
D&N Bank, will continue to be subject to an assessment to fund repayment of the Financing Corporation's bond obligation of 6.5 cents per $100 of deposits while BIF insured institutions will pay 1.3 cents per $100 of deposits until the year 2000 when the assessment will be imposed at the same rate on all FDIC insured institutions.
REGULATORY CAPITAL REQUIREMENTS
Federally insured savings institutions, such as the Bank, are required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a tangible capital requirement, a leverage ratio (or core capital) requirement and a risk-based capital requirement applicable to such savings institutions. These capital requirements must be generally as stringent as the comparable capital requirements for national banks. The OTS is also authorized to impose capital requirements in excess of these standards on individual institutions on a case-by-case basis.
The capital regulations require tangible capital of at least 1.5% of
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adjusted total assets (as defined by regulation). Tangible capital generally includes common stockholders' equity and retained income, and certain noncumulative perpetual preferred stock and related income. In addition, all intangible assets, other than a limited amount of mortgage servicing rights (MSRs) must be deducted from tangible capital. At December 31, 1997, the Bank had $2,136,000 of unamortized MSRs, none of which was required to be deducted from tangible capital.
At December 31, 1997, the Bank had tangible capital of $119.5 million, or 6.55% of adjusted total assets, which is approximately $92.1 million above the minimum requirement of 1.5% of adjusted total assets in effect on that date.
The capital standards also require core capital equal to at least 3% of adjusted total assets (as defined by regulation). Core capital generally consists of tangible capital plus certain intangible assets, including a limited amount of purchased credit card relationships. As a result of the prompt corrective action provisions discussed below, however, a savings institution must maintain a core capital ratio of at least 4% to be considered adequately capitalized unless its supervisory condition is such to allow it to maintain a 3% ratio.
At December 31, 1997, the Bank had core capital equal to $119.5 million, or 6.55% of adjusted total assets, which is $64.7 million above the minimum leverage ratio requirement of 3% as in effect on that date.
The OTS risk-based requirement requires savings institutions to have total capital of at least 8% of risk-weighted assets. Total capital consists of core capital, as defined above, and supplementary capital. Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary capital may be used to satisfy the risk-based requirement only to the extent of core capital. The OTS is also authorized to require a savings institution to maintain an additional amount of total capital to account for concentration of credit risk and the risk of non-traditional activities. At December 31, 1997 the Bank had $10.4 million of general loss reserves which could be counted as supplementary capital.
On December 31, 1997, the Bank had total capital of $129.9 million (including $119.5 million in core capital and $10.4 million in qualifying supplementary capital) and risk-weighted assets of $1.08 billion (including $48.0 million in converted off-balance sheet assets); or total capital of 11.98% of risk-weighted assets. This amount was $43.1 million above the 8% requirement in effect on that date.
The OTS and the FDIC are authorized and, under certain circumstances required, to take certain actions against institutions that fail to meet their
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capital requirements. The OTS is generally required to take action to restrict the activities of an "undercapitalized institution" (generally defined to be one with less than either a 4% core ratio, a 4% Tier 1 risk-based capital ratio or an 8% risk-based capital ratio). Any such institution must submit a capital restoration plan and until such plan is approved by the OTS may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The OTS is authorized to impose the additional restrictions, discussed below, that are applicable to significantly undercapitalized institutions. On December 31, 1997, the Bank had a Tier 1 risk-based capital ratio of 11.02%.
Any savings institution that fails to comply with its capital plan or is "significantly undercapitalized" (i.e., Tier 1 risk-based or core capital ratios of less than 3% or a risk-based capital ratio of less than 6%) must be made subject to one or more of additional specified actions and operating restrictions which may cover all aspects of its operations and include a forced merger or acquisition of the institution. An institution that becomes "critically undercapitalized" (i.e., a tangible capital ratio of 2% or less) is subject to further mandatory restrictions on its activities in addition to those applicable to significantly undercapitalized institutions. In addition, the OTS must appoint a receiver (or conservator with the concurrence of the FDIC) for a savings institution, with certain limited exceptions, within 90 days after it becomes critically undercapitalized. Any undercapitalized institution is also subject to the general enforcement authority of the OTS and the FDIC, including the appointment of conservator or a receiver.
If the OTS determines that an institution is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice, it is authorized to reclassify a well-capitalized institution as an adequately capitalized institution and if the institution is adequately capitalized, to impose the restrictions applicable to an undercapitalized institution. If the institution is undercapitalized, the OTS is authorized to impose the restrictions applicable to a significantly undercapitalized institution.
The imposition by the OTS or the FDIC of any of these measures on the Bank may have a substantial adverse effect on the Bank's operations and profitability. The Company's stockholders do not have preemptive rights, and therefore, if the Company is directed by the OTS or the FDIC to issue additional shares of Common Stock, such issuance may result in the dilution in the percentage of ownership of the Company.
LIMITATIONS ON DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS
OTS regulations impose various restrictions on institutions with respect to their ability to pay dividends or make other distributions of capital. OTS regulations prohibit an institution from declaring or paying any dividends or
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from repurchasing any of its stock if, as a result, the regulatory capital of the institution would be reduced below the amount required to be maintained for the liquidation account established in connection with its mutual to stock conversion.
Generally, institutions such as the Bank, that before and after the proposed distribution meet their capital requirements, may make capital distributions during any calendar year equal to the greater of 100% of net income for the year-to-date plus 50% of the amount by which the lesser of the institution's tangible, core or risk-based capital exceeds its fully phased-in capital requirement for such capital component, as measured at the beginning of the calendar year, or 75% of its net income for the most recent four quarter period. However, an institution deemed to be in need of more than normal supervision by the OTS may have its dividend authority restricted by the OTS. The Bank may pay dividends in accordance with this general authority.
Savings institutions that will meet their current minimum capital requirement following a proposed capital distribution need only submit written notice to the OTS 30 days prior to such distribution. The OTS may object to the distribution during the 30-day period based on safety and soundness concerns. See "Regulatory Capital Requirements."
LIQUIDITY
All savings institutions, including the Bank, are required to maintain an average daily balance of liquid assets equal to a certain percentage of the sum of its average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. The liquidity asset ratio requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings institutions. At the present time, the minimum liquid asset ratio is 4%, as changed during 1997.
During 1997, the OTS lowered the minimum liquid asset ratio from 5% to 4%, and changed the definition of "liquid assets" to include obligations of the United States which have a remaining life greater than five years. This allows the Bank to use substantially all of its investment security and mortgage-backed security portfolios, which are not otherwise encumbered. The OTS also discontinued the 1% short-term liquid asset requirement.
At December 31, 1997, the Bank was in compliance with the liquidity ratio requirement, with a liquid asset ratio of 13.9%.
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ACCOUNTING
An OTS policy statement applicable to all savings institutions clarifies and reemphasizes that the investment activities of a savings institution must be in compliance with approved and documented investment policies and strategies, and must be accounted for in accordance with GAAP. Under the policy statement, management must support its classification of and accounting for loans and securities (i.e., whether held for investment, available for sale or trading) with appropriate documentation. The Bank is in compliance with these rules.
The OTS has adopted an amendment to its accounting regulations, which may be made more stringent than GAAP, to require that transactions be reported in a manner that best reflects their underlying economic substance and inherent risk and that financial reports must incorporate any other accounting regulations or orders prescribed by the OTS.
QUALIFIED THRIFT LENDER TEST
All savings institutions, including the Bank, are required to meet a qualified thrift lender ("QTL") test to avoid certain restrictions on their operations. This test requires a savings institution to have at least 65% of its portfolio assets as defined by regulation in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. Such assets primarily consist of residential housing related loans and investments. At December 31, 1997, the Bank met the test and has always met the test since its inception.
Any savings institution that fails to meet the QTL test must convert to a national bank charter, unless it requalifies as a QTL and thereafter remains a QTL. If the institution does not requalify and converts to a national bank charter, it must remain SAIF-insured until the FDIC permits it to transfer to the Bank Insurance Fund. If an institution that fails the test has not yet requalified and has not converted to a national bank, its new investments and activities are limited to those permissible for both a savings institution and a national bank, and it is limited to national bank branching rights in its home state. In addition, the institution is immediately ineligible to receive any new FHLB borrowings and is subject to national bank limits for payment of dividends. If such institution has not requalified or converted to a national bank within three years after the failure, it must divest of all investments and cease all activities not permissible for a national bank. In addition, it must repay promptly any outstanding FHLB borrowings, which may result in prepayment penalties. If any institution that fails the QTL test is controlled by a holding company, then within one year after the failure, the holding company must register as a bank holding company and become subject to all restrictions on bank holding companies. See "Holding Company Regulation."
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COMMUNITY REINVESTMENT ACT
Under the Community Reinvestment Act ("CRA"), every FDIC insured institution has a continuing and affirmative obligation consistent with safe and sound banking practices to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OTS, in connection with the examination of the Bank, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications, such as a merger or the establishment of a branch, by the Bank. An unsatisfactory rating may be used as the basis for the denial of an application by the OTS.
The federal banking agencies, including the OTS, have recently revised the CRA regulations and the methodology for determining an institution's compliance with the CRA. Due to the heightened attention being given to the CRA in the past few years, the Bank may be required to devote additional funds for investment and lending in its local community. The Bank was examined for CRA compliance in 1995 and received a rating of "Satisfactory".
HOLDING COMPANY REGULATION
The Company is a unitary savings and loan holding company subject to regulatory oversight by the OTS. As such, the Company is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over the Company and its non-savings institution subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution.
As a unitary savings and loan holding company, the Company generally is not subject to activity restrictions. If the Company acquires control of another savings institution as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of the Company and any of its subsidiaries (other than the Bank or any other SAIF-insured savings institution) would become subject to such restrictions unless such other institutions each qualify as a QTL and were acquired in a supervisory acquisition.
If the Bank fails the QTL test, the Company must obtain the approval of the OTS prior to continuing after such failure, directly or through its other subsidiaries, any business activity other than those approved for multiple savings and loan holding companies or their subsidiaries. In addition, within
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one year of such failure the Company must register as, and will become subject to, the restrictions applicable to bank holding companies. The activities authorized for a bank holding company are more limited than are the activities authorized for a unitary or multiple savings and loan holding company. See " Qualified Thrift Lender Test."
The Company must obtain approval from the OTS before acquiring control of any other SAIF-insured institution. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings institutions in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings institution.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW and Super NOW checking accounts). At December 31, 1997, the Bank was in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements that may be imposed by the OTS. See "Liquidity."
Savings institutions are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require institutions to exhaust other reasonable alternative sources of funds, including FHLB borrowings, before borrowing from the Federal Reserve Bank.
FEDERAL HOME LOAN BANK SYSTEM
The Bank is a member of the FHLB of Indianapolis, which is one of 12 regional FHLBs, that administer the home financing credit function of savings institutions. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. In addition, all long-term advances are required to provide funds for residential home financing.
As a member, the Bank is required to purchase and maintain stock in the FHLB of Indianapolis. At December 31, 1997, the Bank had $23.2 million in FHLB stock, which was in compliance with this requirement. In past years,
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the Bank has received substantial dividends on its FHLB stock. Over the past five calendar years such dividends have averaged 7.56% and were 7.99% for calendar year 1997.
Under federal law the FHLBs are required to provide funds for the resolution of troubled savings institutions and to contribute to low- and moderate priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate- income housing projects. These contributions have affected adversely the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of the Bank's FHLB stock may result in a corresponding reduction in the Bank's capital.
For the year ended December 31, 1997, the dividends paid by the FHLB of Indianapolis to the Bank totaled $1.6 million. The $447,000 dividend received for the quarter ended December 31, 1997 reflects an annualized rate of 8.00%.
FEDERAL AND STATE TAXATION
D&N and its subsidiaries file a consolidated federal income tax return on a calendar year basis using the accrual method of accounting.
Savings institutions, such as the Bank, were permitted to establish reserves for bad debts and make annual additions thereto which could be taken as a deduction in computing taxable income for federal income tax purposes. This tax bad debt reserve method available to thrifts institutions was repealed for tax years beginning after 1995. As a result, the Bank was required to change from the reserve method to the specific charge-off method to compute its bad debt deduction. Basically, repeal of the thrift bad debt reserve method puts large thrifts, such as the Bank, on the tax method used by large commercial banks.
Upon repeal, the Bank is required to recapture into income the portion of its bad debt reserves (other than the supplemental reserve) that exceeds its base year reserves (i.e. its tax reserves for the last tax year beginning before 1988). The recapture amount resulting from the change in the Bank's method of accounting for its bad debt reserves is taken into taxable income ratably (on a straight-line basis) over a six-year period.
The base year reserve is frozen, not forgiven. Certain events can still trigger a recapture of the base year reserve. For example, while the base year reserve will not be recaptured if the thrift converts to a bank charter or is merged into a bank, it will be recaptured if the thrift ceases to qualify as a bank for federal income tax purposes. The base year reserves also remain
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subject to income tax penalty provisions which, in general, require recapture upon certain stock redemptions of, and excess distributions to, shareholders.
In addition to the regular income tax, corporations, such as the Company, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20% on alternative minimum income, which is the sum of a corporation's regular taxable income (with certain adjustments) and tax preference items, less any available exemption. The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax and net operating losses can offset no more than 90% of alternative minimum taxable income.
D&N and its consolidated subsidiaries have been audited or their books closed without audit by the IRS with respect to consolidated federal income tax returns through December 31, 1993. With respect to years examined by the IRS, either all deficiencies have been satisfied or sufficient reserves have been established to satisfy asserted deficiencies. In the opinion of management, any examination of open returns (including returns of subsidiaries and predecessors of, or entities merged into, D&N) would not result in a deficiency which could have a material adverse effect on the financial condition of D&N and its consolidated subsidiaries. See Note M of Notes to Consolidated Financial Statements.
During the third quarter of 1996, the Bank recognized an adjustment to its balance of deferred tax assets following the enactment in August of federal legislation which resolved the recapture status of previously allowed accelerated deductions for bad debts. Thrift institutions such as the Bank had been permitted to deduct a portion of their income as bad debt allowances. This practice was more advantageous than the specific-loss method of deduction which was mandated for other classes of financial institutions. The opportunity to use the percentage-of-income method expired in 1995, but the status of previously accelerated deductions remained in question until the 1996 legislation was enacted. The presence of unresolved prior deductions was felt to be hindrance to evolution and consolidation of the financial services industry because thrift institutions that had recorded such accelerated deductions were required to repay them before charter conversions or acquisitions by non-thrift institutions could be approved. The new legislation required that accelerated deductions recorded after 1987 would have to be repaid, but forgave that portion of institutions' accelerated loan loss deductions that were recorded before 1988.
MICHIGAN TAXATION. The State of Michigan imposes a tax on intangible personal property in the amount of $.20 per $1,000 of deposits of a savings bank or a savings and loan institution less deposits owed to the federal or Michigan state governments, their agencies or certain other financial institutions. The Michigan intangibles tax is being phased out over four years
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until the tax is fully repealed effective January 1, 1998. The State of Michigan also imposes a "Single Business Tax." The Single Business Tax is a value-added type of tax for the privilege of doing business in the State of Michigan. The major components of the Single Business Tax are federal taxable income, compensation and depreciation as increased by net operating loss carryforwards, if any, utilized in arriving at federal taxable income, and decreased by the cost of acquisition of tangible assets during the year. The tax rate is 2.30% of the Michigan adjusted tax base.
DELAWARE TAXATION. As a Delaware business corporation, the Company is required to file annual returns with and pay annual fees to the State of Delaware. The Company is also subject to an annual franchise tax imposed by the State of Delaware based on the number of authorized shares of the Company stock.
ITEM 2.
ITEM 2. PROPERTIES
At December 31, 1997, the Bank operated through 37 full service community banking offices, seven savings agency offices and four mortgage banking offices. The net book value of the land, buildings and leasehold improvements owned by D&N Bank at that date was $11,686,000, and the net book value of its office furniture, fixtures and equipment was $4,936,000.
COMPUTER EQUIPMENT. D&N Bank processes all depositor and borrower customer files and transactions through a third party data services provider including general ledger accounting and information reporting. The book value of all computer equipment and software owned by the Bank was $934,000 at December 31, 1997. The Bank also leases an insignificant amount of data processing hardware and software.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is a defendant in a number of matters of litigation, substantially all of which have arisen in the ordinary course of business. It is the opinion of management that the resulting liabilities, if any, from these actions will not materially affect the Consolidated Financial Statements.
D&N Bank is a plaintiff, like approximately 120 other institutions, in a currently pending claim in the United States Court of Federal Claims seeking substantial damages as a result of the 1989 Financial Institutions Reform, Recovery and Enforcement Act's mandatory phase-out of the regulatory capital treatment of supervisory goodwill. The ultimate outcome of these matters cannot be ascertained at this time.
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ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 1997.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Page 52 of the attached 1997 Annual Report to Stockholders is herein incorporated by reference.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Page 4 of the attached 1997 Annual Report to Stockholders is herein incorporated by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Pages 12 through 23 of the attached 1997 Annual Report to Stockholders are herein incorporated by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS SUPPLEMENTARY DATA
Pages 24 through 49 of the attached 1997 Annual Report to Stockholders are herein incorporated by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There has been no Current Report on Form 8-K filed within 24 months prior to the date of the most recent financial statements reporting a change of accountants and/or reporting disagreements on any matter of accounting principle or financial statement disclosure.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning Executive Officers of the Company is
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contained on page 27 herein. Information concerning Directors of the Company, is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held in 1998, except for information contained under the heading "Compensation Committee Report" and "Stockholder Return Performance Presentation." A copy of this Proxy Statement will be filed not later than 120 days after the close of the fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated herein by reference from the Company's definitive Proxy Statement or the Annual Meeting of Stockholders to be held in 1998, except for information contained under the heading "Compensation Committee Report" and "Stockholder Return Performance Presentation." A copy of this Proxy Statement will be filed not later than 120 days after the close of the fiscal year.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held in 1998, except for information contained under the heading "Compensation Committee Report" and "Stockholder Return Performance Presentation." A copy of this Proxy Statement will be filed not later than 120 days after the close of the fiscal year.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning certain relationships and related transactions incorporated herein by reference from the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held in 1998, except for the information contained under the heading Compensation Committee Report" and "Stockholder Return Performance Presentation." A copy of this Proxy Statement will be filed not later than 120 days after the close of the fiscal year.
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PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The following information appearing in the Registrant's Annual Report to Stockholders for the year ended December 31, 1997, is incorporated by reference in this Annual Report on Form 10-K as Exhibit 13.
(a) (2) Financial Statement Schedules
All financial statement schedules have been omitted as the required information is inapplicable or has been included in the Notes to Consolidated Financial Statements.
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(A) (3) EXHIBITS
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*Filed as exhibits to the Registrant's registration statement on Form S-2 (File No. 33-69300) filed with the Commission on September 23, 1993 or as part of reports filed for the purpose of updating such description. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K.
(b) Reports on Form 8-K
None.
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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.
D&N FINANCIAL CORPORATION
Date March 25, 1998 By: /s/ GEORGE J. BUTVILAS --------------------------------- --------------------------- GEORGE J. BUTVILAS (Duly Authorized Representative)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
By: /s/ GEORGE J. BUTVILAS By: /s/ KENNETH D. SEATON --------------------------------- --------------------------- GEORGE J. BUTVILAS KENNETH D. SEATON Director, President and Director, Chairman of the Board Chief Executive Officer (Principal Executive Officer)
Date March 25, 1998 Date March 25, 1998 --------------------------------- ---------------------------
By: /s/ JOSEPH C. BROMLEY By: /s/ MARY P. CAULEY --------------------------------- --------------------------- JOSEPH C. BROMLEY MARY P. CAULEY Director Director
Date March 25, 1998 Date March 25, 1998 --------------------------------- ---------------------------
By: /s/ STEVEN COLEMAN By: /s/ STANLEY A. JACOBSON --------------------------------- --------------------------- STEVEN COLEMAN STANLEY A. JACOBSON Director Director
Date March 25, 1998 Date March 25, 1998 --------------------------------- ---------------------------
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By: /s/ RANDOLPH P. PIPER By: /s/ B. THOMAS M. SMITH, JR. --------------------------------- --------------------------- RANDOLPH P. PIPER B. THOMAS M. SMITH, JR. Director Director
Date March 25, 1998 Date March 25, 1998 --------------------------------- ---------------------------
BY: /s/ PETER VAN PELT By: /s/ STEVEN E. ZACK --------------------------------- --------------------------- PETER VAN PELT STEVEN E. ZACK Director Director
Date March 25, 1998 Date March 25, 1998 --------------------------------- ---------------------------
By: /s/ KENNETH R. JANSON --------------------------------- KENNETH R. JANSON Executive Vice President/ Chief Financial Officer
Date March 25, 1998 ---------------------------------
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*Filed as exhibits to the Registrant's registration statement on Form S-2 (File No. 33-69300) filed with the Commission on September 23, 1993 or as part of reports filed for the purpose of updating such description. All of such previously filed documents are hereby incorporated herein by reference in accordance with Item 601 of Regulation S-K.
(b) Reports on Form 8-K
None.
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