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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
2005
FORM 10-K
ANNUAL REPORT UNDER SECTION 13 OR 15 (D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
COMMISSION FILE NUMBER 1-13805
HARRIS PREFERRED CAPITAL CORPORATION
(Exact name of registrant as specified in its charter)
MARYLAND 36-4183096
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 WEST MONROE STREET, CHICAGO, ILLINOIS 60603
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(312) 461-2121
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
7 3/8% Noncumulative Exchangeable New York Stock Exchange
Preferred Stock, Series A, par value
$1.00 per share
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
NOTE -- checking the box above will not relieve any registrant required to
file reports pursuant to Section 13 or 15(d) of the Exchange Act from their
obligations under those Sections.
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (229.405 of this chapter) is not contained herein, and
will not be contained to the best of registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of this Form 10-
K or any amendment to this Form 10-K. [X]
Indicate by check mark whether this registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated
filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
The number of shares of Common Stock, $1.00 par value, outstanding on March
29, 2006 was 1,000. No common equity is held by nonaffiliates.
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HARRIS PREFERRED CAPITAL CORPORATION
TABLE OF CONTENTS
PART I
Item 1. Business......................................................... 2
Item 1A. Risk Factors..................................................... 6
Item 1B. Unresolved Staff Comments........................................ 11
Item 2. Properties....................................................... 11
Item 3. Legal Proceedings................................................ 11
Item 4. Submission of Matters to a Vote of Security Holders ............. 11
PART II
Item 5. Market for the Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity securities................ 11
Item 6. Selected Financial Data ......................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 13
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ...... 17
Item 8. Financial Statements and Supplementary Data...................... 17
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure............................................. 17
Item 9A. Controls and Procedures.......................................... 17
Item 9B. Other Information................................................ 17
PART III
Item 10. Directors and Executive Officers of the Registrant .............. 17
Item 11. Executive Compensation .......................................... 19
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters.................................. 19
Item 13. Certain Relationships and Related Transactions................... 20
Item 14. Principal Accountant Fees and Services........................... 20
PART IV
Item 15 Exhibits, Financial Statement Schedules.......................... 21
(a) Exhibits
31.1 Certification of Janine Mulhall pursuant to Rule 13a - 14(a)
31.2 Certification of Paul R. Skubic pursuant to Rule 13a - 14(a)
32.1 Certification pursuant to 18 U.S.C. Section 1350.
(b) Reports on Form 8-K
None
Signatures................................................................ 23
1
PART I
FORWARD-LOOKING INFORMATION
Forward-looking statements contained in this Annual Report on Form 10-K
("Report") of Harris Preferred Capital Corporation (the "Company") may include
certain forward-looking information, within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended, including (without limitation) statements with respect
to the Company's expectations, intentions, beliefs or strategies regarding the
future. Forward-looking statements include the Company's statements regarding
tax treatment as a real estate investment trust, liquidity, provision for loan
losses, capital resources and investment activities. In addition, in those and
other portions of this document, the words "anticipate," "believe," "estimate,"
"expect," "intend" and other similar expressions, as they relate to the Company
or the Company's management, are intended to identify forward-looking
statements. Such statements reflect the current views of the Company with
respect to future events and are subject to certain risks, uncertainties and
assumptions. It is important to note that the Company's actual results could
differ materially from those described herein as anticipated, believed,
estimated or expected. Among the factors that could cause the results to differ
materially are the risks discussed in "Risk Factors" below (Item 1A of this
Report). The Company assumes no obligation to update any such forward-looking
statements.
ITEM 1. BUSINESS
GENERAL
Harris Preferred Capital Corporation is a Maryland corporation incorporated
on September 24, 1997, pursuant to the Maryland General Corporation Law. The
Company's principal business objective is to acquire, hold, finance and manage
qualifying real estate investment trust ("REIT") assets (the "Mortgage Assets"),
consisting of mortgage-backed securities, notes issued by Harris N.A. (the
"Bank") secured by real estate mortgage assets (the "Securing Mortgage Loans")
and other obligations secured by real property, as well as certain other
qualifying REIT assets. The Company's assets are held in a Maryland real estate
investment trust subsidiary, Harris Preferred Capital Trust. The Company has
elected to be treated as a REIT under the Internal Revenue Code of 1986 (the
"Code"), and will generally not be subject to federal income tax if it
distributes 90% of its adjusted REIT ordinary taxable income and meets all of
the qualifications necessary to be a REIT. All of the shares of the Company's
common stock, par value $1.00 per share (the "Common Stock"), are owned by
Harris Capital Holdings, Inc. ("HCH"), a wholly-owned subsidiary of the Bank.
The Company was formed by the Bank to provide investors with the opportunity to
invest in residential mortgages and other real estate assets and to provide the
Bank with a cost-effective means of raising capital for federal regulatory
purposes.
On February 11, 1998, the Company, through a public offering (the
"Offering"), issued 10,000,000 shares of its 7 3/8% Noncumulative Exchangeable
Preferred Stock, Series A (the "Preferred Shares"), $1.00 par value. The
Offering raised $250 million less $7.9 million of underwriting fees. The
Preferred Shares are traded on the New York Stock Exchange under the symbol "HBC
Pr A". Holders of Preferred Shares are entitled to receive, if declared by the
Company's Board of Directors, noncumulative dividends at a rate of 7 3/8% per
annum of the $25 per share liquidation preference (an amount equivalent to
$1.8438 per share per annum). Dividends on the Preferred Shares, if authorized
and declared, are payable quarterly in arrears on March 30, June 30, September
30 and December 30 of each year. The Preferred Shares may be redeemed for cash
at the option of the Company, in whole or in part, at any time and from time to
time, at the principal amount thereof, plus the quarterly accrued and unpaid
dividends, if any, thereon. The Company may not redeem the Preferred Shares
without prior approval from the Office of the Comptroller of the Currency (the
"OCC") or the appropriate successor or other federal regulatory agency.
Each Preferred Share will be automatically exchanged (the "Automatic
Exchange") for one newly issued preferred share of the Bank ("Bank Preferred
Share") in the event (i) the Bank becomes less than "adequately capitalized"
under regulations established pursuant to the Federal Deposit Insurance
Corporation Improvement Act of 1991, as amended, (ii) the Bank is placed into
conservatorship or receivership, (iii) the OCC directs such exchange in writing
because, in its sole discretion and even if the Bank is not less than
"adequately capitalized," the OCC anticipates that the Bank may become less than
adequately capitalized in the near term, or (iv) the OCC in its
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sole discretion directs in writing an exchange in the event that the Bank has a
Tier 1 risk-based capital ratio of less than 5% (each an "Exchange Event"). In
the event of an exchange, the Bank Preferred Shares would constitute a new
series of preferred shares of the Bank, would have the same dividend rights,
liquidation preference, redemption options and other attributes as the Preferred
Shares, except that the Bank Preferred Shares would not be listed on the New
York Stock Exchange and would rank pari passu in terms of cash dividend payments
and liquidation preference with any outstanding shares of preferred stock of the
Bank.
Effective May 27, 2005, Harris Bankcorp, Inc., the Bank's parent company,
consolidated 26 of its Illinois bank charters (including Harris Trust and
Savings Bank) into one national bank charter, Harris N.A. Prior to that time and
under the same conditions as described in the prior paragraph, each Preferred
Share was automatically exchangeable for one newly issued preferred share of
Harris Trust and Savings Bank, which was subject to regulation by the Board of
Governors of the Federal Reserve System. References herein to the Bank for those
times prior to the charter consolidation are intended to refer to its
predecessor, Harris Trust and Savings Bank.
Concurrent with the issuance of the Preferred Shares, the Bank contributed
additional capital of $241 million, net of acquisition costs, to the Company.
The Company and the Bank undertook the Offering for two principal reasons: (i)
the qualification of the Preferred Shares as Tier 1 capital of the Bank for U.S.
banking regulatory purposes under relevant regulatory capital guidelines, as a
result of the treatment of the Preferred Shares as a minority interest in a
consolidated subsidiary of the Bank, and (ii) lack of federal income tax on the
Company's earnings used to pay the dividends on the Preferred Shares, as a
result of the Company's qualification as a REIT. On December 30, 1998, the Bank
contributed the common stock of the Company to HCH, a newly-formed and wholly-
owned subsidiary of the Bank. The Bank is an indirect wholly-owned U.S.
subsidiary of Bank of Montreal. The Bank is required to maintain direct or
indirect ownership of at least 80% of the outstanding Common Stock of the
Company for as long as any Preferred Shares are outstanding.
The Company used the Offering proceeds and the additional capital
contributed by the Bank to purchase $356 million of notes (the "Notes") from the
Bank and $135 million of mortgage-backed securities at their estimated fair
value. The Notes are obligations issued by the Bank that are recourse only to
the underlying mortgage loans (the "Securing Mortgage Loans") and were acquired
pursuant to the terms of a loan agreement with the Bank. The principal amount of
the Notes equals approximately 80% of the principal amounts of the Securing
Mortgage Loans.
BUSINESS
The Company was formed for the purpose of raising capital for the Bank. One
of the Company's principal business objectives is to acquire, hold, finance and
manage Mortgage Assets. These Mortgage Assets generate interest income for
distribution to stockholders. A portion of the Mortgage Assets of the Company
consists of Notes issued by the Bank that are recourse only to Securing Mortgage
Loans that are secured by real property. The Notes mature on October 1, 2027 and
pay interest at 6.4% per annum. Payments of interest are made to the Company
from payments made on the Securing Mortgage Loans. Pursuant to an agreement
between the Company and the Bank, the Company, through the Bank as agent,
receives all scheduled payments made on the Securing Mortgage Loans, retains a
portion of any such payments equal to the amount due on the Notes and remits the
balance, if any, to the Bank. The Company also retains approximately 80% of any
prepayments of principal in respect of the Securing Mortgage Loans and applies
such amounts as a prepayment on the Notes. The Company has a security interest
in the real property securing the Securing Mortgage Loans and will be entitled
to enforce payment on the loans in its own name if a mortgagor should default.
In the event of such default, the Company would have the same rights as the
original mortgagee to foreclose the mortgaged property and satisfy the
obligations of the Bank out of the proceeds.
The Company may from time to time acquire fixed-rate or variable-rate
mortgage-backed securities representing interests in pools of mortgage loans.
The Bank may have originated a portion of any such mortgage-backed securities by
exchanging pools of mortgage loans for the mortgage-backed securities. The
mortgage loans underlying the mortgage-backed securities will be secured by
single-family residential properties located throughout the United States. The
Company intends to acquire only investment grade mortgage-backed securities
issued by agencies of the federal government or government sponsored agencies,
such as the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal
National Mortgage Association ("Fannie Mae") and the Government
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National Mortgage Association ("GNMA"). The Company does not intend to acquire
any interest-only, principal-only or similar speculative mortgage-backed
securities.
The Bank may from time to time acquire or originate both conforming and
nonconforming residential mortgage loans. Conventional conforming residential
mortgage loans comply with the requirements for inclusion in a loan guarantee
program sponsored by either FHLMC or Fannie Mae. Nonconforming residential
mortgage loans are residential mortgage loans that do not qualify in one or more
respects for purchase by Fannie Mae or FHLMC under their standard programs. The
nonconforming residential mortgage loans that the Company purchases will be
nonconforming because they have original principal balances which exceed the
limits for FHLMC or Fannie Mae under their standard programs. The Company
believes that all residential mortgage loans will meet the requirements for sale
to national private mortgage conduit programs or other investors in the
secondary mortgage market. As of December 31, 2005 and 2004 and for each of the
years then ended, the Company did not directly hold any residential mortgage
loans.
The Company may from time to time acquire commercial mortgage loans secured
by industrial and warehouse properties, recreational facilities, office
buildings, retail space and shopping malls, hotels and motels, hospitals,
nursing homes or senior living centers. The Company's current policy is not to
acquire any interest in a commercial mortgage loan if commercial mortgage loans
would constitute more than 5% of the Company's Mortgage Assets at the time of
its acquisition. Unlike residential mortgage loans, commercial mortgage loans
generally lack standardized terms. Commercial real estate properties themselves
tend to be unique and are more difficult to value than residential real estate
properties. Commercial mortgage loans may also not be fully amortizing, meaning
that they may have a significant principal balance or "balloon" payment due on
maturity. Moreover, commercial properties, particularly industrial and warehouse
properties, are generally subject to relatively greater environmental risks than
non-commercial properties, generally giving rise to increased costs of
compliance with environmental laws and regulations. There is no requirement
regarding the percentage of any commercial real estate property that must be
leased at the time the Bank acquires a commercial mortgage loan secured by such
commercial real estate property, and there is no requirement that commercial
mortgage loans have third party guarantees. The credit quality of a commercial
mortgage loan may depend on, among other factors, the existence and structure of
underlying leases, the physical condition of the property (including whether any
maintenance has been deferred), the creditworthiness of tenants, the historical
and anticipated level of vacancies and rents on the property and on other
comparable properties located in the same region, potential or existing
environmental risks, the availability of credit to refinance the commercial
mortgage loan at or prior to maturity and the local and regional economic
climate in general. Foreclosures of defaulted commercial mortgage loans are
generally subject to a number of complicated factors, including environmental
considerations, which are generally not present in foreclosures of residential
mortgage loans. As of December 31, 2005 and 2004 and for each of the years then
ended, the Company did not hold any commercial mortgage loans.
The Company may invest in assets eligible to be held by REITs other than
those described above. In addition to commercial mortgage loans and mortgage
loans secured by multi-family properties, such assets could include cash, cash
equivalents and securities, including shares or interests in other REITs and
partnership interests. At December 31, 2005, the Company held $20.5 million of
short-term money market assets and $75 million of U.S. Treasury securities. At
December 31, 2004, the Company held $10.5 million of short-term money market
assets and $45 million of U.S. Treasury securities.
The Company intends to continue to acquire Mortgage Assets from the Bank
and/or affiliates of the Bank on terms that are comparable to those that could
be obtained by the Company if such Mortgage Assets were purchased from unrelated
third parties. The Company may also from time to time acquire Mortgage Assets
from unrelated third parties.
The Company intends to maintain a substantial portion of its portfolio in
Bank-secured obligations and mortgage-backed securities. The Company may,
however, invest in other assets eligible to be held by a REIT. The Company's
current policy and the Servicing Agreement (defined below) prohibit the
acquisition of any Mortgage Asset constituting an interest in a mortgage loan
(other than an interest resulting from the acquisition of mortgage-backed
securities), which mortgage loan (i) is delinquent (more than 30 days past due)
in the payment of principal or interest at the time of proposed acquisition;
(ii) is or was at any time during the preceding 12 months (a) on
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nonaccrual status or (b) renegotiated due to financial deterioration of the
borrower; or (iii) has been, more than once during the preceding 12 months, more
than 30 days past due in payment of principal or interest. Loans that are on
"nonaccrual status" are generally loans that are past due 90 days or more in
principal or interest. The Company maintains a policy of disposing of any
mortgage loan which (i) falls into nonaccrual status, (ii) has to be
renegotiated due to the financial deterioration of the borrower, or (iii) is
more than 30 days past due in the payment of principal or interest more than
once in any 12 month period. The Company may choose, at any time subsequent to
its acquisition of any Mortgage Assets, to require the Bank (as part of the
Servicing Agreement) to dispose of the mortgage loans for any of these reasons
or for any other reason.
The Bank services the Securing Mortgage Loans and the other mortgage loans
purchased by the Company on behalf of, and as agent for, the Company and is
entitled to receive fees in connection with the servicing thereof pursuant to
the servicing agreement (the "Servicing Agreement"). The Bank receives a fee
equal to 0.25% per annum on the principal balances of the loans serviced.
Payment of such fees is subordinate to payments of dividends on the Preferred
Shares. The Servicing Agreement requires the Bank to service the loans in a
manner generally consistent with accepted secondary market practices, with any
servicing guidelines promulgated by the Company and, in the case of residential
mortgage loans, with Fannie Mae and FHLMC guidelines and procedures. The
Servicing Agreement requires the Bank to service the loans solely with a view
toward the interest of the Company and without regard to the interest of the
Bank or any of its affiliates. The Bank will collect and remit principal and
interest payments, administer mortgage escrow accounts, submit and pursue
insurance claims and initiate and supervise foreclosure proceedings on the loans
it services. The Bank may, with the approval of a majority of the Company's
Board of Directors, as well as a majority of the Company's Independent
Directors, subcontract all or a portion of its obligations under the Servicing
Agreement to unrelated third parties. An "Independent Director" is a director
who is not a current officer or employee of the Company or a current director,
officer or employee of the Bank or of its affiliates. The Bank will not, in
connection with the subcontracting of any of its obligations under the Servicing
Agreement, be discharged or relieved in any respect from its obligations under
the Servicing Agreement. The Company may terminate the Servicing Agreement upon
the occurrence of such events as they relate to the Bank's proper and timely
performance of its duties and obligations under the Servicing Agreement. As long
as any Preferred Shares remain outstanding, the Company may not terminate, or
elect to renew, the Servicing Agreement without the approval of a majority of
the Company's Independent Directors.
The Company entered into an advisory agreement with the Bank (the "Advisory
Agreement") pursuant to which the Bank administers the day-to-day operations of
the Company. The Bank is responsible for (i) monitoring the credit quality of
Mortgage Assets held by the Company, (ii) advising the Company with respect to
the reinvestment of income from and payments on, and with respect to the
acquisition, management, financing and disposition of the Mortgage Assets held
by the Company, and (iii) monitoring the Company's compliance with the
requirements necessary to qualify as a REIT, and other financial and tax-related
matters. The Bank may from time to time subcontract all or a portion of its
obligations under the Advisory Agreement to one or more of its affiliates. The
Bank may, with the approval of a majority of the Company's Board of Directors,
as well as a majority of the Company's Independent Directors, subcontract all or
a portion of its obligations under the Advisory Agreement to unrelated third
parties. The Bank will not, in connection with the subcontracting of any of its
obligations under the Advisory Agreement, be discharged or relieved in any
respect from its obligations under the Advisory Agreement. The Advisory
Agreement is renewed annually. The Company may terminate the Advisory Agreement
at any time upon 60 days' prior written notice. As long as any Preferred Shares
remain outstanding, any decision by the Company either to renew the Advisory
Agreement or to terminate the Advisory Agreement must be approved by a majority
of the Board of Directors, as well as by a majority of the Company's Independent
Directors.
The Advisory Agreements in effect in 2005 and 2004 entitled the Bank to
receive advisory fees of $122,000 and $124,000, respectively.
The Company may from time to time purchase additional Mortgage Assets out
of proceeds received in connection with the repayment or disposition of Mortgage
Assets, the issuance of additional shares of Preferred Stock or additional
capital contributions with respect to the Common Stock. The Company may also
issue additional series of Preferred Stock. However, the Company may not issue
additional shares of Preferred Stock senior to the Series A Preferred Shares
either in the payment of dividends or in the distribution of assets on
liquidation without the consent of holders of at least 67% of the outstanding
shares of Preferred Stock at that time or
5
without approval of a majority of the Company's Independent Directors. The
Company does not currently intend to issue any additional shares of Preferred
Stock unless it simultaneously receives additional capital contributions from
HCH or other affiliates sufficient to support the issuance of such additional
shares of Preferred Stock.
Although the Company does not currently intend to incur any indebtedness in
connection with the acquisition and holding of Mortgage Assets, the Company may
do so at any time (although indebtedness in excess of 25% of the Company's total
stockholders' equity may not be incurred without the approval of a majority of
the Company's Independent Directors). To the extent the Company were to change
its policy with respect to the incurrence of indebtedness, the Company would be
subject to risks associated with leverage, including, without limitation,
changes in interest rates and prepayment risk.
EMPLOYEES
As of December 31, 2005, the Company had no paid employees. All officers of
the Company were employed by the Bank.
ENVIRONMENTAL MATTERS
In the event that the Company is forced to foreclose on a defaulted
Securing Mortgage Loan to recover its investment in such loan, the Company may
be subject to environmental liabilities in connection with the underlying real
property, which could exceed the value of the real property. Although the
Company intends to exercise due diligence to discover potential environmental
liabilities prior to the acquisition of any property through foreclosure,
hazardous substances or wastes, contaminants, pollutants or sources thereof (as
defined by state and federal laws and regulations) may be discovered on
properties during the Company's ownership or after a sale thereof to a third
party. If such hazardous substances are discovered on a property which the
Company has acquired through foreclosure or otherwise, the Company may be
required to remove those substances and clean up the property. There can be no
assurance that in such a case the Company would not incur full recourse
liability for the entire costs of any removal and clean-up, that the cost of
such removal and clean-up would not exceed the value of the property or that the
Company could recoup any of such costs from any third party. The Company may
also be liable to tenants and other users of neighboring properties. In
addition, the Company may find it difficult or impossible to sell the property
prior to or following any such clean-up. The Company has not foreclosed on any
Securing Mortgage Loans during 2005 and 2004.
QUALIFICATION AS A REIT
The Company elected to be taxed as a REIT commencing with its taxable year
ended December 31, 1998 and intends to comply with the provisions of the Code
with respect thereto. The Company will not be subject to Federal income tax to
the extent it distributes 90% (95% for years prior to January 1, 2001) of its
adjusted REIT ordinary taxable income to stockholders and as long as certain
assets, income and stock ownership tests are met. For 2005 as well as 2004, the
Company met all Code requirements for a REIT, including the asset, income, stock
ownership and distribution tests. Cash distributions in the amount of $1.8438
per Preferred Share were paid in 2005 and 2004. For the year ended December 31,
2004 there were no common stock dividends declared, as there were no earnings
available after payment of the preferred dividends. However, on September 13,
2004, the Company paid a cash dividend of $904 thousand on the outstanding
common shares to the stockholder of record on September 6, 2004. These dividends
completed the 2003 REIT tax compliance requirements. Through December 31, 2005,
no common dividends applicable to that year were paid.
ITEM 1A. RISK FACTORS
Set forth below and elsewhere in this Report and in other documents we file
with the SEC (including the February 5, 1998 Prospectus (the "1998 Prospectus")
for the Offering (SEC File No. 333-40257)) are risks and uncertainties with
respect to the Company, the Preferred Shares and the Bank. This Report contains
forward-looking statements that involve risks and uncertainties. The Company's
actual results may differ significantly from the results discussed in the
forward-looking statements. Factors that might cause such differences include
those discussed below.
6
DECLINING INTEREST RATES WILL REDUCE EARNINGS OF THE COMPANY
The Company's income will consist primarily of interest payments on the
earning assets held by it. If there is a decline in interest rates during a
period of time when the Company must reinvest payments of interest and principal
in respect of its earning assets, the Company may find it difficult to purchase
additional earning assets that generate sufficient income to support payment of
dividends on the Preferred Shares.
Because the rate at which dividends, if, when and as authorized and
declared, are payable on the Preferred Shares is fixed, there can be no
assurance that an interest rate environment in which there is a decline in
interest rates would not adversely affect the Company's ability to pay dividends
on the Preferred Shares.
DIVIDENDS MAY NOT BE AUTHORIZED QUARTERLY AND DIVIDENDS NOT AUTHORIZED WILL
NOT BE PAID
Dividends on the Preferred Shares are not cumulative. Consequently, if the
Board of Directors does not authorize a dividend on the Preferred Shares for any
quarterly period, the holders of the Preferred Shares would not be entitled to
recover such dividend whether or not funds are or subsequently become available.
Quarterly dividends may not always be paid on the Preferred Shares. The Board of
Directors may determine, in its business judgment, that it would be in the best
interests of the Company to pay less than the full amount of the stated dividend
on the Preferred Shares or no dividend for any quarter, notwithstanding that
funds are available. Factors that may be considered by the Board of Directors in
making this determination are the Company's financial condition and capital
needs, the impact of legislation and regulations as then in effect or as may be
proposed, economic conditions, and such other factors as the Board of Directors
may deem relevant. To remain qualified as a REIT, the Company must distribute
annually at least 90% of its "REIT taxable income" (not including capital gains)
to stockholders. See "-- Tax Risks."
AUTOMATIC EXCHANGE FOR BANK PREFERRED SHARES COULD OCCUR WHEN VALUE OF BANK
PREFERRED SHARES IS IMPAIRED
An investment in the Preferred Shares involves risk with respect to the
performance and capital levels of the Bank. A decline in the performance and
capital levels of the Bank or the placement of the Bank into conservatorship or
receivership could result in the automatic exchange of the Preferred Shares for
Bank Preferred Shares, which would be an investment in the Bank and not in the
Company. As a result, holders of Preferred Shares would become preferred
stockholders of the Bank at a time when the Bank's financial condition was
deteriorating or when the Bank had been placed into conservatorship or
receivership. If an Exchange Event occurs, the Bank would likely be unable to
pay dividends on the Bank Preferred Shares.
An investment in the Bank is also subject to certain risks that are
distinct from the risks associated with an investment in the Company. For
example, an investment in the Bank would involve risks relating to the capital
levels of, and other federal regulatory requirements applicable to, the Bank,
and the performance of the Bank's loan portfolio. An investment in the Bank is
also subject to the general risks inherent in equity investments in depository
institutions. In the event of a liquidation of the Bank, the claims of
depositors and secured, senior, general and subordinated creditors of the Bank
would be entitled to a priority of payment over the claims of holders of equity
interests such as the Bank Preferred Shares. As a result, if the Bank were to be
placed into receivership, the holders of the Bank Preferred Shares likely would
receive, if anything, substantially less than they would have received had the
Preferred Shares not been exchanged for Bank Preferred Shares.
BANK PREFERRED SHARES WILL NOT BE LISTED ON ANY EXCHANGE AND MARKETS MAY NOT
BE LIQUID
Although the Preferred Shares are listed on the NYSE, the Bank does not
intend to apply for listing of the Bank Preferred Shares on any national
securities exchange. Consequently, there can be no assurance as to the liquidity
of the trading markets for the Bank Preferred Shares, if issued, or that an
active public market for the Bank Preferred Shares would develop or be
maintained.
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DIVIDENDS AND OPERATIONS OF THE COMPANY RESTRICTED BY REGULATION
Because the Company is a subsidiary of the Bank, banking regulatory
authorities will have the right to examine the Company and its activities. Under
certain circumstances, including any determination that the Bank's relationship
to the Company results in an unsafe and unsound banking practice, such
regulatory authorities will have the authority to restrict the ability of the
Company to transfer assets, to make distributions to its stockholders (including
dividends to the holders of Preferred Shares, as described below), or to redeem
shares of Preferred Stock, or even to require the Bank to sever its relationship
with or divest its ownership of the Company. Such actions could potentially
result in the Company's failure to qualify as a REIT.
Payment of dividends on the Preferred Shares could also be subject to
regulatory limitations if the Bank became less than "adequately capitalized" for
purposes of the Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"). Less than "adequately capitalized" is currently defined as having
(i) a total risk-based capital ratio of less than 8.0%, (ii) a Tier 1 risk-based
capital ratio of less than 4.0%, or (iii) a Tier 1 leverage ratio of less than
4.0% (or 3.0% under certain circumstances not currently applicable to the Bank).
At December 31, 2005, the Bank's total risk-based capital ratio was 11.40%, its
Tier 1 risk-based capital ratio was 9.34% and its Tier 1 leverage ratio was
8.27%.
If the Automatic Exchange occurs, the Bank would likely be unable to pay
dividends on the Bank Preferred Shares. In all circumstances following the
Automatic Exchange, the Bank's ability to pay dividends would be subject to
various restrictions under applicable regulations. Furthermore, in the event the
Bank is placed into conservatorship or receivership (whether before or after the
Automatic Exchange), the Bank would be unable to pay dividends on the Bank
Preferred Shares. In addition, in the event of a liquidation of the Bank, the
claims of the Bank's depositors and of its secured, senior, general and
subordinated creditors would be entitled to a priority of payment over the
dividend and other claims of holders of equity interests such as the Bank
Preferred Shares.
TAX RISKS
ADVERSE CONSEQUENCES OF FAILURE TO QUALIFY AS A REIT
The Company intends to operate so as to qualify as a REIT under the Code.
No assurance can be given that the Company will be able to continue to operate
in a manner so as to qualify as a REIT. Qualification as a REIT involves the
application of highly technical and complex Code provisions for which there are
only limited judicial or administrative interpretations. The determination of
various factual matters and circumstances, not entirely within the Company's
control, may affect the Company's ability to continue to qualify as a REIT.
Although the Company is not aware of any proposal in Congress to amend the tax
laws in a manner that would materially and adversely affect the Company's
ability to operate as a REIT, no assurance can be given that new legislation or
new regulations, administrative interpretations or court decisions will not
significantly change the tax laws in the future with respect to qualification as
a REIT or the federal income tax consequences of such qualification.
If in any taxable year the Company fails to qualify as a REIT, the Company
would not be allowed a deduction for distributions to stockholders in computing
its taxable income and would be subject to federal income tax (including any
applicable alternative minimum tax) on its taxable income at regular corporate
rates. As a result, the amount available for distribution to the Company's
stockholders including the holders of the Preferred Shares, would be reduced for
the year or years involved. In addition, unless entitled to relief under certain
statutory provisions, the Company would be disqualified from treatment as a REIT
for the four taxable years following the year during which qualification was
lost. A failure of the Company to qualify as a REIT would not necessarily give
the Company the right to redeem the Preferred Shares, nor would it give the
holders of the Preferred Shares the right to have their shares redeemed.
Notwithstanding that the Company currently intends to operate in a manner
designed to enable it to qualify as a REIT, future economic, market, legal, tax
or other considerations may cause the Company to determine that it is in the
best interest of the Company and the holders of its Common Stock and Preferred
Stock to revoke the REIT election. As long as any Preferred Shares are
outstanding, any such determination by the Company may not be made without the
approval of a majority of the Independent Directors. The tax law prohibits the
Company from electing treatment as a REIT for the four taxable years following
the year of such revocation.
8
REIT REQUIREMENTS WITH RESPECT TO STOCKHOLDER DISTRIBUTIONS
To qualify as a REIT under the Code, the Company generally will be required
each year to distribute as dividends to its stockholders at least 90% of its
"REIT taxable income" (excluding capital gains). Failure to comply with this
requirement would result in the Company's income being subject to tax at regular
corporate rates. In addition, the Company will be subject to a 4% nondeductible
excise tax on the amount, if any, by which certain distributions considered as
paid by it with respect to any calendar year are less than the sum of 85% of its
ordinary income for the calendar year, 95% of its capital gains net income for
the calendar year and any undistributed taxable income from prior periods. Under
certain circumstances, banking regulatory authorities may restrict the ability
of the Company, as a subsidiary of the Bank, to make distributions to its
stockholders. Such a restriction could subject the Company to federal income and
excise tax and result in the Company's failure to meet REIT requirements with
respect to stockholder distributions.
REDEMPTION UPON OCCURRENCE OF A TAX EVENT
At any time following the occurrence of a Tax Event (as defined under
"Description of Series A Preferred Shares -- Redemption" in the 1998
Prospectus), the Company will have the right to redeem the Preferred Shares in
whole but not in part. The occurrence of a Tax Event will not, however, give the
holders of the Preferred Shares any right to have such shares redeemed.
AUTOMATIC EXCHANGE UPON OCCURRENCE OF THE EXCHANGE EVENT
Upon the occurrence of the Exchange Event, the outstanding Preferred Shares
will be automatically exchanged on a one-for-one basis into Bank Preferred
Shares. Assuming, as is anticipated to be the case, that the Bank Preferred
Shares are nonvoting, the Automatic Exchange will be taxable, and each holder of
Preferred Shares will have a gain or loss, as the case may be, measured by the
difference between the basis of such holder in the Preferred Shares and the fair
market value of the Bank Preferred Shares received in the Automatic Exchange.
Assuming that such holder's Preferred Shares were held as capital assets prior
to the Automatic Exchange, any gain or loss will be capital gain or loss.
RELATIONSHIP WITH THE BANK AND ITS AFFILIATES; CONFLICTS OF INTEREST
The Bank and its affiliates are involved in virtually every aspect of the
Company's existence. The Bank is the sole holder of the Common Stock of the
Company and will administer the day-to-day activities of the Company in its role
as Advisor under the Advisory Agreement. The Bank will also act as Servicer of
the Mortgage Loans on behalf of the Company under the Servicing Agreement. In
addition, other than the Independent Directors, all of the officers and
directors of the Company are also officers and/or directors of the Bank and/or
affiliates of the Bank. Their compensation is paid by the Bank, and they have
substantial responsibilities in connection with their work as officers of the
Bank. As the holder of all of the outstanding voting stock of the Company, the
Bank will have the right to elect all directors of the Company, including the
Independent Directors. The Bank and its affiliates may have interests which are
not identical to those of the Company. Consequently, conflicts of interest may
arise with respect to transactions, including without limitation, future
acquisitions of Mortgage Assets from the Bank and/or affiliates of the Bank;
servicing of Mortgage Loans; future dispositions of Mortgage Assets to the Bank;
and the renewal, termination or modification of the Advisory Agreement or the
Servicing Agreement. It is the intention of the Company and the Bank that any
agreements and transactions between the Company, on the one hand, and the Bank
and/or its affiliates, on the other hand, are fair to all parties and consistent
with market terms, including prices paid and received for the Initial Mortgage
Assets, on the acquisition or disposition of Mortgage Assets by the Company or
in connection with the servicing of Mortgage Loans. The requirement in the terms
of the Preferred Shares that certain actions of the Company be approved by a
majority of the Independent Directors is also intended to ensure fair dealings
between the Company and the Bank and its affiliates. However, there can be no
assurance that such agreements or transactions will be on terms as favorable to
the Company as those that could have been obtained from unaffiliated third
parties.
9
RISK OF FUTURE REVISIONS IN POLICIES AND STRATEGIES BY BOARD OF DIRECTORS
The Board of Directors has established the investment policies and
operating policies and strategies of the Company, all material aspects of which
are described in this report. These policies may be amended or revised from time
to time at the discretion of the Board of Directors (in certain circumstances
subject to the approval of a majority of the Independent Directors) without a
vote of the Company's stockholders, including holders of the Preferred Shares.
The ultimate effect of any change in the policies and strategies of the Company
on a holder of Preferred Shares may be positive or negative.
POSSIBLE LEVERAGE
Although the Company does not currently intend to incur any indebtedness in
connection with the acquisition and holding of Mortgage Assets, the Company may
do so at any time (although indebtedness in excess of 25% of the Company's total
stockholders' equity may not be incurred without the approval of a majority of
the Independent Directors of the Company). To the extent the Company were to
change its policy with respect to the incurrence of indebtedness, the Company
would be subject to risks associated with leverage, including, without
limitation, changes in interest rates and prepayment risk.
ADDITIONAL ISSUANCES OF PREFERRED STOCK COULD HAVE DILUTIVE EFFECT
The charter of the Company authorizes 20,000,000 shares of Preferred Stock
of the Company, 10,000,000 shares of which have been issued. The Company could
issue additional preferred shares that rank equal to the Preferred Shares
without the approval of the holders of the Preferred Shares. Such future
issuances could have the effect of diluting the holders of the Preferred Shares.
RISK FACTORS RELATING TO THE BANK
Because of the possibility of the Automatic Exchange, an investment in
Preferred Shares involves a high degree of risk with respect to the performance
and capital levels of the Bank. Investors in the Preferred Shares should
carefully consider the following risk factors and other considerations relating
to the Bank before deciding whether to invest in such shares.
POSSIBLE ADVERSE EFFECTS OF ECONOMIC CONDITIONS
Economic conditions beyond the Bank's control may have a significant impact
on the Bank's operations, including changes in net interest income. Examples of
such conditions include: (i) the strength of credit demand by customers; (ii)
the introduction and growth of new investment instruments and transaction
accounts by nonbank financial competitors; and (iii) changes in the general
level of interest rates, including changes resulting from the monetary
activities of the Board of Governors. Economic growth in the Bank's market areas
is dependent upon the local economy. Adverse changes in the economy of the
Chicago metropolitan area and other market areas would likely reduce the Bank's
growth rate and could otherwise have a negative effect on its business,
including the demand for new loans, the ability of customers to repay loans and
the value of the collateral pledged as security therefor.
INCREASE IN INTEREST RATES MAY ADVERSELY AFFECT OPERATING RESULTS
The Bank's operating results depend to a large extent on its net interest
income, which is the difference between the interest the Bank receives from its
loans, securities and other assets and the interest the Bank pays on its
deposits and other liabilities. Interest rates are highly sensitive to many
factors, including governmental monetary policies and domestic and international
economic and political conditions. Conditions such as inflation, recession,
unemployment, money supply, international disorders and other factors beyond the
control of the Bank may affect interest rates. If generally prevailing interest
rates increase, the "net interest spread" of the Bank, which is the difference
between the rates of interest earned and the rates of interest paid by the Bank,
is likely to contract, resulting in less net interest income. The Bank's
liabilities have shorter terms and are more interest-sensitive than its assets.
There can be no assurance that the Bank will be able to adjust its asset and
liability positions sufficiently to offset any negative effect of changing
market interest rates.
10
COMPETITION
The Bank faces strong direct competition for deposits, loans and other
financial services from other commercial banks, thrifts, credit unions,
stockbrokers and finance divisions of auto and farm equipment companies. Some of
the competitors are local, while others are statewide or nationwide. Several
major multibank holding companies currently operate in the Chicago metropolitan
area. Many of these financial institutions are larger than the Bank and have
greater access to capital and other resources. Some of the financial
institutions and financial services organizations with which the Bank competes
are not subject to the same degree of regulation as that imposed on bank holding
companies, and federally insured, state-chartered banks and national banks. As a
result, such nonbank competitors have advantages over the Bank in providing
certain services. The banking industry is undergoing rapid technological changes
with frequent introductions of new technology-driven products and services. In
addition to better serving customers, the effective use of technology increases
efficiency and enables financial institutions to reduce costs. The Bank's future
success will depend in part on its ability to address the needs of its customers
by using technology to provide products and services that will satisfy customer
demands for convenience as well as to create additional efficiencies in the
Bank's operations. Many of the Bank's competitors have greater resources to
invest in technological improvements. There can be no assurance that the Bank
will be able to effectively implement such products and services or be
successful in marketing such products and services to its customers.
GOVERNMENT REGULATION
The Bank is subject to extensive federal and state legislation, regulation
and supervision. Recently enacted, proposed and future legislation and
regulations have had, will continue to have or may have significant impact on
the financial services industry. Some of the legislative and regulatory changes
may benefit the Bank; others, however, may increase its costs of doing business
and assist competitors of the Bank. There can be no assurance that state or
federal regulators will not, in the future, impose further restriction or limits
on the Bank's activities.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2. PROPERTIES
None as of December 31, 2005.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently involved in any material litigation nor, to
the Company's knowledge is any material litigation currently threatened against
the Company or the Bank other than routine litigation arising in the ordinary
course of business. See Note 8 to Financial Statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 2005.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
HCH presently owns all 1,000 shares of the common stock of the Company,
which are not listed or traded on any securities exchange. For the year ended
December 31, 2005 there were no common stock dividends declared through year-
end. The Company may distribute 2005 earnings available after payment of the
preferred dividend, as a common dividend during 2006. On September 13, 2004 the
Company paid a cash dividend of $904 thousand (declared December 2, 2003), on
the outstanding common shares to the stockholder of record on September 6, 2004.
These dividends completed the 2003 REIT tax compliance requirements regarding
income distributions.
11
The Preferred Shares are traded on the New York Stock Exchange under the
symbol "HBC Pr A". During 2005 and 2004, the Company declared and paid cash
dividends to preferred stockholders of approximately $18.4 million in each year.
Although the Company declared cash dividends on the Preferred Shares for 2005
and 2004, no assurances can be made as to the declaration of, or if declared,
the amount of, future distributions since such distributions are subject to the
Company's financial condition and capital needs; the impact of legislation and
regulations as then in effect or as may be proposed; economic conditions; and
such other factors as the Board of Directors may deem relevant. Notwithstanding
the foregoing, to remain qualified as a REIT, the Company must distribute
annually at least 90% of its ordinary taxable income to preferred and /or common
stockholders.
The Company did not purchase or redeem any common or preferred shares
during 2005 or 2004.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the Company and
should be read in conjunction with the Consolidated Financial Statements and
notes thereto and Management's Discussion and Analysis of Financial Condition
and Results of Operations contained in this Report.
FOR THE YEARS ENDED DECEMBER 31
------------------------------------------------
2005 2004 2003 2002 2001
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Statement of Operations Data:
Interest income....................... $ 20,165 $ 16,998 $ 17,678 $ 19,934 $ 28,715
Non-interest income................... (707) 1,062 4,158 2,677 4,796
Operating expenses:
Loan servicing fees................. 31 44 70 131 243
Advisory fees....................... 122 124 56 43 35
General and administrative.......... 287 362 362 314 300
-------- -------- -------- -------- --------
Total operating expenses......... 440 530 488 488 578
-------- -------- -------- -------- --------
Net income............................ 19,018 17,530 21,348 22,123 32,933
Preferred stock dividends............. 18,438 18,438 18,438 18,438 18,438
-------- -------- -------- -------- --------
Net income available (loss allocated)
to common stockholder............... $ 580 $ (908) $ 2,910 $ 3,685 $ 14,495
======== ======== ======== ======== ========
Basic and diluted earnings (loss) per
common share........................ $ 580 $ (908) $ 2,910 $ 3,685 $ 14,495
======== ======== ======== ======== ========
Distributions per preferred share..... $ 1.8438 $ 1.8438 $ 1.8438 $ 1.8438 $ 1.8438
======== ======== ======== ======== ========
Balance Sheet Data (end of period):
Total assets.......................... $479,875 $489,022 $494,318 $502,042 $489,342
======== ======== ======== ======== ========
Total liabilities..................... $ 129 $ 134 $ 84 $ 96 $ 100
======== ======== ======== ======== ========
Total stockholders' equity............ $479,746 $488,888 $494,234 $501,946 $489,242
======== ======== ======== ======== ========
Cash Flows Data:
Operating activities.................. $ 19,859 $ 15,998 $ 18,046 $ 19,440 $ 28,736
======== ======== ======== ======== ========
Investing activities.................. $ (1,128) $ 2,825 $ 3,120 $ 2,440 $ 4,035
======== ======== ======== ======== ========
Financing activities.................. $(18,438) $(19,342) $(20,968) $(21,658) $(33,084)
======== ======== ======== ======== ========
12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and notes thereto appearing later in this
Report.
SUMMARY
YEAR ENDED DECEMBER 31, 2005 COMPARED TO DECEMBER 31, 2004
The Company's net income for 2005 was $19 million. This represented an 8.5%
increase from 2004 net income of $17.5 million. Earnings increased primarily
because of higher interest income on earning assets.
Interest income on securities purchased under agreement to resell for the
year ended December 31, 2005 was $1.6 million compared to $1.1 million a year
ago. Interest income on the Notes for 2005 totaled $655 thousand and yielded
6.4% on $10 million of average principal outstanding compared to $907 thousand
and a 6.4% yield on $14 million average principal outstanding for 2004. The
decrease in interest income from the notes was attributable to a reduction in
the Note balance because of customer payoffs in the Securing Mortgage Loans. The
average outstanding balance of the Securing Mortgage Loans was $13 million for
2005 and $18 million for 2004. Interest income on securities available-for-sale
for 2005 was $17.8 million, resulting in a yield of 4.3% on an average balance
of $418 million compared to interest income of $15.0 million with a yield of
4.3% on an average balance of $353 million for 2004. The increase in interest
income on securities available-for-sale was primarily attributable to an
increase in the average mortgage-backed securities portfolio. Losses on
investment securities sales in 2005 were $0.7 million compared to $1.1 million
of gains recognized in 2004. There were no Company borrowings during either
year.
Operating expenses for the year ended December 31, 2005 totaled $440
thousand compared to $530 thousand a year ago. Loan servicing expenses for 2005
totaled $31 thousand, a decrease of $13 thousand or 30% from 2004. This decrease
was attributable to the reduction in the principal balance of the Notes.
Advisory fees for the year ended December 31, 2005 were $122 thousand compared
to $124 thousand for the same period a year ago. General and administrative
expenses totaled $287 thousand for 2005 and $362 thousand for 2004. The decrease
is partially due to reduced 10-K processing costs and legal costs.
On December 30, 2005, the Company paid a cash dividend of $0.46094 per
share on the outstanding Preferred Shares to the stockholders of record on
December 15, 2005 as declared on December 2, 2005. On December 30, 2004, the
Company paid a cash dividend of $0.46094 per share on the outstanding Preferred
Shares to the stockholders of record on December 15, 2004 as declared on
December 2, 2004. For each of the full years, the Company declared and paid
$18.4 million of dividends to holders of Preferred Shares for 2005 and 2004,
respectively. For the year ended December 31, 2004 there were no common stock
dividends declared as there were no earnings available after payment of the
preferred dividends. The Company may distribute 2005 earnings available after
payment of the preferred dividend, as a common dividend during 2006. However on
September 13, 2004 the Company paid a cash dividend of $904 thousand on the
outstanding common shares to the stockholder of record on September 6, 2004.
These common share dividends completed the Company's 2003 REIT tax compliance
requirements.
At December 31, 2005 and 2004, there were no Securing Mortgage Loans on
nonaccrual status and there was no allowance for loan losses.
YEAR ENDED DECEMBER 31, 2004 COMPARED TO DECEMBER 31, 2003
The Company's net income for 2004 was $17.5 million. This represented an
18% decrease from 2003 net income of $21.3 million. Earnings decreased primarily
because of a substantial decrease in gains from security sales compared to last
year and lower interest income on earning assets.
Interest income on securities purchased under agreement to resell for the
year ended December 31, 2004 was $1.1 million compared to $1.3 million a year
ago. Interest income on the Notes for 2004 totaled $907 thousand and yielded
6.4% on $14 million of average principal outstanding compared to $1.5 million
and a 6.4% yield on
13
$24 million average principal outstanding for 2003. The decrease in income was
attributable to a reduction in the Note balance because of customer payoffs in
the Securing Mortgage Loans. The average outstanding balance of the Securing
Mortgage Loans was $18 million for 2004 and $29 million for 2003. Interest
income on securities available-for-sale for 2004 was $15.0 million, resulting in
a yield of 4.3% on an average balance of $353 million compared to interest
income of $14.9 million with a yield of 4.6% on an average balance of $326
million for 2003. The increase in interest income on securities available-for-
sale was primarily attributable to an increase in the average mortgage-backed
securities portfolio partially offset by lower yields than the prior year. Gains
from investment securities sales were $1.1 million in 2004 and $4.2 million in
2003. There were no Company borrowings during either year.
Operating expenses for the year ended December 31, 2004 totaled $530
thousand compared to $488 thousand a year ago. Loan servicing expenses for 2004
totaled $44 thousand, a decrease of $26 thousand or 37% from 2003. This decrease
was attributable to the reduction in the principal balance of the Notes.
Advisory fees for the year ended December 31, 2004 were $124 thousand compared
to $56 thousand for the same period a year ago, due to higher internal
processing, record-keeping and overhead costs. General and administrative
expenses for the same period totaled $362 thousand for both 2004 and 2003.
On December 30, 2004, the Company paid a cash dividend of $0.46094 per
share on the outstanding Preferred Shares to the stockholders of record on
December 15, 2004 as declared on December 2, 2004. On December 30, 2003, the
Company paid a cash dividend of $0.46094 per share on the outstanding Preferred
Shares to the stockholders of record on December 15, 2003 as declared on
December 2, 2003. On a year-to-date basis, the Company declared and paid $18.4
million of dividends to holders of Preferred Shares for 2004 and 2003,
respectively. For the year ended December 31, 2004 there were no common stock
dividends declared, as there were no earnings available after payment of the
preferred dividends. A cash dividend on common stock of $2.0 million was
declared on December 2, 2003 to the stockholder of record on December 15, 2003
and paid on December 31, 2003. In addition, on September 12, 2004 and September
12, 2003, the Company paid a cash dividend of $904 thousand (declared December
2, 2003) and $530 thousand (declared December 4, 2002), on the outstanding
common shares to the stockholder of record on September 6, 2004 and September 3,
2003, respectively. These common share dividends completed the Company's 2003
and 2002 REIT tax compliance requirements.
At December 31, 2004 and 2003, there were no Securing Mortgage Loans on
nonaccrual status and there was no allowance for loan losses.
QUARTER ENDED DECEMBER 31, 2005 COMPARED TO QUARTER ENDED DECEMBER 31, 2004
The Company's net income decreased for the fourth quarter of 2005 to $4.8
million compared to $5.0 million in the fourth quarter of 2004. While interest
income on earnings assets rose quarter over quarter, the increase was more than
offset by a decline in non-interest income of $358 thousand from fourth quarter
2004.
Fourth quarter 2005 interest income on the Notes totaled $142 thousand and
yielded 6.4% on $9 million of average principal outstanding compared to interest
income of $199 thousand and a 6.4% yield on $12 million average principal
outstanding for the fourth quarter of 2004. The decrease in income was
attributable to a reduction in the Note balance because of principal paydowns by
customers in the Securing Mortgage Loans. The average outstanding balance of the
Securing Mortgage Loans for the fourth quarter of 2005 and 2004 was $11 million
and $16 million, respectively. Interest income on securities available-for-sale
for the current quarter was $4.2 million resulting in a yield of 4.3% on an
average balance of $388 million, compared to interest income of $4.6 million
with a yield of 4.2% on an average balance of $441 million for the same period a
year ago. The increase in total interest income is primarily attributable to the
increase in higher yields on short-term investments offset by a decrease in
mortgage-backed securities.
There were no Company borrowings during the fourth quarter of 2005 or 2004.
Fourth quarter 2005 operating expenses totaled $136 thousand, a decrease of
$26 thousand from the fourth quarter of 2004. Loan servicing expenses totaled $7
thousand, a decrease of $3 thousand or 30% from the prior year's fourth quarter,
attributable to the reduction in the principal balance of the Notes. Advisory
fees for the fourth quarter of 2005 were $23 thousand compared to $38 thousand
in the prior year's fourth quarter, due to decreased
14
costs for processing, recordkeeping and administration. General and
administrative expenses totaled $106 thousand in the current quarter compared to
$114 thousand for the same period in 2004, partially attributable to lower costs
for outside expert services.
ALLOWANCE FOR LOAN LOSSES
The Company does not currently maintain an allowance for loan losses due to
the over-collateralization of the Securing Mortgage Loans and the prior and
expected credit performance of the collateral pool.
CONCENTRATIONS OF CREDIT RISK
A majority of the collateral underlying the Securing Mortgage Loans is
located in Illinois. The financial viability of customers in this state is, in
part, dependent on the states' economies. The collateral may be subject to a
greater risk of default than other comparable loans in the event of adverse
economic, political or business developments or natural hazards that may affect
such region and the ability of property owners in such region to make payments
of principal and interest on the underlying mortgages. The Company's maximum
risk of accounting loss, should all customers in Illinois fail to perform
according to contract terms and all collateral prove to be worthless, was
approximately $7 million at December 31, 2005 and $11 million at December 31,
2004.
INTEREST RATE RISK
The Company's income consists primarily of interest payments on the
Mortgage Assets and the securities it holds. If there is a decline in interest
rates during a period of time when the Company must reinvest payments of
interest and principal with respect to its Mortgage Assets and other interest
earning assets, the Company may find it difficult to purchase additional earning
assets that generate sufficient income to support payment of dividends on the
Preferred Shares. Because the rate at which dividends, if, when and as
authorized and declared, are payable on the Preferred Shares is fixed, there can
be no assurance that an interest rate environment in which there is a decline in
interest rates would not adversely affect the Company's ability to pay dividends
on the Preferred Shares.
COMPETITION
The Company does not engage in the business of originating mortgage loans.
While the Company will acquire additional Mortgage Assets, it anticipates that
such assets will be acquired from the Bank, affiliates of the Bank or
unaffiliated parties. Accordingly, the Company does not expect to compete with
mortgage conduit programs, investment banking firms, savings and loan
associations, banks, thrift and loan associations, finance companies, mortgage
bankers or insurance companies in acquiring its assets.
LIQUIDITY RISK MANAGEMENT
The objective of liquidity management is to ensure the availability of
sufficient cash flows to meet all of the Company's financial commitments. In
managing liquidity, the Company takes into account various legal limitations
placed on a REIT.
The Company's principal liquidity needs are to maintain the current
portfolio size through the acquisition of additional qualifying assets and to
pay dividends to its stockholders after satisfying obligations to creditors. The
acquisition of additional qualifying assets is funded with the proceeds obtained
from repayment of principal balances by individual mortgages or maturities of
securities held for sale on a reinvested basis. The payment of dividends on the
Preferred Shares will be made from legally available funds, principally arising
from operating activities of the Company. The Company's cash flows from
operating activities principally consist of the collection of interest on short
term qualifying investments, the Notes and mortgage-backed securities. The
Company does not have and does not anticipate having any material capital
expenditures.
In order to remain qualified as a REIT, the Company must distribute
annually at least 90% of its adjusted REIT ordinary taxable income, as provided
for under the Code, to its common and preferred stockholders. The Company
currently expects to distribute dividends annually equal to 90% or more of its
adjusted REIT ordinary taxable income.
15
The Company anticipates that cash and cash equivalents on hand and the cash
flow from the Notes, short-term investments and mortgage-backed securities will
provide adequate liquidity for its operating, investing and financing needs
including the capacity to continue preferred dividend payments on an
uninterrupted basis.
As presented in the accompanying Statement of Cash Flows, the primary
sources of funds in addition to $19.9 million provided from operations during
2005 were $253.8 million from the maturities and sales of securities available-
for-sale. In 2004, the primary sources of funds other than $16.0 million
provided from operations were $673.8 million from the maturities and sales of
securities available-for-sale. The primary uses of funds for 2005 were $248.5
million in purchases of securities available-for-sale and $18.4 in preferred
stock dividends paid and $10.0 million securities purchased under agreement to
resell. In 2004, the primary uses of funds were $676.7 million in purchases of
securities available-for-sale and $18.4 and $904 thousand in preferred stock
dividends and common stock dividends paid, respectively.
ACCOUNTING PRONOUNCEMENTS
The FASB issued SFAS No. 154, "Accounting Changes and Error Corrections-a
replacement of APB Opinion No. 20 and FASB Statement No. 3" in May 2005. The
Statement replaces Accounting Principles Board ("APB") Opinion No. 20,
"Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim
Financial Statements," and requires retrospective application to prior period
financial statements for reporting a change in accounting principle. It also
requires restatement of prior period financial statements for reporting an error
correction. The Statement is effective for accounting changes and error
corrections made in fiscal years beginning after December 15, 2005. The Company
does not expect the adoption of this Statement to have a material effect on its
financial position or results of operations.
The Company adopted the American Institute of Certified Public Accountants
("AICPA") Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or
Debt Securities Acquired in a Transfer," in 2005. The SOP applies to the
purchase of a loan, a group of loans, and loans acquired in a purchase business
combination. It addresses accounting for differences, attributable to credit
quality, between contractual and expected cash flows from the initial investment
in loans acquired in a transfer. Acquired loans in scope will exhibit a
deterioration of credit quality from the origination date to the acquisition
date and a probability at acquisition that the acquirer will be unable to
collect all contractually required payments. Loans in scope that the Company
acquires in a business combination are initially recorded at fair value which is
based on the present value of expected cash flows. Any allowance for loan losses
related to the loans is not carried over at acquisition. Undiscounted expected
cash flows in excess of the initial valuation are accreted into interest income.
If the Company cannot reasonably estimate the timing and amount of expected cash
flows, then the loan is placed on nonaccrual status. If it probable, upon
subsequent evaluation, that the Company will be unable to collect the expected
cash flows, then the loan is considered impaired. The Company does not expect
the adoption of the Statement to have a material effect on its financial
position or results of operations.
The FASB issued FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments," in November 2005. The FSP provides guidance on determining whether
an investment is impaired, evaluating whether an impairment is other-than-
temporary and measuring an impairment loss. It applies to debt and equity
securities within the scope of FAS 115, "Accounting for Certain Investments in
Debt and Equity Securities," and equity securities that are cost-method
investments. It is effective for reporting periods beginning after December 15,
2005. The Company does not expect the adoption of this FSP to have a material
effect on its financial position or results of operations.
OTHER MATTERS
As of December 31, 2005, the Company believes that it is in full compliance
with the REIT tax rules, and expects to qualify as a REIT under the provisions
of the Code. The Company expects to meet all REIT requirements regarding the
ownership of its stock and anticipates meeting the annual distribution
requirements.
16
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of December 31, 2005, the Company had $9 million invested in Notes, a
decrease of $3 million from December 31, 2004. The decline was attributable to
customer payoffs in the Securing Mortgage Loans. At December 31, 2005, the
Company held $374 million in mortgage-backed securities compared to $419 million
at December 31, 2004. At December 31, 2005, the Company held $75 million in U.S.
Treasuries compared to $45 million at December 31, 2004. At December 31, 2005,
the Company held an investment of $20.5 million in securities purchased from the
Bank under agreement to resell compared to $10.5 million at December 31, 2004.
The Company is subject to exposure for fluctuations in interest rates. Adverse
changes in interest rates could impact negatively the value of mortgage-backed
securities, as well as the levels of interest income to be derived from these
assets.
The Company's investments held in mortgage-backed securities are secured by
adjustable and fixed interest rate residential mortgage loans. The yield to
maturity on each security depends on, among other things, the price at which
each such security is purchased, the rate and timing of principal payments
(including prepayments, repurchases, defaults and liquidations), the pass-
through rate and interest rate fluctuations. Changes in interest rates could
impact prepayment rates as well as default rates, which in turn would impact the
value and yield to maturity of the Company's mortgage-backed securities.
The Company currently has no outstanding borrowings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Refer to the Index to Consolidated Financial Statements for the required
information.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no disagreements with accountants on any matter of
accounting principles, practices or financial statement disclosure.
ITEM 9A. CONTROLS AND PROCEDURES
As of December 31, 2005, Paul R. Skubic, the Chairman of the Board, Chief
Executive Officer and President of the Company, and Janine Mulhall, the Chief
Financial Officer of the Company, evaluated the effectiveness of the disclosure
controls and procedures of the Company and concluded that these disclosure
controls and procedures are effective to ensure that material information for
the Company required to be included in this Report has been made known to them
in a timely fashion. There were no changes in the Company's internal controls
over financial reporting identified in connection with such evaluations that
occurred during the quarter ended December 31, 2005 that have materially
affected or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's Board of Directors consists of five members. The Company does
not anticipate that it will require any additional employees because it has
retained the Bank to perform certain functions pursuant to the Advisory
Agreement described above. Each officer of the Company currently is also an
officer of the Bank and/or affiliates of the Bank. The Company maintains
corporate records and audited financial statements that are separate from those
of the Bank or any of the Bank's affiliates. None of the officers, directors or
employees of the Company will have a direct or indirect pecuniary interest in
any Mortgage Asset to be acquired or disposed of by the Company
17
or in any transaction in which the Company has an interest or will engage in
acquiring, holding and managing Mortgage Assets.
Pursuant to terms of the Preferred Shares, the Company's Independent
Directors will consider the interests of the holders of both the Preferred
Shares and the Common Stock in determining whether any proposed action requiring
their approval is in the best interests of the Company.
The persons who are directors and executive officers of the Company are as
follows:
NAME AGE POSITION AND OFFICES HELD
---- --- -------------------------
Paul R. Skubic........... 57 Chairman of the Board, President
Janine Mulhall........... 44 Chief Financial Officer
Frank M. Novosel......... 59 Treasurer, Director
Teresa L. Patton......... 58 Vice President of Operations
Margaret M. Sulkin....... 47 Assistant Treasurer
Delbert J. Wacker........ 74 Director
David J. Blockowicz...... 63 Director
Forrest M. Schneider..... 58 Director
The following is a summary of the experience of the executive officers and
directors of the Company:
Mr. Skubic has been Vice President and Controller of the Bank and Chief
Accounting Officer for Harris Bankcorp, Inc., and the Bank since 1990. Prior to
joining Harris Bankcorp, Inc., Mr. Skubic was employed by Arthur Andersen & Co.
He is a certified public accountant.
Ms. Mulhall, has been Senior Vice President and Chief Financial Officer of
Harris Bankcorp, Inc. since July 2003. From November 1995 to that time she held
several positions in the Finance area of Harris Bankcorp's parent company, Bank
of Montreal, including most recently Vice President and Chief Accountant. From
1984 to 1995, Ms. Mulhall was with KPMG, LLP in Toronto. She is a Canadian
Chartered Accountant.
Mr. Novosel has been a Vice President in the Treasury Group of the Bank
since 1995. Previously, he served as Treasurer of Harris Bankcorp, Inc.,
managing financial planning. Mr. Novosel is a Chartered Financial Analyst and a
member of the CFA Society of Chicago.
Ms. Patton has been a Vice President in Residential Mortgages at the Bank
for 16 years and is currently the Director of Secondary Marketing. Prior to this
position she was the Manager of Sales and Delivery for the Residential Mortgage
Division. She has been employed by the Bank for over 28 years holding positions
in Consumer and Commercial Banking.
Ms. Sulkin has been a Vice President in the Taxation Department of the Bank
since 1992. Ms. Sulkin has been employed by the Bank since 1984. Prior to
joining the Bank, she was employed by KPMG LLP. She is a certified public
accountant.
Mr. Wacker retired as a partner from Arthur Andersen & Co. in 1987 after 34
years. From July 1988 to November 1990, he was Vice President -Treasurer,
Parkside Medical Services, a subsidiary of Lutheran General Health System. From
November 1990 to September 1993, he completed various financial consulting
projects for Lutheran General.
Mr. Blockowicz is a certified public accountant and is a partner with
Blockowicz & Tognocchi LLC. Prior to forming his firm, Mr. Blockowicz was a
partner with Arthur Andersen & Co. through 1990.
Mr. Schneider is President and Chief Executive Officer of Lane Industries,
Inc. Mr. Schneider is a director of Lane Industries and director of Acco Brands
Corporation. He has been employed by Lane Industries since 1976. He is a
graduate of the University of Illinois where he received his B.S. and masters
degree in finance.
18
INDEPENDENT DIRECTORS
The terms of the Preferred Shares require that, as long as any Preferred
Shares are outstanding, certain actions by the Company be approved by a majority
of the Company's Independent Directors. Delbert J. Wacker, David J. Blockowicz
and Forrest M. Schneider are the Company's Independent Directors.
If at any time the Company fails to declare and pay a quarterly dividend
payment on the Preferred Shares, the number of directors then constituting the
Board of Directors of the Company will be increased by two at the Company's next
annual meeting and the holders of Preferred Shares, voting together with the
holders of any other outstanding series of Preferred Stock as a single class,
will be entitled to elect two additional directors to serve on the Company's
Board of Directors. Any member of the Board of Directors elected by holders of
the Company's Preferred Shares will be deemed to be an Independent Director for
purposes of the actions requiring the approval of a majority of the Independent
Directors.
AUDIT COMMITTEE
The Board of Directors of the Company has established an audit committee,
with an approved Audit Committee Charter, which will review the engagement of
independent accountants and review their independence. The audit committee will
also review the adequacy of the Company's internal accounting controls. The
audit committee is comprised of Delbert J. Wacker, David J. Blockowicz and
Forrest M. Schneider. The Company's Board of Directors has determined that each
member of the audit committee is an audit committee financial expert as defined
in rules of the Securities and Exchange Commission. Each audit committee member
is independent as defined in rules of the New York Stock Exchange.
COMPENSATION OF DIRECTORS AND OFFICERS
The Company pays the Independent Directors of the Company fees for their
services as directors. The Independent Directors receive annual compensation of
$10,000 plus a fee of $750 for each attendance (in person or by telephone) at
each meeting of the Board of Directors or the audit committee. The annual
compensation has been increased to $12,000 and the fee for each attendance has
been increased to $1,000, effective January 1, 2006
The Company has adopted a code of ethics for its senior officers and which
is filed as an Exhibit hereto.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Based on a review of reports filed with respect to the year ended December
31, 2005, the Company believes that all ownership reports were filed on a timely
basis.
ITEM 11. EXECUTIVE COMPENSATION
The Company will not pay any compensation to its officers or employees or
to directors who are not Independent Directors.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
No person owns of record or is known by the Company to own beneficially
more than 5% of the outstanding 7 3/8% Noncumulative Exchangeable Preferred
Stock, Series A.
19
(b) SECURITY OWNERSHIP OF MANAGEMENT
The following table shows the ownership as of March 1, 2006 of 7 3/8%
Noncumulative Exchangeable Preferred Stock, Series A, by the only Officer or
Director who own any such shares.
NAME OF AMOUNT OF PERCENT
TITLE OF CLASS BENEFICIAL OWNER BENEFICIAL OWNERSHIP OF CLASS
-------------- ------------------- -------------------- --------
Preferred Stock..................... Paul R. Skubic 1,300 Shares .013%
Preferred Stock..................... Forrest Schneider 2,200 Shares .022%
Preferred Stock..................... David J. Blockowicz 1,000 Shares .01%
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) TRANSACTIONS WITH MANAGEMENT AND OTHERS
The Bank, through its wholly-owned subsidiary, HCH, indirectly owns 100% of
the common stock of the Company.
A substantial portion of the assets of the Company initially consisted of
Notes issued by the Bank. The Notes mature on October 1, 2027 and pay interest
at 6.4% per annum. During 2005, the Company received repayments on the Notes of
$3 million compared to 2004 repayments of $4 million. In years ended December
31, 2005, 2004 and 2003, the Bank paid interest on the Notes in the amount of
$655 thousand, $907 thousand and $1.5 million, respectively, to the Company.
The Company purchases U.S. Treasury and Federal agency securities from the
Bank under agreements to resell identical securities. At December 31, 2005, the
Company held $20.5 million of such assets and had earned $1.6 million of
interest from the Bank during 2005. At December 31, 2004, the Company held $10.5
million of such assets and earned $1.1 million of interest for 2004. The Company
receives rates on these assets comparable to the rates that the Bank offers to
unrelated counterparties under similar circumstances.
The Bank and the Company have entered into a Servicing Agreement and an
Advisory Agreement, the terms of which are described in further detail on page 5
of this Report. In 2005, the Bank received payments of $31 thousand and $122
thousand, respectively, compared to $44 thousand and $124 thousand for 2004,
under the terms of these agreements.
(b) CERTAIN BUSINESS RELATIONSHIPS
Paul R. Skubic, Chairman of the Board of the Company, and all of its
executive officers, Janine Mulhall, Frank M. Novosel, Teresa L. Patton and
Margaret M. Sulkin, are also officers of the Bank.
(c) INDEBTEDNESS OF MANAGEMENT
None.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
AUDIT FEES
For year ended December 31, 2005, the Company's principal accountant billed
$58 thousand for the audit of the Company's annual financial statements and
review of financial statements included in Form 10-Q filings. For year ended
December 31, 2004 the Company's principal accountant billed $42 thousand for the
audit of the Company's annual financial statements and review of financial
statements included in Form 10-Q filings.
AUDIT-RELATED FEES
There were no fees billed for services reasonably related to the
performance of the audit or review of the Company's financial statements outside
of those fees disclosed above under "Audit Fees" for years ended December 31,
2005 and 2004.
20
ALL OTHER FEES
There were no other fees billed to the Company by the Company's principal
accountants other than those disclosed above for years ended December 31, 2005
and 2004.
PRE-APPROVAL POLICIES AND PROCEDURES
Prior to engaging accountants to perform a particular service, the Board of
Directors obtains an estimate for the service to be performed. All of the
services described above were approved by the audit committee and Board of
Directors in accordance with its procedures.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Documents filed with Report:
(1) Consolidated Financial Statements (See page 20 for a listing of
all financial statements included in Item 8)
(2) Financial Statement Schedules
All schedules normally required by Form 10-K are omitted since they
are either not applicable or because the required information is shown in
the financial statements or notes thereto.
(3) Exhibits:
*3(a)(I) Articles of Incorporation of the Company
*3(a)(ii) Form of Articles of Amendment and Restatement of the Company
establishing the Series A Preferred Shares
*3(b) Bylaws of the Company
*4 Specimen of certificate representing Series A Preferred Shares
*10(a) Form of Servicing Agreement between the Company and the Bank
*10(b) Form of Advisory Agreement between the Company and the Bank
*10(c) Form of Bank Loan Agreement between the Company and the Bank
*10(d) Form of Mortgage Loan Assignment Agreement between the Company and
the Bank
14 Code of Ethics for Senior Officers (Incorporated by reference to
Exhibit 14 to the Company's Annual Report on Form 10-K for the year
ended December 31, 2004)
24 Power of attorney
31.1 Certification of Janine Mulhall pursuant to Rule 13a -- 14(a)
31.2 Certification of Paul R. Skubic pursuant to Rule 13a -- 14(a)
32.1 Certification pursuant to 18 U.S.C. Section 1350
--------
* Incorporated by reference to the exhibit of the same number filed with the
Company's Registration Statement on Form S-11 (Securities and Exchange
Commission file number 333-40257)
21
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following consolidated financial statements are included in Item 8 of
this Annual Report on Form 10-K:
HARRIS PREFERRED CAPITAL CORPORATION
Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income and Comprehensive Income
Consolidated Statements of Changes in Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
HARRIS N.A.
Financial Review
Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Condition
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
All schedules are omitted since the required information is not present or
is not present in amounts sufficient to require submission of the schedule or
because the information required is included in the consolidated financial
statements and notes hereof.
22
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Harris Preferred Capital Corporation has duly caused this
Report to be signed on its behalf by the undersigned, thereunto duly authorized
on the 29th day of March 2006.
/s/ PAUL R. SKUBIC
----------------------------------------
Paul R. Skubic
Chairman of the Board and President
/s/ JANINE MULHALL
----------------------------------------
Janine Mulhall
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by Paul R. Skubic, Chairman of the Board and President of
the Company, as attorney-in-fact for the following Directors on behalf of Harris
Preferred Capital Corporation of the 29th day of March 2006.
David J. Blockowicz Forrest M. Schneider
Frank M. Novosel Delbert J. Wacker
Paul R. Skubic
Attorney-In-Fact
Supplemental Information
No proxy statement will be sent to security holders in 2006.
23
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors
of Harris Preferred Capital Corporation
We have audited the accompanying consolidated balance sheets of Harris
Preferred Capital Corporation and subsidiary (the Company) as of December 31,
2005 and 2004, and the related consolidated statements of operations and
comprehensive income, changes in stockholders' equity, and cash flows for each
of the years in the two year period ended 12/31/05. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. The accompanying consolidated financial
statements of the Company as of December 31, 2003, were audited by other
auditors whose report thereon dated February 23, 2004 expressed an unqualified
opinion on those statements.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstance but not for
the purpose of expressing an opinion on the effectiveness of the Company's
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Company
as of December 31, 2005 and 2004, and the results of their operations and their
cash flows for each of the years in the two year period ended 12/31/05, in
conformity with U.S. generally accepted accounting principles.
-s- KPMG LLP
March 15, 2006
Chicago, Illinois
24
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and the Board of Directors
of Harris Preferred Capital Corporation
In our opinion, the consolidated statements of operations and comprehensive
income, of changes in stockholders' equity and of cash flows for the year ended
December 31, 2003 present fairly, in all material respects, the results of
operations and cash flows of Harris Preferred Capital Corporation for the year
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States of America. 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 audit. We conducted our audit
of these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
Chicago, Illinois
February 23, 2004
25
HARRIS PREFERRED CAPITAL CORPORATION
CONSOLIDATED BALANCE SHEETS
DECEMBER 31
------------------
2005 2004
-------- --------
(IN THOUSANDS,
EXCEPT SHARE DATA)
ASSETS
Cash on deposit with Harris N.A. ............................ $ 700 $ 407
Securities purchased from Harris N.A. under agreement to
resell..................................................... 20,500 10,500
Notes receivable from Harris N.A. ........................... 8,684 12,129
Securities available-for-sale:
Mortgage-backed............................................ 373,584 419,315
U.S. Treasury.............................................. 74,946 44,993
Securing mortgage collections due from Harris N.A. .......... -- 78
Other assets................................................. 1,461 1,600
-------- --------
TOTAL ASSETS............................................... $479,875 $489,022
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accrued expenses............................................. $ 129 $ 134
-------- --------
Commitments and contingencies................................ -- --
STOCKHOLDERS' EQUITY
7 3/8% Noncumulative Exchangeable Preferred Stock, Series A
($1 par value); liquidation value of $250,000; 20,000,000
shares authorized, 10,000,000 shares issued and
outstanding................................................ 250,000 250,000
Common stock ($1 par value); 1,000 shares authorized, issued
and outstanding............................................ 1 1
Additional paid-in capital................................... 240,733 240,733
Distributions in excess of earnings.......................... (2) (582)
Accumulated other comprehensive income -- net unrealized
losses on available-for-sale securities.................... (10,986) (1,264)
-------- --------
TOTAL STOCKHOLDERS' EQUITY................................. 479,746 488,888
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY................. $479,875 $489,022
======== ========
The accompanying notes are an integral part of these financial statements.
26
HARRIS PREFERRED CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED
DECEMBER 31
-------------------------
2005 2004 2003
------- ------- -------
(IN THOUSANDS, EXCEPT
SHARE DATA)
INTEREST INCOME:
Securities purchased from Harris N.A. under agreement
to resell......................................... $ 1,618 $ 1,060 $ 1,266
Notes receivable from Harris N.A..................... 655 907 1,508
Securities available-for-sale:
Mortgage-backed................................... 17,804 14,973 14,791
U.S. Treasury..................................... 88 58 113
------- ------- -------
Total interest income........................... 20,165 16,998 17,678
NON-INTEREST INCOME:
(Loss)/gain on sale of securities.................... (707) 1,062 4,158
------- ------- -------
(707) 1,062 4,158
OPERATING EXPENSES:
Loan servicing fees paid to Harris N.A............... 31 44 70
Advisory fees paid to Harris N.A..................... 122 124 56
General and administrative........................... 287 362 362
------- ------- -------
Total operating expenses..................... 440 530 488
------- ------- -------
Net income............................................. 19,018 17,530 21,348
Preferred stock dividends.............................. 18,438 18,438 18,438
------- ------- -------
NET INCOME AVAILABLE (LOSS ALLOCATED) TO COMMON
STOCKHOLDER.......................................... $ 580 $ (908) $ 2,910
======= ======= =======
Basic and diluted earnings (loss) per common share..... $ 580 $ (908) $ 2,910
======= ======= =======
Net income............................................. $19,018 $17,530 $21,348
Other comprehensive loss -- net unrealized losses on
available-for-sale securities........................ (9,722) (3,534) (8,092)
------- ------- -------
Comprehensive income................................... $ 9,296 $13,996 $13,256
======= ======= =======
The accompanying notes are an integral part of these financial statements.
27
HARRIS PREFERRED CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
(DISTRIBUTIONS IN
EXCESS OF ACCUMULATED
ADDITIONAL EARNINGS) EARNINGS OTHER TOTAL
PREFERRED COMMON PAID-IN IN EXCESS OF COMPREHENSIVE STOCKHOLDERS'
STOCK STOCK CAPITAL DISTRIBUTIONS INCOME (LOSS) EQUITY
--------- ------ ---------- ------------------ ------------- -------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
BALANCE AT DECEMBER 31, 2002.. $250,000 $ 1 $240,733 $ 850 $ 10,362 $501,946
======== === ======== ======== ======== ========
Net income.................. -- -- -- 21,348 -- 21,348
Other comprehensive loss.... -- -- -- -- (8,092) (8,092)
Dividends declared on common
stock ($2,530.00 per
share)................... -- -- -- (2,530) -- (2,530)
Dividends declared on
preferred stock ($1.8438
per share)............... -- -- -- (18,438) -- (18,438)
-------- --- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 2003.. $250,000 $ 1 $240,733 $ 1,230 $ 2,270 $494,234
======== === ======== ======== ======== ========
Net income.................. -- -- -- 17,530 -- 17,530
Other comprehensive loss.... -- -- -- -- (3,534) (3,534)
Dividends declared on common
stock ($904 per share)... -- -- -- (904) -- (904)
Dividends declared on
preferred stock ($1.8438
per share)............... -- -- -- (18,438) -- (18,438)
-------- --- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 2004.. $250,000 $ 1 $240,733 $ (582) $ (1,264) $488,888
======== === ======== ======== ======== ========
Net income.................. -- -- -- 19,018 -- 19,018
Other comprehensive loss.... -- -- -- -- (9,722) (9,722)
Dividends declared on common
stock.................... -- -- -- -- -- --
Dividends declared on
preferred stock ($1.8438
per share)............... -- -- -- (18,438) -- (18,438)
-------- --- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 2005.. $250,000 $ 1 $240,733 $ (2) $(10,986) $479,746
======== === ======== ======== ======== ========
The accompanying notes are an integral part of these financial statements.
28
HARRIS PREFERRED CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
------------------------------------
2005 2004 2003
--------- -------------- ---------
(IN THOUSANDS)
OPERATING ACTIVITIES:
Net income.................................... $ 19,018 $ 17,530 $ 21,348
Adjustments to reconcile net income to net
cash provided by operating activities:
Loss/ (gain) on sale of securities......... 707 (1,062) (4,158)
Net decrease (increase) in other assets.... 139 (521) 868
Net (decrease) increase in accrued
expenses................................. (5) 50 (12)
--------- --------- ---------
Net cash provided by operating
activities............................ 19,859 15,997 18,046
--------- --------- ---------
INVESTING ACTIVITIES:
Net (increase) decrease in securities
purchased from Harris N.A. under agreement
to resell.................................. (10,000) 1,000 8,500
Repayments of notes receivable from Harris
N.A. ...................................... 3,445 4,418 14,531
Decrease in securing mortgage collections due
from Harris N.A. .......................... 78 336 2,516
Purchases of securities available-for-sale.... (248,487) (676,706) (765,405)
Proceeds from sales of securities available-
for-sale................................... -- 51,458 99,756
Proceeds from maturities/redemptions of
securities available-for-sale.............. 253,836 622,320 643,222
--------- --------- ---------
Net cash (used in) provided by investing
activities............................ (1,128) 2,826 3,120
--------- --------- ---------
FINANCING ACTIVITIES:
Cash dividends paid on preferred stock........ (18,438) (18,438) (18,438)
Cash dividends paid on common stock........... -- (904) (2,530)
--------- --------- ---------
Net cash used by financing activities.... (18,438) (19,342) (20,968)
--------- --------- ---------
Net increase (decrease) in cash on deposit
with Harris N.A. .......................... 293 (519) 198
Cash on deposit with Harris N.A. at beginning
of year.................................... 407 926 728
--------- --------- ---------
Cash on deposit with Harris N.A. at end of
year....................................... $ 700 $ 407 $ 926
========= ========= =========
The accompanying notes are an integral part of these financial statements.
29
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION
Harris Preferred Capital Corporation (the "Company") is a Maryland
corporation whose principal business objective is to acquire, hold, finance and
manage qualifying real estate investment trust ("REIT") assets (the "Mortgage
Assets"), consisting of a limited recourse note or notes (the "Notes") issued by
Harris N.A. (the "Bank") secured by real estate mortgage assets (the "Securing
Mortgage Loans") and other obligations secured by real property, as well as
certain other qualifying REIT assets. The Company holds its assets through a
Maryland real estate investment trust subsidiary, Harris Preferred Capital
Trust. The Company has elected to be a REIT under sections 856 through 860 of
the Internal Revenue Code of 1986, as amended (the "Code"), and will generally
not be subject to Federal income tax to the extent that it meets all of the REIT
requirements in the Code Sections 856-860. All of the 1,000 shares of the
Company's common stock, par value $1.00 per share (the "Common Stock"), are
owned by Harris Capital Holdings, Inc. ("HCH"), a wholly-owned subsidiary of the
Bank. On December 30, 1998, the Bank transferred its ownership of the common
stock of the Company to HCH. The Bank is required to maintain direct or indirect
ownership of at least 80% of the outstanding Common Stock of the Company for as
long as any 7 3/8% Noncumulative Exchangeable Preferred Stock, Series A (the
"Preferred Shares"), $1.00 par value, is outstanding. The Company was formed to
provide the opportunity to invest in residential mortgages and other real estate
assets and to provide the Bank with a cost-effective means of raising capital
for federal regulatory purposes.
On February 11, 1998, the Company completed an initial public offering (the
"Offering") of 10,000,000 shares of the Company's Preferred Shares, receiving
proceeds of $242,125,000, net of underwriting fees. The Preferred Shares are
traded on the New York Stock Exchange. Concurrent with the issuance of the
Preferred Shares, the Bank contributed additional capital of $250 million to the
Company.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on deposit with the Bank.
ALLOWANCE FOR PROBABLE LOAN LOSSES
The allowance for possible loan losses is maintained at a level considered
adequate to provide for probable loan losses. The allowance is increased by
provisions charged to operating expense and reduced by net charge-offs. Known
losses of principal on impaired loans are charged off. The provision for loan
losses is based on past loss experience, management's evaluation of the loan
portfolio securing the Mortgage Assets under current economic conditions and
management's estimate of anticipated, but as yet not specifically identified,
loan losses. Such estimates are reviewed periodically and adjustments, if
necessary, are recorded during the periods in which they become known. At
December 31, 2005 and 2004, no allowance for probable loan losses was recorded
under this policy.
INCOME TAXES
The Company has elected to be taxed as a REIT commencing with its taxable
year ended December 31, 1998 and intends to comply with the provisions of the
Code with respect thereto. The Company does not expect to be subject to Federal
income tax because assets, income distribution and stock ownership tests in Code
Sections 856-860 are met. Accordingly, no provision for income taxes is included
in the accompanying financial statements.
The REIT Modernization Act, which took effect on January 1, 2001, modified
certain provisions of the Code with respect to the taxation of REITs. A key
provision of this tax law change reduced the required level of distributions by
a REIT from 95% to 90% of ordinary taxable income.
30
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SECURITIES
The Company classifies all securities as available-for-sale, even if the
Company has no current plans to divest. Available-for-sale securities are
reported at fair value with unrealized gains and losses included as a separate
component of stockholders' equity.
Interest income on securities, including amortization of discount or
premium, is included in earnings. Realized gains and losses, as a result of
securities sales, are included in gain on sale of securities in the consolidated
statement of operations, with the cost of securities sold determined on the
specific identification basis.
The Company purchases U.S. Treasury and Federal agency securities from the
Bank under agreements to resell identical securities. The amounts advanced under
these agreements represent short-term loans and are reflected as securities
purchased under agreement to resell in the consolidated balance sheet.
Securities purchased under agreement to resell totaled $20.5 million at December
31, 2005 compared to $10.5 million at December 31, 2004. The securities
underlying the agreements are book-entry securities. Securities are transferred
by appropriate entry into the Company's account with the Bank under a written
custodial agreement with the Bank that explicitly recognizes the Company's
interest in these securities.
The Company's investment securities are exposed to various risks such as
interest rate, market and credit. Due to the level of risk associated with
certain investment securities and the level of uncertainty related to changes in
the value of investment securities, it is at least reasonably possible that
changes in risks in the near term would materially affect the carrying value of
investments in securities available-for-sale currently reported in the
consolidated balance sheet.
In making a determination of temporary vs. other-than-temporary impairment
of an investment, a major consideration of management is whether the Company
will be able to collect all amounts due according to the contractual terms of
the investment. Such a determination involves estimation of the outcome of
future events as well as knowledge and experience about past and current events.
Factors considered include the following: whether the fair value is
significantly below cost and the decline is attributable to specific adverse
conditions in an industry or geographic area; the period of time the decline in
fair value has existed; if an outside rating agency has downgraded the
investment; if dividends have been reduced or eliminated; if scheduled interest
payments have not been made and finally, whether the financial condition of the
issuer has deteriorated
NEW ACCOUNTING PRONOUNCEMENTS
The FASB issued SFAS No. 154, "Accounting Changes and Error Corrections-a
replacement of APB Opinion No. 20 and FASB Statement No. 3" in May 2005. The
Statement replaces Accounting Principles Board ("APB") Opinion No. 20,
"Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim
Financial Statements," and requires retrospective application to prior period
financial statements for reporting a change in accounting principle. It also
requires restatement of prior period financial statements for reporting an error
correction. The Statement is effective for accounting changes and error
corrections made in fiscal years beginning after December 15, 2005. The Company
does not expect the adoption of this Statement to have a material effect on its
financial position or results of operations.
The Company adopted the American Institute of Certified Public Accountants
("AICPA") Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or
Debt Securities Acquired in a Transfer," in 2005. The SOP applies to the
purchase of a loan, a group of loans, and loans acquired in a purchase business
combination. It addresses accounting for differences, attributable to credit
quality, between contractual and expected cash flows from the initial investment
in loans acquired in a transfer. Acquired loans in scope will exhibit a
deterioration of credit quality from the origination date to the acquisition
date and a probability at acquisition that the acquirer will be unable to
collect all contractually required payments. Loans in scope that the Company
acquires in a business combination are initially recorded at fair value which is
based on the present value of expected cash flows. Any allowance for loan losses
related to the loans is not carried over at acquisition. Undiscounted expected
cash flows in
31
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
excess of the initial valuation are accreted into interest income. If the
Company cannot reasonably estimate the timing and amount of expected cash flows,
then the loan is placed on nonaccrual status. If it is probable, upon subsequent
evaluation, that the Company will be unable to collect the expected cash flows,
then the loan is considered impaired. The Company does not expect the adoption
of the Statement to have a material effect on its financial position or results
of operations.
The FASB issued FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments," in November 2005. The FSP provides guidance on determining whether
an investment is impaired, evaluating whether an impairment is other-than-
temporary and measuring an impairment loss. It applies to debt and equity
securities within the scope of FAS 115, "Accounting for Certain Investments in
Debt and Equity Securities," and equity securities that are cost-method
investments. It is effective for reporting periods beginning after December 15,
2005. The Company does not expect the adoption of this FSP to have a material
effect on its financial position or results of operations.
MANAGEMENT'S ESTIMATES
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America,
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
3. NOTES RECEIVABLE FROM THE BANK
On February 11, 1998, proceeds received from the Offering were used in part
to purchase $356 million of Notes at a rate of 6.4%. The Notes are secured by
mortgage loans originated by the Bank. The principal amount of the Notes equals
approximately 80% of the aggregate outstanding principal amount of the Mortgage
Loans. During 2005, the Company received repayments on the Notes of $3.4 million
compared to 2004 repayments of $4.4 million. For years ended December 31, 2005,
2004 and 2003, the Bank paid interest on the Notes in the amount of $655
thousand, $907 thousand and $1.5 million, respectively, to the Company.
The Notes are recourse only to the Securing Mortgage Loans that are secured
by real property. The Notes mature on October 1, 2027. Payments of principal and
interest on the Notes are recorded monthly from payments received on the
Securing Mortgage Loans. The Company has a security interest in the real
property securing the underlying mortgage loans and is entitled to enforce
payment on the Securing Mortgage Loans in its own name if a mortgagor should
default. In the event of default, the Company has the same rights as the
original mortgagee to foreclose the mortgaged property and satisfy the
obligations of the Bank out of the proceeds. The Securing Mortgage Loans are
serviced by the Bank, as agent of the Company.
The Company intends that each mortgage loan securing the Notes will
represent a first lien position and will be originated in the ordinary course of
the Bank's real estate lending activities based on the underwriting standards
generally applied (at the time of origination) for the Bank's own account. The
Company also intends that all Mortgage Assets held by the Company will meet
market standards, and servicing guidelines promulgated by the Company, and
Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan
Mortgage Corporation ("FHLMC") guidelines and procedures.
The balance of Securing Mortgage Loans at December 31, 2005 and 2004 was
$11 million and $15 million, respectively. The weighted average interest rate on
those loans at December 31, 2005 and 2004 was 6.725% and 5.862%, respectively.
None of the Securing Mortgage Loans collateralizing the Notes were on
nonaccrual status at December 31, 2005 or 2004.
32
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A majority of the collateral securing the underlying mortgage loans is
located in Illinois. The financial viability of customers in this state is, in
part, dependent on the states' economies. The Company's maximum risk of
accounting loss, should all customers in Illinois fail to perform according to
contract terms and all collateral prove to be worthless, was approximately $7
million at December 31, 2005 and $11 million at December 31, 2004.
4. SECURITIES
The amortized cost and estimated fair value of securities available-for-
sale were as follows:
DECEMBER 31, 2005 DECEMBER 31, 2004
---------------------------------------------- ----------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
--------- ---------- ---------- -------- --------- ---------- ---------- --------
(IN THOUSANDS)
AVAILABLE-FOR-SALE
SECURITIES
Mortgage-backed..... $384,570 -- $10,986 $373,584 $420,583 $971 $2,239 $419,315
U.S. Treasury....... 74,946 -- -- 74,946 44,989 4 -- 44,993
-------- --- ------- -------- -------- ---- ------ --------
Total Securities.... $459,516 $-- $10,986 $448,530 $465,572 $975 $2,239 $464,308
======== === ======= ======== ======== ==== ====== ========
The following table summarizes mortgage-backed securities with unrealized
losses as of December 31, 2005, the amount of the unrealized loss and the
related fair value of the securities with unrealized losses. The unrealized
losses have been further segregated by mortgage-backed securities that have been
in a continuous unrealized loss position for less than 12 months and those that
have been in a continuous unrealized loss position for 12 or more months. There
were 20 securities that were in a loss position for 12 or more months.
Management believes that all of the unrealized losses are temporary.
LENGTH OF CONTINUOUS UNREALIZED LOSS POSITION
----------------------------------------------------------------------
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
---------------------- ---------------------- ----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ----------
(IN THOUSAND)
Mortgage-backed......... $89,256 $1,791 $284,328 $9,195 $373,584 $10,986
======= ====== ======== ====== ======== =======
The amortized cost and estimated fair value of total available-for-sale
securities at December 31, 2005, by contractual maturity, are shown below.
Expected maturities can differ from contractual maturities since borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties. The U.S. Treasury Bills held at December 31, 2005 mature within the
next month.
DECEMBER 31, 2005
-------------------
AMORTIZED FAIR
COST VALUE
--------- --------
Maturities:
Within 1 year........................................ $ 74,946 $ 74,946
1 to 5 years......................................... 132,469 129,121
5 to 10 years........................................ 82,698 79,293
Over 10 years........................................ 169,403 165,170
-------- --------
Total Securities....................................... $459,516 $448,530
======== ========
33
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. COMMON AND PREFERRED STOCK
On February 11, 1998, the Company issued 10,000,000 Preferred Shares,
Series A, at a price of $25 per share pursuant to its Registration Statement on
Form S-11. Proceeds from this issuance, net of underwriting fees, totaled
$242,125,000. The liquidation value of each Preferred Share is $25 plus any
authorized, declared and unpaid dividends. The Preferred Shares are redeemable
at the option of the Company, in whole or in part, at the liquidation preference
thereof, plus the quarterly accrued and unpaid dividends, if any, to the date of
redemption. The Company may not redeem the Preferred Shares without prior
approval from the Office of the Comptroller of the Currency or the appropriate
successor or other federal regulatory agency. Except under certain limited
circumstances, as defined, the holders of the Preferred Shares have no voting
rights. The Preferred Shares are automatically exchangeable for a new series of
preferred stock of the Bank upon the occurrence of certain events.
Holders of Preferred Shares are entitled to receive, if declared by the
Board of Directors of the Company, noncumulative dividends at a rate of 7 3/8%
per annum of the $25 per share liquidation preference (an amount equivalent to
$1.84375 per share per annum). Dividends on the Preferred Shares, if authorized
and declared, are payable quarterly in arrears on March 30, June 30, September
30, and December 30 each year. Dividends paid to the holders of the Preferred
Shares for the years ended December 31, 2005 and 2004 were $18,438,000 in both
years. The allocations of the distributions declared and paid for income tax
purposes for the year ended December 31, 2005 were 100% of ordinary income. The
allocations of the distributions declared and paid for income tax purposes for
the year ended December 31, 2004 were 87.7% of ordinary income, 7.4% of capital
gain and 4.9% return of capital.
On December 30, 1998, the Bank contributed the Common Stock of the Company
to HCH. The Bank is required to maintain direct or indirect ownership of at
least 80% of the outstanding Common Stock of the Company for as long as any
Preferred Shares are outstanding. Dividends on Common Stock are paid if and when
authorized and declared by the Board of Directors out of funds legally available
after all preferred dividends have been paid. There were no common stock
dividends paid in 2005. On September 13, 2004 the Company paid a cash dividend
of $904 thousand on the outstanding common shares. These dividends completed the
2003 REIT tax compliance requirements.
6. TRANSACTIONS WITH AFFILIATES
The Company entered into an advisory agreement (the "Advisory Agreement")
with the Bank pursuant to which the Bank administers the day-to-day operations
of the Company. The Bank is responsible for (i) monitoring the credit quality of
Mortgage Assets held by the Company; (ii) advising the Company with respect to
the reinvestment of income from and payments on, and with respect to, the
acquisition, management, financing, and disposition of the Mortgage Assets held
by the Company; and (iii) monitoring the Company's compliance with the
requirements necessary to qualify as a REIT.
The Advisory Agreement in effect for 2005, 2004 and 2003 entitled the Bank
to receive advisory fees of $122,000, $124,000,and $56,000, respectively for
processing, recordkeeping, legal, management and other services.
The Securing Mortgage Loans are serviced by the Bank pursuant to the terms
of a servicing agreement (the "Servicing Agreement"). The Bank receives a fee
equal to 0.25% per annum on the principal balances of the loans serviced. The
Servicing Agreement requires the Bank to service the mortgage loans in a manner
generally consistent with accepted secondary market practices, and servicing
guidelines promulgated by the Company and with Fannie Mae and FHLMC guidelines
and procedures. In 2005, 2004, and 2003 the Bank received payments of $31
thousand, $44 thousand and $70 thousand, respectively.
The Company purchases U.S. Treasury and Federal agency securities from the
Bank under agreements to resell identical securities. At December 31, 2005, the
Company held $20.5 million of such assets and had earned $1.6 million of
interest from the Bank during 2005. At December 31, 2004 the Company held $10.5
million of such
34
HARRIS PREFERRED CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
assets and earned $1.1 million of interest for 2004. The Company receives rates
on these assets comparable to the rates that the Bank offers to unrelated
counterparties under similar circumstances.
7. OPERATING SEGMENT
The Company's operations consist of monitoring and evaluating the
investments in Mortgage Assets. Accordingly, the Company operates in only one
segment. The Company has no external customers and transacts most of its
business with the Bank.
8. COMMITMENTS AND CONTINGENCIES
Legal proceedings in which the Company is a defendant may arise in the
normal course of business. At December 31, 2005 and 2004, there was no pending
litigation against the Company.
9. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The following table sets forth selected quarterly financial data for the
Company:
YEAR ENDED DECEMBER 31, 2005 YEAR ENDED DECEMBER 31, 2004
------------------------------------- ---------------------------------------
FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- ------- ------- -------- -------- ------- -------
(IN THOUSANDS EXCEPT PER SHARE DATA)
Total interest income.... $4,969 $ 5,040 $ 5,067 $ 5,089 $ 3,383 $ 3,847 $ 4,805 $ 4,963
Total noninterest
income................. (194) (178) (176) (159) 398 -- 464 200
Total operating
expenses............... 134 82 88 136 137 137 94 162
------ ------- ------- ------- -------- -------- ------- -------
Net income............... 4,641 4,780 4,803 4,794 3,644 3,710 5,175 5,001
Preferred dividends...... 4,609 4,609 4,609 4,611 4,609 4,609 4,609 4,611
------ ------- ------- ------- -------- -------- ------- -------
Net income available
(loss allocated) to
common stockholder..... $ 32 $ 171 $ 194 $ 183 $ (965) $ (899) $ 566 $ 390
====== ======= ======= ======= ======== ======== ======= =======
Basic and diluted
earnings (loss) per
common share........... $32.00 $171.00 $194.00 $183.00 $(965.00) $(899.00) $566.00 $390.00
====== ======= ======= ======= ======== ======== ======= =======
FINANCIAL STATEMENTS OF HARRIS N.A.
The following unaudited financial information and audited financial
statements for Harris N.A. are included because the Preferred Shares are
automatically exchangeable for a new series of preferred stock of the Bank upon
the occurrence of certain events.
On May 27, 2005, Harris Bankcorp, Inc., the Bank's parent company,
consolidated 26 of its separate bank subsidiaries in Illinois (including Harris
Trust and Savings Bank, the parent company of Harris Capital Holdings, Inc. at
that date) into one national bank, Harris N.A. Each outstanding share of the
Company's Series A Preferred Stock became automatically exchangeable for one
newly issued preferred share of Harris N.A. under the same exchange conditions
previously in existence for preferred shares of Harris Trust and Savings Bank,
except that the primary regulator for purposes of the exchange conditions will
be the Office of the Comptroller of the Currency, not the Board of Governors of
the Federal Reserve Bank. References herein to the "Bank" for those times prior
to the charter consolidation are intended to refer to Harris Trust and Savings
Bank.
Financial statements are presented for the Bank using the historical cost
basis for all combining entities, similar to pooling-of-interests accounting.
Results for prior periods have been restated assuming the combination had taken
place before the earliest period presented
35
HARRIS N.A.
CERTAIN INFORMATION REGARDING HARRIS N.A.
Harris N.A. ("the Bank") is an Illinois banking operation located at 111
West Monroe Street, Chicago, Illinois 60603. The Bank is a wholly-owned
subsidiary of Harris Bankcorp, Inc., a multibank holding company incorporated
under the laws of the State of Delaware and headquartered in Chicago and
registered under the Bank Holding Company Act of 1956, as amended. Harris
Bankcorp, Inc. is a wholly-owned subsidiary of Harris Financial Corp. ("HFC").
Harris Bankcorp, Inc. also owns four other banks, one with locations in
communities near Chicago, one with locations in Arizona, Florida and Washington,
one with locations in northwest Indiana and one wholesale bank. HFC is a wholly-
owned subsidiary of Bank of Montreal. At December 31, 2005, Harris Bankcorp
Inc.'s assets amounted to $37.2 billion, with the Bank representing
approximately 93 percent of that total.
On May 27, 2005 Harris Bankcorp, Inc. consolidated 26 of its individually
chartered bank subsidiaries (including Harris Trust and Savings Bank) into one
national bank, Harris N.A. The combination was recorded at historical carrying
value and prior year financial statements have been restated.
The Bank, a federally-chartered bank, has its principal office, 172
domestic branch offices and 297 automated teller machines located in the Chicago
area. The Bank also has offices in Atlanta, Los Angeles, Boston and San
Francisco and a foreign branch office in Nassau. At December 31, 2005, the Bank
had total assets of $34.48 billion, total deposits of $24.01 billion, total
loans of $22.97 billion and equity capital of $2.79 billion.
The Bank provides a broad range of banking and financial services to
individuals and corporations domestically and abroad, including corporate
banking, personal financial services, personal trust services and investment
services. The Bank also offers (i) demand and time deposit accounts; (ii)
various types of loans (including term, real estate, revolving credit facilities
and lines of credit); (iii) sales and purchases of foreign currencies; (iv)
interest rate management products (including swaps, forward rate agreements and
interest rate guarantees); (v) cash management services; (vi) underwriting of
municipal bonds; (vii) financial consulting; and (viii) a wide variety of
personal trust and trust-related services.
Competitors of the Bank include commercial banks, savings and loan
associations, consumer and commercial finance companies, credit unions and other
financial services companies. Based on legislation passed in 1986 that allows
Illinois banks to be acquired by banks or holding companies in states with a
reciprocal law in effect, together with the Federal Interstate Banking
Efficiency Act of 1994 that allows for both interstate banking and interstate
branching in certain circumstances, the Bank believes that the level of
competition will increase in the future.
The Bank is subject to regulation by the Board of Governors of the Federal
Reserve System and the Federal Deposit Insurance Corporation. As a federally-
chartered bank, it is also regulated by the Office of the Comptroller of the
Currency. These regulatory bodies examine the Bank and supervise numerous
aspects of its business. The Federal Reserve System regulates money and credit
conditions and interest rates in order to influence general economic conditions,
primarily through open market operations in U.S. Government securities, varying
the discount rate on bank borrowings, setting reserve requirements against
financial institution deposits and prescribing minimum capital requirements for
member banks. These policies have a significant influence on overall growth and
distribution of bank loans, investments and deposits, and affect interest rates
charged on loans and earned on investments or paid for time, savings and other
deposits. Board of Governors monetary policies have had a significant effect on
the operating results of commercial banks in the past and this is expected to
continue.
Although primarily focusing on U.S. domestic customers, identifiable
foreign assets accounted for 4 percent of the Bank's total consolidated assets
at December 31, 2005 and foreign net loss was $31.1 million in 2005. Foreign
activities result from three primary sources: (i) lending to foreign banks and
other financial institutions; (ii) time deposits held or issued to foreign
banks; and (iii) foreign exchange trading profits of approximately $5.6 million.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
2005 COMPARED TO 2004
SUMMARY
The Bank had 2005 net income of $203.4 million, a decrease of $47.5 million
or 19 percent from 2004. Return on equity ("ROE") was 7.58 percent in the
current year compared to 9.72 percent in the prior year. Return on assets
("ROA") was 0.62 percent compared to 0.82 percent a year ago.
Net interest income on a fully taxable equivalent basis was $797.1 million,
down $7.0 million or 1 percent from $804.1 million in 2004. Average earning
assets grew 8 percent from $27.41 billion to $29.70 billion in the current year
primarily attributable to an increase of $2.3 billion in average loans. Net
interest margin decreased from 2.93 percent to 2.68 percent in 2005. This
decline primarily reflects a flat yield curve thereby reducing spreads on
earning assets and related funding and a greater reliance on wholesale funding.
This was partially offset by growth in the loan portfolio which accounted for
virtually the entire increase in interest-earning assets.
The provision for loan losses was $16.3 million in 2005 compared to $21.9
million in 2004. Net loan charge-offs during the current year were $17.2 million
compared to $30.3 million in the same period last year, reflecting lower write-
offs in the corporate loan portfolio. The decrease in provision was based on
management's estimate of potentially lower loan losses due to continued declines
in non-performing loan levels as well as reduced charge-offs.
Noninterest income was $395.1 million, a decrease from the 2004 amount of
$461.8 million. This was primarily attributable to a $26.5 million decrease in
net securities gains, a $7.7 million gain recognized in 2004 on the termination
of a swap, a $7.1 million gain recognized in 2004 on a loan restructuring, a
$6.4 million decrease in mortgage servicing fees, a $6.2 million decrease in
service charges and fees, a $4.0 million decrease in money market and bond
trading profits and a $3.6 million decrease in letter of credit fees. The
decreases were partially offset by increased bank-owned insurance income.
Noninterest expense of $865.8 million in 2005 increased $12.2 million or 1
percent from last year. The increase was attributable to additional occupancy
costs related to the sale of a major building in 2005 and higher intercompany
services. The increases were partially offset by reduced salaries and other
compensation expenses. Income taxes decreased $35.9 million, reflecting lower
pretax income in 2005. In addition, the effective tax rate decreased from 32.5%
in 2004 to 29.4% in 2005 primarily due to lower state income taxes and a higher
proportion of nontaxable income.
Nonperforming assets at December 31, 2005 totaled $133 million or 0.58
percent of total loans, compared to $142 million or 0.70 percent a year earlier.
At December 31, 2005, the allowance for loan losses was $318 million, equal to
1.38 percent of loans outstanding compared to $317 million at the end of 2004,
equal to 1.57 percent of loans outstanding. The ratio of the allowance for loan
losses to nonperforming assets was 239 percent at December 31, 2005 compared to
223 percent at December 31, 2004.
At December 31, 2005 consolidated stockholder's equity of the Bank amounted
to $2.79 billion, up from $2.63 billion at December 31, 2004. In 2005 Villa Park
Trust and Savings Bank ("Villa Park"), a wholly owned subsidiary of Harris
Bankcorp, Inc., was merged with and into the Bank. At the time, Villa Park total
assets were $327 million and total deposits were $260 million. The impact on the
Bank's stockholder's equity was an increase of $64 million. The combination was
recorded using historical carrying values for Villa Park as recognized by
Bankcorp. In consideration of this contribution to its capital, the Bank issued
61,256 shares of common stock to Bankcorp. The Bank paid $90 million in
dividends on common stock in 2005.
The Bank's regulatory capital leverage ratio was 8.27 percent at December
31, 2005 compared to 8.40 percent at December 31, 2004. Regulators require most
banking institutions to maintain capital leverage ratios of not less than 4.0
percent. At December 31, 2005, the Bank's Tier 1 and total risk based capital
ratios were 9.34 percent and 11.40 percent, respectively, compared to respective
ratios of 9.97 percent and 12.30 percent at December 31, 2004. The 2005 year-end
risk-based capital ratios marginally dropped from the previous year due to a
proportionately
37
higher increase in risk-weighted assets over Tier 1 capital; however, year-end
ratios substantially exceeded minimum required regulatory ratios of 4.0 percent
and 8.0 percent, respectively.
2004 COMPARED TO 2003
SUMMARY
The Bank had 2004 net income of $250.8 million, an increase of $40.9
million or 20 percent from 2003. ROE was 9.72 percent in 2004 compared to 8.39
percent in the prior year. ROA was 0.82 percent compared to 0.72 percent in
2003.
Net interest income on a fully taxable equivalent basis was $804.1 million,
down $9.6 million or 1 percent from $813.7 million in 2003. Average earning
assets grew 5 percent from $26.04 billion to $27.41 billion in 2004 primarily
attributable to an increase of $1.7 billion in average loans offset by a slight
decline in securities available for sale. Net interest margin decreased from
3.12 percent to 2.93 percent in 2004. This decline primarily reflects the impact
of lower yields in the investment securities portfolio and higher funding costs
for certain borrowings. This was partially offset by strong growth in the retail
loan base.
The provision for loan losses was $21.9 million in 2004 compared to $129.5
million in 2003. Net loan charge-offs during the year were $30.3 million in 2004
compared to $90.6 million in 2003, reflecting lower write-offs in the corporate
loan portfolio. The decrease in provision was based on management's estimate of
potentially lower loan losses due to continued declines in non-performing loan
levels as well as reduced charge-offs.
Noninterest income was $461.8 million, a decrease from the 2003 amount of
$475.9 million. This was primarily attributable to a $14.0 million decrease in
service fees and charges, a $3.4 million decrease in bank-owned insurance
income, a $3.3 million decrease in letter of credit and a $2.5 million reduction
in syndication fees. This was partially offset by increased trust and investment
management fees and a gain on the sale of assets received in an earlier troubled
debt restructuring.
Noninterest expense of $853.6 million in 2004 increased $14.6 million or
1.7 percent from 2003. The increase was attributable to additional charges for
intercompany services and employee benefit costs. The increases were partially
offset by reduced salaries and other compensation expenses. Income taxes
increased $34.3 million, reflecting higher pretax income in 2004.
Nonperforming assets at December 31, 2004 totaled $142 million or 0.70
percent of total loans, compared to $196 million or 1.10 percent a year earlier.
At December 31, 2004, the allowance for loan losses was $317 million, equal to
1.57 percent of loans outstanding compared to $324 million at the end of 2003,
equal to 1.81 percent of loans outstanding. The ratio of the allowance for loan
losses to nonperforming assets was 223 percent at December 31, 2004 compared to
165 percent at December 31, 2003.
At December 31, 2004 consolidated stockholder's equity of the Bank amounted
to $2.63 billion, up from $2.52 billion at December 31, 2003. The Bank paid cash
and non-cash dividends totaling $129 million in 2004.
The Bank's regulatory capital leverage ratio was 8.40 percent at December
31, 2004 compared to 8.34 percent at December 31, 2003. Regulators require most
banking institutions to maintain capital leverage ratios of not less than 4.0
percent. At December 31, 2004, the Bank's Tier 1 and total risk based capital
ratios were 9.97 percent and 12.30 percent, respectively, compared to respective
ratios of 10.14 percent and 12.28 percent at December 31, 2003. The 2004 year-
end risk-based capital ratios substantially exceeded minimum required regulatory
ratios of 4.0 percent and 8.0 percent, respectively.
38
INDEPENDENT AUDITORS' REPORT
To the Stockholder and Board
of Directors of Harris N.A.
We have audited the accompanying consolidated statements of condition of
Harris N.A. (an indirect wholly-owned subsidiary of Bank of Montreal) and
subsidiaries as of December 31, 2005 and 2004, and the related consolidated
statements of income, comprehensive income, changes in stockholder's equity and
cash flows for each of the years in the three year period ended December 31,
2005. These consolidated financial statements are the responsibility of Harris
N.A.'s management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Harris N.A.
and subsidiaries as of December 31, 2005 and 2004, and the results of their
operations and their cash flows for each of the years in the three year period
ended December 31, 2005 in conformity with United States of America generally
accepted accounting principles.
-s- KPMG LLP
Chicago, Illinois
March 16, 2006
39
HARRIS N.A. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
DECEMBER 31
------------------------
2005 2004
----------- -----------
(IN THOUSANDS EXCEPT
SHARE DATA)
ASSETS
Cash and demand balances due from banks.................. $ 1,303,916 $ 947,580
Money market assets:
Interest-bearing deposits at banks..................... 1,007,212 662,366
Federal funds sold..................................... 303,130 94,950
Securities available-for-sale (including $3.71 billion
and $4.27 billion of securities pledged as collateral
for repurchase agreements at December 31, 2005 and
December 31, 2004, respectively)....................... 6,398,367 7,154,743
Trading account assets................................... 181,121 90,130
Loans.................................................... 22,971,375 20,218,993
Allowance for loan losses................................ (317,777) (316,575)
----------- -----------
Net loans.............................................. 22,653,598 19,902,418
Premises and equipment................................... 416,578 455,211
Bank-owned insurance..................................... 1,115,172 1,072,660
Loans held for sale...................................... 32,364 43,423
Goodwill and other intangible assets..................... 335,049 306,760
Other assets............................................. 731,241 651,119
----------- -----------
TOTAL ASSETS........................................... $34,477,748 $31,381,360
=========== ===========
LIABILITIES
Deposits in domestic offices -- noninterest-bearing...... $ 6,077,792 $ 5,432,999
-- interest-bearing......... 16,749,110 15,646,690
Deposits in foreign offices -- interest-bearing.......... 1,270,741 1,677,428
----------- -----------
Total deposits......................................... 24,097,643 22,757,117
Federal funds purchased.................................. 975,990 1,114,400
Securities sold under agreement to repurchase............ 2,485,650 3,405,296
Short-term borrowings.................................... 2,041,715 214,145
Short-term senior notes.................................. 800,000 200,000
Accrued interest, taxes and other expenses............... 247,778 227,680
Other liabilities........................................ 247,544 289,130
Minority interest -- preferred stock of subsidiary....... 250,000 250,000
Preferred stock issued to Harris Bankcorp, Inc........... -- 5,000
Long-term notes -- senior................................ 250,000 --
Long-term notes -- subordinated.......................... 292,750 292,750
----------- -----------
TOTAL LIABILITIES...................................... 31,689,070 28,755,518
----------- -----------
STOCKHOLDER'S EQUITY
Common stock ($10 par value); authorized 40,000,000
shares; issued and outstanding 13,548,513 and
13,487,257 shares at December 31, 2005 and December 31,
2004, respectively..................................... 135,485 134,873
Surplus.................................................. 1,111,922 1,057,814
Retained earnings........................................ 1,609,465 1,477,163
Accumulated other comprehensive loss..................... (68,194) (44,008)
----------- -----------
TOTAL STOCKHOLDER'S EQUITY............................. 2,788,678 2,625,842
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY............. $34,477,748 $31,381,360
=========== ===========
The accompanying notes to consolidated financial statements are an integral part
of these statements.
40
HARRIS N.A. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31
----------------------------------
2005 2004 2003
---------- ---------- ----------
(IN THOUSANDS)
INTEREST INCOME
Loans............................................... $1,191,236 $ 949,894 $ 870,860
Money market assets:
Deposits at banks................................. 9,537 5,419 3,065
Federal funds sold................................ 8,551 3,452 2,497
Trading accounts.................................... 5,202 2,396 1,672
Securities available-for-sale:
U.S. Treasury and federal agency.................. 167,820 133,612 208,389
State and municipal............................... 19,652 19,410 21,769
Other............................................. 16,614 11,015 2,779
---------- ---------- ----------
Total interest income............................. 1,418,612 1,125,198 1,111,031
---------- ---------- ----------
INTEREST EXPENSE
Deposits............................................ 434,967 253,932 236,505
Short-term borrowings............................... 159,701 56,003 52,218
Short-term senior notes............................. 14,555 3,238 3,722
Minority interest -- dividends on preferred stock of
subsidiary........................................ 18,438 18,437 18,438
Long-term notes -- senior........................... 5,123 -- --
Long-term notes -- subordinated..................... 10,759 8,437 11,333
---------- ---------- ----------
Total interest expense............................ 643,543 340,047 322,216
---------- ---------- ----------
NET INTEREST INCOME................................. 775,069 785,151 788,815
Provision for loan losses........................... 16,327 21,920 129,526
---------- ---------- ----------
NET INTEREST INCOME AFTER PROVISION FOR LOAN
LOSSES............................................ 758,742 763,231 659,289
---------- ---------- ----------
NONINTEREST INCOME
Trust and investment management fees................ 92,213 93,174 85,275
Money market and bond trading....................... 8,026 11,994 9,343
Foreign exchange.................................... 5,635 5,850 5,076
Service charges and fees............................ 123,236 129,451 143,401
Net securities (losses) gains....................... (415) 26,067 26,528
Bank-owned insurance................................ 42,754 40,355 43,712
Gain from loan restructuring........................ -- 7,131 --
Letter of credit fees............................... 19,666 23,284 26,630
Syndication fees.................................... 10,375 11,655 14,168
Other............................................... 93,657 112,800 121,777
---------- ---------- ----------
Total noninterest income.......................... 395,147 461,761 475,910
---------- ---------- ----------
NONINTEREST EXPENSES
Salaries and other compensation..................... 348,428 362,354 388,243
Pension, profit sharing and other employee
benefits.......................................... 107,432 105,806 97,792
Net occupancy....................................... 71,960 60,396 57,369
Equipment........................................... 54,144 55,497 57,898
Marketing........................................... 36,956 37,122 33,434
Communication and delivery.......................... 22,382 23,891 24,592
Expert services..................................... 26,701 23,524 27,616
Contract programming................................ 33,406 31,137 28,930
Intercompany services............................... 42,977 33,540 13,105
Other............................................... 105,075 104,026 93,953
---------- ---------- ----------
849,461 837,293 822,932
Amortization of intangibles......................... 16,378 16,333 16,059
---------- ---------- ----------
Total noninterest expenses........................ 865,839 853,626 838,991
---------- ---------- ----------
Income before income taxes.......................... 288,050 371,366 296,208
Applicable income taxes............................. 84,678 120,538 86,268
---------- ---------- ----------
NET INCOME.......................................... $ 203,372 $ 250,828 $ 209,940
========== ========== ==========
The accompanying notes to consolidated financial statements are an integral part
of these statements.
41
HARRIS N.A. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31
----------------------------------
2005 2004 2003
-------- -------------- --------
(IN THOUSANDS)
NET INCOME......................................... $203,372 $250,828 $209,940
Other comprehensive (loss) income:
Cash flow hedges:
Net unrealized (loss) gain on derivative
instruments, net of tax (benefit) expense of
($10,757) in 2005, ($3,119) in 2004 and $21
in 2003..................................... (18,316) (5,309) 35
Less reclassification adjustment for losses
included in net income, net of tax benefit
of $2,636 in 2005, $0 in 2004 and $0 in
2003........................................ 4,488 -- --
Minimum pension liability adjustment net of tax
expense (benefit) of $877 in 2005, $6,252 in
2004 and ($3,161) in 2003..................... 2,337 4,865 (4,793)
Unrealized losses on available-for-sale
securities:
Unrealized holding losses arising during
period, net of tax benefit of $7,010 in
2005, $29,309 in 2004 and $28,309 in 2003... (12,948) (48,066) (41,541)
Less reclassification adjustment for losses
(gains) included in net income, net of tax
benefit (expense) of $162 in 2005, ($10,185)
in 2004 and ($10,346) in 2003............... 253 (15,882) (16,182)
-------- -------- --------
Other comprehensive loss......................... (24,186) (64,392) (62,481)
-------- -------- --------
Comprehensive income............................... $179,186 $186,436 $147,459
======== ======== ========
The accompanying notes to consolidated financial statements are an integral part
of these statements.
42
HARRIS N.A. AND SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY
ACCUMULATED
OTHER TOTAL
COMMON RETAINED COMPREHENSIVE STOCKHOLDER'S
STOCK SURPLUS EARNINGS INCOME (LOSS) EQUITY
-------- ---------- ---------- ------------- -------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
BALANCE AT DECEMBER 31, 2002.... $133,873 $1,005,893 $1,258,990 $ 82,197 $2,480,953
Stock option exercise......... -- 11,340 -- -- 11,340
Tax benefit from stock option
exercise................... -- 2,972 -- -- 2,972
Net income.................... -- -- 209,940 -- 209,940
Dividends -- ($9.26 per common
share)..................... -- -- (124,000) -- (124,000)
Dividends -- ($0.089 per
preferred share)........... -- -- (446) -- (446)
Other comprehensive loss...... -- -- -- (62,481) (62,481)
-------- ---------- ---------- -------- ----------
BALANCE AT DECEMBER 31, 2003.... 133,873 1,020,205 1,344,484 19,716 2,518,278
Stock option exercise......... -- 7,311 -- -- 7,311
Tax benefit from stock option
exercise................... -- 5,068 -- -- 5,068
Contribution of parent's
banking assets............. 1,000 25,230 9,716 668 36,614
Net income.................... -- -- 250,828 -- 250,828
Dividends -- ($9.90 per common
share)..................... -- -- (123,150) -- (123,150)
Dividends -- ($0.025 per
preferred share)........... -- -- (124) -- (124)
Adjustment of prior quarters'
preferred dividends........ -- -- 766 -- 766
Non-cash dividend of
subsidiary................. -- (5,357) -- (5,357)
Other comprehensive loss...... -- -- -- (64,392) (64,392)
-------- ---------- ---------- -------- ----------
BALANCE AT DECEMBER 31, 2004.... 134,873 1,057,814 1,477,163 (44,008) 2,625,842
Stock option exercise......... -- 3,004 -- -- 3,004
Tax benefit from stock option
exercise................... -- 6,882 -- -- 6,882
Contribution of parent's
banking assets............. 612 44,222 18,992 -- 63,826
Net income.................... -- -- 203,372 -- 203,372
Dividends -- ($6.67 per common
share)..................... -- -- (90,000) -- (90,000)
Dividends -- ($0.025 per
preferred share)........... -- -- (62) -- (62)
Other comprehensive loss...... -- -- -- (24,186) (24,186)
-------- ---------- ---------- -------- ----------
BALANCE AT DECEMBER 31, 2005.... $135,485 $1,111,922 $1,609,465 $(68,194) $2,788,678
======== ========== ========== ======== ==========
The accompanying notes to consolidated financial statements are an integral part
of these statements.
43
HARRIS N.A. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31
---------------------------------------
2005 2004 2003
----------- ----------- -----------
(IN THOUSANDS)
OPERATING ACTIVITIES:
Net Income........................................ $ 203,372 $ 250,828 $ 209,940
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses...................... 16,327 21,920 129,526
Depreciation and amortization, including
intangibles.................................. 70,750 73,259 72,182
Deferred tax (benefit) expense................. (11,769) 6,331 2,347
Tax benefit from stock option exercise......... 6,882 5,068 2,972
Net securities losses (gains).................. 415 (26,067) (26,528)
Increase in bank-owned insurance............... (42,666) (39,560) (43,054)
Trading account net cash purchases............. (52,948) (27,550) (14,712)
(Increase) decrease in accrued interest
receivable................................... (30,610) (554) 12,808
Increase (decrease) in accrued interest
payable...................................... 26,065 (435) 4,449
Decrease (increase) in loans held for sale..... 11,059 125,481 (19,593)
Other, net..................................... (43,579) 119,718 76,433
----------- ----------- -----------
Net cash provided by operating activities...... 153,298 508,439 406,770
----------- ----------- -----------
INVESTING ACTIVITIES:
Net increase in interest-bearing deposits at
banks........................................ (264,377) (263,775) (70,916)
Net (increase) decrease in Federal funds sold.. (199,480) (10,078) 121,700
Proceeds from sales of securities available-
for-sale..................................... 154,226 2,863,585 1,646,486
Proceeds from maturities of securities
available-for-sale........................... 5,451,765 6,034,737 6,870,977
Purchases of securities available-for-sale..... (4,858,662) (7,821,378) (9,084,182)
Net increase in loans.......................... (2,574,668) (2,261,588) (1,339,163)
Net sales (purchases) of premises and
equipment.................................... 39,677 (80,289) (77,171)
Other, net..................................... (127) 1,718 1,998
----------- ----------- -----------
Net cash (used in) provided by investing
activities................................... (2,251,646) (1,537,068) (1,930,271)
----------- ----------- -----------
FINANCING ACTIVITIES:
Cash received in contribution of parent's
banking assets............................... 4,927 3,379 --
Net increase in deposits....................... 925,305 1,071,249 2,112,880
Net (decrease) increase in Federal funds
purchased and securities sold under agreement
to repurchase................................ (1,058,056) 185,689 (208,570)
Net increase (decrease) in other short-term
borrowings................................... 1,827,570 (239,536) (332,372)
Proceeds from issuance of short-term senior
notes........................................ 2,595,000 2,380,000 2,590,000
Repayment of short-term senior notes........... (1,995,000) (2,180,000) (2,790,000)
Proceeds from issuance of long-term senior
notes........................................ 250,000 -- --
Proceeds from issuance of long-term
subordinated notes........................... -- 206,250 58,000
Repayment of long-term subordinated notes...... -- (225,000) --
Cash dividends paid on common stock............ (90,000) (123,150) (124,000)
Cash dividends paid on preferred stock......... (62) -- --
Retirement of preferred stock.................. (5,000) -- --
Cash portion of dividend of non-bank
subsidiary................................... -- (5,076) --
----------- ----------- -----------
Net cash provided by financing activities.... 2,454,684 1,073,805 1,305,938
----------- ----------- -----------
Net increase (decrease) in cash and demand
balances due from banks...................... 356,336 45,176 (217,563)
Cash and demand balances due from banks at
January 1.................................... 947,580 902,404 1,119,967
----------- ----------- -----------
Cash and demand balances due from banks at
December 31.................................. $ 1,303,916 $ 947,580 $ 902,404
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest..................................... $ 617,477 $ 340,482 $ 317,767
Income taxes................................. $ 56,807 $ 43,651 $ 21,173
FINANCING ACTIVITY AFFECTING ASSETS AND LIABILITIES
BUT NOT RESULTING IN CASH FLOWS:
Net increase in assets and liabilities due to
contribution of parent's banking assets...... $ 58,899 $ 33,235 $ --
The accompanying notes to consolidated financial statements are an integral part
of these statements.
44
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND NATURE OF OPERATIONS
Harris N.A. is a wholly-owned subsidiary of Harris Bankcorp, Inc.
("Bankcorp"), a Delaware corporation which is a wholly-owned subsidiary of
Harris Financial Corp. ("HFC"), a Delaware corporation which is a wholly-owned
subsidiary of Bank of Montreal ("BMO"). Throughout these Notes to Consolidated
Financial Statements, the term "Bank" refers to Harris N.A. and subsidiaries.
On May 27, 2005 Bankcorp consolidated 26 of its individually chartered bank
subsidiaries (including Harris Trust and Savings Bank) into one national bank,
Harris N.A. The combination was recorded at historical carrying value and prior
year financial statements have been restated.
The consolidated financial statements include the accounts of the Bank and
its wholly-owned subsidiaries. Significant intercompany accounts and
transactions have been eliminated. Certain reclassifications were made to
conform prior years' financial statements to the current year's presentation.
See Note 23 to the Consolidated Financial Statements for additional information
on business combinations and Note 24 for additional information on related party
transactions.
The Bank provides banking, trust and other services domestically and
internationally through the main banking facility and 5 active nonbank
subsidiaries. The Bank provides a variety of financial services to commercial
and industrial companies, financial institutions, governmental units, not-for-
profit organizations and individuals throughout the U.S., primarily the Midwest,
and abroad. Services rendered and products sold to customers include demand and
time deposit accounts and certificates; various types of loans; sales and
purchases of foreign currencies; interest rate management products; cash
management services; underwriting of municipal bonds; financial consulting; and
personal trust and trust-related services.
BASIS OF ACCOUNTING
The accompanying consolidated financial statements are prepared in
accordance with accounting principles generally accepted in the United States of
America and conform to practices within the banking industry.
FOREIGN CURRENCY AND FOREIGN EXCHANGE CONTRACTS
Assets and liabilities denominated in foreign currencies have been
translated into United States dollars at respective year-end rates of exchange.
Monthly translation gains or losses are computed at rates prevailing at month-
end. There were no material translation gains or losses during any of the years
presented. Foreign exchange trading positions including spot, forwards, option
contracts and swaps are revalued monthly using prevailing market rates. Exchange
adjustments are included with noninterest income in the Consolidated Statements
of Income.
DERIVATIVE FINANCIAL INSTRUMENTS
The Bank uses various interest rate, foreign exchange, equity and commodity
derivative contracts in the management of its risk strategy or as part of its
dealer and trading activities. Interest rate contracts may include futures,
forwards, forward rate agreements, option contracts, caps, floors, collars and
swaps. Foreign exchange contracts may include spot, forwards, futures, option
contracts and swaps. Equity contracts and commodity contracts may include option
contracts and swaps.
All derivative instruments are recognized at fair value in the Consolidated
Statements of Condition as other assets or other liabilities. All derivative
instruments are designated either as hedges or as held for trading or non-
hedging purposes.
Derivative instruments that are used in the management of the Bank's risk
strategy may qualify for hedge accounting if the derivatives are designated as
hedges and applicable hedge criteria are met. On the date that the
45
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Bank enters into a derivative contract, it designates the derivative as a hedge
of the fair value of a recognized asset or liability or an unrecognized firm
commitment, a hedge of a forecasted transaction or the variability of cash flows
that are to be received or paid in connection with a recognized asset or
liability, a foreign currency fair value or cash flow hedge. Changes in the fair
value of a derivative that is highly effective (as defined) and qualifies as a
fair value hedge, along with changes in the fair value of the hedged item, are
recorded in current period earnings. Changes in the fair value of a derivative
that is highly effective (as defined) and qualifies as a cash flow hedge, to the
extent that the hedge is effective, are recorded in other comprehensive income
until earnings are impacted by the hedged item. Net gains or losses resulting
from hedge ineffectiveness are recorded in current period earnings. Changes in
the fair value of a derivative that is highly effective (as defined) and
qualifies as a foreign currency hedge are recorded in either current period
earnings or other comprehensive income depending on whether the hedging
relationship meets the criteria for a fair value or cash flow hedge.
The Bank formally documents all hedging relationships at inception of hedge
transactions. The process includes documenting the risk management objective and
strategy for undertaking the hedge transaction and identifying the specific
derivative instrument and the specific asset, liability, firm commitment or
forecasted transaction. The Bank formally assesses, both at inception and on an
ongoing quarterly basis, whether the derivative hedging instruments have been
highly effective in offsetting changes in the fair value or cash flows of the
hedged items and whether the derivatives are expected to remain highly effective
in future periods.
Hedge accounting is discontinued prospectively when the Bank determines
that the hedge is no longer highly effective, the derivative instrument expires
or is sold, terminated or exercised, it is no longer probable that the
forecasted transaction will occur, the hedged firm commitment no longer meets
the definition of a firm commitment, or the designation of the derivative as a
hedging instrument is no longer appropriate.
When hedge accounting is discontinued because a fair value hedge is no
longer highly effective, the derivative instrument continues to be recorded on
the balance sheet at fair value but the hedged item is no longer adjusted for
changes in fair value that are attributable to the hedged risk. The carrying
amount of the hedged item, including the basis adjustments from hedge
accounting, is accounted for in accordance with applicable generally accepted
accounting principles. For a hedged loan, the basis adjustment is amortized over
its remaining life. When hedge accounting is discontinued because the hedged
item in a fair value hedge no longer meets the definition of a firm commitment,
the derivative instrument continues to be recorded on the balance sheet at fair
value and any asset or liability that was recorded to recognize the firm
commitment is removed from the balance sheet and recognized as a gain or loss in
current period earnings. When hedge accounting is discontinued because a cash
flow hedge is no longer highly effective, the gain or loss on the derivative
that is in accumulated other comprehensive income ("AOCI") remains there until
earnings are impacted by the hedged item and the derivative instrument is marked
to market through earnings. When hedge accounting is discontinued because it is
no longer probable that the forecasted transaction in a cash flow hedge will
occur, the gain or loss on the derivative that was in AOCI is recognized
immediately in earnings and the derivative instrument is marked to market
through earnings. When hedge accounting is discontinued and the derivative
remains outstanding, the derivative may be redesignated as a hedging instrument
as long as the applicable hedge criteria are met under the terms of the new
contract.
Derivative instruments that are entered into for risk management purposes
and do not otherwise qualify for hedge accounting are marked to market and the
resulting unrealized gains and losses are recognized in noninterest income in
the period of change.
Derivative instruments that are used as part of the Bank's dealer and
trading activities are marked to market and the resulting unrealized gains and
losses are recognized in noninterest income in the period of change.
IMPACT OF NEW ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based
Payment," in 2004. The Statement replaces SFAS No. 123,
46
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
"Accounting for Stock-Based Compensation," and supersedes Accounting Principles
Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS
123(R) applies primarily to accounting for transactions where an entity obtains
employee services in share-based payment transactions using the fair value based
method of accounting. The Statement is effective as of the beginning of the
first annual reporting period that begins after December 15, 2005. The Bank uses
the fair value based method of accounting for its stock-based compensation plans
and is in the process of assessing the impact of adopting this Statement on its
financial position and results of operations.
The FASB issued SFAS No. 154, "Accounting Changes and Error Corrections-a
replacement of APB Opinion No. 20 and FASB Statement No. 3" in May 2005. The
Statement replaces Accounting Principles Board ("APB") Opinion No. 20,
"Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim
Financial Statements," and requires retrospective application to prior period
financial statements for reporting a change in accounting principle. It also
requires restatement of prior period financial statements for reporting an error
correction. The Statement is effective for accounting changes and error
corrections made in fiscal years beginning after December 15, 2005. The Bank
does not expect the adoption of this Statement to have a material effect on its
financial position or results of operations.
The Bank adopted the American Institute of Certified Public Accountants
("AICPA") Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or
Debt Securities Acquired in a Transfer," in 2005. The SOP applies to the
purchase of a loan, a group of loans, and loans acquired in a purchase business
combination. It addresses accounting for differences, attributable to credit
quality, between contractual and expected cash flows from the initial investment
in loans acquired from a third party. Acquired loans in scope will exhibit a
deterioration of credit quality from their origination date to the acquisition
date and a probability at acquisition that the acquirer will be unable to
collect all contractually required payments. Loans in scope that the Bank
acquires in a business combination are initially recorded at fair value which is
based on the present value of expected cash flows. Any allowance for loan losses
related to the loans is not carried over at acquisition. Undiscounted expected
cash flows in excess of the initial valuation are accreted into interest income.
If the Bank cannot reasonably estimate the timing and amount of expected cash
flows, then the loan is placed on nonaccrual status. If it is probable, upon
subsequent evaluation, that the Bank will be unable to collect the expected cash
flows, then the loan is considered impaired. On December 1, 2005, Bankcorp
completed its acquisition of Edville Bankcorp, Inc. and its subsidiary Villa
Park Trust and Savings Bank. Immediately thereafter, Edville Bankcorp, Inc. was
merged with and into Bankcorp. On December 3, 2005, Villa Park Trust and Savings
Bank was merged with and into the Bank. The allocation of the purchase price is
subject to refinement as Bankcorp completes the valuation of assets acquired and
liabilities assumed, including the application of this SOP to the loans
acquired. See Note 23 to the Consolidated Financial Statements for additional
information on business combinations.
The FASB issued FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments," in November 2005. The FSP provides guidance on determining whether
an investment is impaired, evaluating whether an impairment is other-than-
temporary and measuring an impairment loss. It applies to debt and equity
securities within the scope of FAS 115, "Accounting for Certain Investments in
Debt and Equity Securities," and equity securities that are cost-method
investments. It is effective for reporting periods beginning after December 15,
2005. The Bank does not expect the adoption of this FSP to have a material
effect on its financial position or results of operations.
SECURITIES
The Bank classifies securities as either trading account assets or
available-for-sale. Trading account assets include securities acquired as part
of trading activities and are typically purchased with the expectation of near-
term profit. These assets consist primarily of municipal bonds and U.S.
government securities. All other securities are classified as available-for-
sale, even if the Bank has no current plans to divest.
47
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Trading account assets are reported at fair value with unrealized gains and
losses included in trading account income, which also includes realized gains
and losses from closing such positions. Available-for-sale securities are
reported at fair value with unrealized gains and losses included, on an after-
tax basis, in a separate component of stockholder's equity. Purchase premiums
and discounts are recognized in interest income using the interest method over
the terms of the securities. Realized gains and losses, as a result of
securities sales, are included in securities gains, with the cost of securities
sold determined on the specific identification basis.
In making a determination of temporary vs. other-than-temporary impairment
of an investment, a major consideration of management is whether the Bank will
be able to collect all amounts due according to the contractual terms of the
investment. Such a determination involves estimation of the outcome of future
events as well as knowledge and experience about past and current events.
Factors considered include the following: whether the fair value is
significantly below cost and the decline is attributable to specific adverse
conditions in an industry or geographic area; the period of time the decline in
fair value has existed; if an outside rating agency has downgraded the
investment; if dividends have been reduced or eliminated; if scheduled interest
payments have not been made and finally, whether the financial condition of the
issuer has deteriorated.
LOANS, LOAN FEES AND COMMITMENT FEES
Loans not held for sale are recorded at the principal amount outstanding,
net of unearned income, deferred fees and deferred origination costs.
Origination fees collected and origination costs incurred on commercial loans,
loan commitments, mortgage loans, consumer loans and standby letters of credit
(except loans held for sale) are generally deferred and amortized over the life
of the related facility. Other loan-related fees that are not the equivalent of
yield adjustments are recognized as income when received or earned. At December
31, 2005 and 2004, the Bank's Consolidated Statements of Condition included
approximately $0.4 million and $10 million, respectively, of deferred loan-
related fees net of deferred origination costs.
In conjunction with its mortgage and commercial banking activities, the
Bank will originate loans with the intention of selling them in the secondary
market. These loans are classified as held for sale and are included in "Loans
held for sale" on the Bank's Consolidated Statements of Condition. The loans are
carried at the lower of allocated cost or current market value, on a portfolio
basis. Deferred origination fees and costs associated with these loans are not
amortized and are included as part of the basis of the loan at time of sale.
Realized gains and unrealized losses are included with other noninterest income.
The Bank engages in the servicing of mortgage loans and acquires mortgage
servicing rights by purchasing or originating mortgage loans and then selling
those loans with servicing rights retained. The rights to service mortgage loans
for others are recognized as separate assets by allocating the total cost of the
mortgage loans to the mortgage servicing rights and the loans (without the
mortgage servicing rights) based on their relative fair values. The capitalized
mortgage servicing rights are amortized in proportion to and over the period of
estimated net servicing income. The capitalized mortgage servicing rights are
periodically evaluated for impairment based on the fair value of those rights.
Fair values are estimated using discounted cash flow analyses. The risk
characteristics of the underlying loans used to stratify capitalized mortgage
servicing rights for purposes of measuring impairment are market interest rates,
loan type and repricing interval.
Commercial and commercial real estate loans are placed on nonaccrual status
when the collection of interest is doubtful or when principal or interest is 90
days past due, unless the credit is adequately collateralized and the loan is in
process of collection. When a loan is placed on nonaccrual status, all interest
accrued but not yet collected which is deemed uncollectible is charged against
interest income in the current year. Interest on nonaccrual loans is recognized
as income only when cash is received and the Bank expects to collect the entire
principal balance of the loan. Loans are returned to accrual status when all the
principal and interest amounts contractually due are brought current and future
payments are reasonably assured. Interest income on restructured loans is
accrued according to the most recently agreed upon contractual terms.
48
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Commercial and commercial real estate loans are charged off when, in
management's opinion, the loan is deemed uncollectible. Consumer installment
loans are charged off when 120 days past due. Consumer revolving loans are
charged off when 180 days past due. Accrued interest on these loans is recorded
to interest income. Consumer installment and consumer revolving loans are not
normally placed on nonaccrual status.
Commercial loan commitments and letters of credit are executory contracts
and the notional balances are not reflected on the Bank's Consolidated
Statements of Condition. Fees collected are generally deferred and recognized
over the life of the facility.
Impaired loans (primarily commercial credits) are measured based on the
present value of expected future cash flows (discounted at the loan's effective
interest rate) or, alternatively, at the loan's observable market price or the
fair value of supporting collateral. Impaired loans are defined as those where
it is probable that amounts due for principal or interest according to
contractual terms will not be collected. Nonaccrual and certain restructured
loans meet this definition. Large groups of smaller-balance, homogeneous loans,
primarily residential real estate and consumer installment loans, are excluded
from this definition of impairment. The Bank determines loan impairment when
assessing the adequacy of the allowance for loan losses.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level considered adequate
to provide for probable loan losses. The allowance is increased by provisions
charged to operating expense and reduced by net charge-offs. Known losses of
principal on impaired loans are charged off. The provision for loan losses is
based on past loss experience, management's evaluation of the loan portfolio
under current economic conditions and management's estimate of losses inherent
in the portfolio. Such estimates are reviewed periodically and adjustments, if
necessary, are recorded during the periods in which they become known.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. For financial reporting purposes, depreciation and amortization is
computed on the straight-line basis over the estimated useful lives of the
assets. Estimated useful lives range from 3 years to 39 years. Certain costs of
internally developed software are capitalized and depreciated over the estimated
useful life of the software on a straight-line basis. Leasehold improvements are
amortized on a straight-line basis over the lesser of the lease term or the
useful life of the asset, not to exceed a maximum that ranges from 10 years to
39 years depending on the type of improvement.
BANK-OWNED INSURANCE
The Bank has purchased life insurance coverage for certain officers. The
one-time premiums paid for the policies, which coincide with the initial cash
surrender value, are recorded as assets on the Consolidated Statements of
Condition. Increases or decreases in cash surrender value (other than proceeds
from death benefits) are recorded as other income or other expense. Proceeds
from death benefits first reduce the cash surrender value attributable to the
individual policy and any additional proceeds are recorded as other income.
GOODWILL AND OTHER INTANGIBLE ASSETS
The Bank records goodwill and other intangible assets in connection with
the acquisition of assets from unrelated parties or the acquisition of new
subsidiaries. Goodwill that originated prior to July 1, 2001 was amortized on a
straight-line basis through 2001 year-end but discontinued effective January 1,
2002 in connection with the adoption of SFAS No. 142, "Goodwill and Other
Intangible Assets." Goodwill arising subsequent to July 1, 2001 is not
amortized. Goodwill is periodically assessed for impairment, at least annually.
The excess of carrying value over fair value, if any, is recorded as an
impairment loss.
49
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Intangible assets with finite lives are amortized on either an accelerated
or straight-line basis depending on the character of the acquired asset.
Original lives range from 3 to 15 years. Intangible assets subject to
amortization are reviewed for impairment when events or future assessments of
profitability indicate that the carrying value may not be recoverable. If the
carrying value is not expected to be recovered and the carrying value exceeds
fair value, an impairment loss is recognized. Intangible assets with indefinite
useful lives are not amortized and are reviewed for impairment annually or more
frequently if events indicate impairment. The excess of carrying value over fair
value, if any, is recorded as an impairment loss.
OTHER ASSETS
Property or other assets received in satisfaction of debt are included in
"Other Assets" on the Bank's Consolidated Statements of Condition and are
recorded at the lower of remaining cost or fair value. Fair values for other
real estate owned are reduced by estimated costs to sell. Losses arising from
subsequent write-downs to fair value are charged directly to noninterest
expense.
RETIREMENT AND OTHER POSTEMPLOYMENT BENEFITS
The Bank has noncontributory defined benefit pension plans covering
virtually all its employees. For its primary plan, the policy of the Bank is to,
at a minimum, fund annually an amount necessary to satisfy the requirements
under the Employee Retirement Income Security Act ("ERISA"), without regard to
prior years' contributions in excess of the minimum.
The Bank provides medical care benefits for retirees meeting certain age
and service requirements. The Bank contributes to the cost of coverage based on
employees' length of service.
Postemployment benefits provided to former or inactive employees after
employment but before retirement are accrued if they meet the conditions for
accrual of compensated absences. Otherwise, postemployment benefits are recorded
when expenses are incurred.
INCOME TAXES
The Bank is included in the consolidated Federal income tax return of HFC.
Income tax return liabilities or benefits for all the consolidated entities are
not materially different than they would have been if computed on a separate
return basis.
Deferred tax assets and liabilities, as determined by the temporary
differences between financial reporting and tax bases of assets and liabilities,
are computed using enacted tax rates and laws. The effect on deferred tax assets
and liabilities of a change in tax rates or law is recognized as income or
expense in the period including the enactment date. In addition, the Corporation
assesses the likelihood that deferred tax assets will be realized in future
periods and recognizes a valuation allowance for those assets unlikely to be
realized. Management's assessment of the Corporation's ability to realize these
deferred tax assets includes the use of management's judgment and estimates of
items such as future taxable income, future reversal of existing temporary
differences, carrybacks to prior years and, if appropriate, the use of future
tax planning strategies.
MANAGEMENT'S ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. The areas requiring significant management judgment include provision
and allowance for loan losses, income taxes, pension cost, postemployment
benefits, valuation of intangible assets, fair values and temporary vs. other-
than-temporary impairment.
50
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. SECURITIES
The amortized cost and estimated fair value of securities "available-for-
sale were as follows:
DECEMBER 31, 2005 DECEMBER 31, 2004
---------------------------------------------- ----------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
(IN THOUSANDS) (IN THOUSANDS)
U.S. Treasury............ $ 776,713 $ -- $ 6,386 $ 770,327 $1,317,138 $ 7 $ 5,885 $1,311,260
Federal agency........... 4,198,013 232 37,141 4,161,104 4,372,401 1,078 20,811 4,352,668
Mortgage-backed.......... 184,215 1,813 480 185,548 213,155 3,514 342 216,327
State and municipal...... 584,339 5,486 2,524 587,301 525,684 11,355 1,251 535,788
Non-mortgage asset
backed................. 559,693 4 2,443 557,254 706,119 -- 10,267 695,852
Other.................... 135,879 954 -- 136,833 41,187 1,661 -- 42,848
---------- ------ ------- ---------- ---------- ------- ------- ----------
Total securities......... $6,438,852 $8,489 $48,974 $6,398,367 $7,175,684 $17,615 $38,556 $7,154,743
========== ====== ======= ========== ========== ======= ======= ==========
The following table summarizes, for available-for-sale securities with
unrealized losses as of December 31, 2005, the amount of the unrealized loss and
the related fair value of the securities with unrealized losses. The unrealized
losses have been further segregated by investment securities that have been in a
continuous unrealized loss position for less than 12 months and those that have
been in a continuous unrealized loss position for 12 or more months. The
majority of unrealized losses are attributable to rising interest rates in 2005.
Management believes that all of the unrealized losses are temporary. Management
believes that the Bank has the ability to hold debt securities until maturity
due to its ability to raise funds as needed in a variety of markets using
multiple instruments.
LENGTH OF CONTINUOUS UNREALIZED LOSS POSITION
----------------------------------------------------------------------------------------
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ------------------------------------ -----------------------
UNREALIZED UNREALIZED NUMBER OF UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES SECURITIES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
DECEMBER 31, 2005
U.S. Treasury.......... $ 650,722 $ 5,272 $ 44,660 $ 1,114 4 $ 695,382 $ 6,386
Federal agency......... 2,970,034 26,822 779,845 10,319 32 3,749,879 37,141
Mortgage-backed........ 80,023 449 9,848 31 4 89,871 480
State and municipal.... 274,649 2,016 20,416 508 107 295,065 2,524
Non-mortgage asset
backed............... 543,123 2,443 -- -- -- 543,123 2,443
Other.................. -- -- -- -- -- -- --
---------- ------- ---------- ------- ---- ---------- -------
Temporarily impaired
securities --
available-for-
sale.............. $4,518,551 $37,002 $ 854,769 $11,972 147 $5,373,320 $48,974
========== ======= ========== ======= ==== ========== =======
DECEMBER 31, 2004
U.S. Treasury.......... $ 954,249 $ 4,292 $ 297,980 $ 1,593 $ 1 $1,252,229 $ 5,885
Federal agency......... 2,881,767 16,748 1,015,681 4,064 11 3,897,448 20,812
Mortgage-backed........ 45,290 216 11,978 126 8 57,268 342
State and municipal.... 173,065 764 10,142 486 37 183,207 1,250
Non-mortgage asset
backed............... 695,832 10,267 -- -- -- 695,832 10,267
Other.................. -- -- -- -- -- -- --
---------- ------- ---------- ------- ---- ---------- -------
Temporarily impaired
securities --
available-for-
sale.............. $4,750,203 $32,287 $1,335,781 $ 6,269 57 $6,085,984 $38,556
========== ======= ========== ======= ==== ========== =======
51
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2005 and 2004, available-for-sale and trading account
securities having a carrying amount of $3.71 billion and $4.27 billion,
respectively, were pledged as collateral for certain liabilities, securities
sold under agreement to repurchase, public and trust deposits, trading account
activities and for other purposes where permitted or required by law. The Bank
maintains effective control over the securities sold under agreement to
repurchase and accounts for the transactions as secured borrowings.
The amortized cost and estimated fair value of available-for-sale
securities at December 31, 2005, by contractual maturity, are shown below.
Expected maturities can differ from contractual maturities since borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties.
DECEMBER 31, 2005
----------------------
AMORTIZED FAIR
COST VALUE
---------- ----------
(IN THOUSANDS)
Maturities:
Within 1 year...................................... $2,296,077 $2,281,797
1 to 5 years....................................... 3,401,377 3,379,180
5 to 10 years...................................... 165,778 162,970
Over 10 years...................................... 255,526 252,039
Mortgage-backed.................................... 184,215 185,548
Other securities without stated maturity............. 135,879 136,833
---------- ----------
Total securities................................ $6,438,852 $6,398,367
========== ==========
In 2005, 2004 and 2003, proceeds from the sale of securities available-for-
sale amounted to $154 million, $2.86 billion and $1.65 billion, respectively.
Gross gains of $0.3 million and gross losses of $0.7 million were realized on
these sales in 2005, gross gains of $26.6 million and gross losses of $0.5
million were realized on these sales in 2004 and gross gains of $27.0 million
and gross losses of $0.5 million were realized on these sales in 2003. Net
unrealized holding gains on trading securities decreased during 2005 from an
unrealized gain of $0.7 million at December 31, 2004 to an unrealized gain of
$0.6 million at December 31, 2005. The decrease of $0.1 million has been
included in 2005 earnings.
52
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. LOANS
The following table summarizes loan balances by category:
DECEMBER 31
------------------------
2005 2004
----------- -----------
(IN THOUSANDS)
Domestic loans:
Commercial, financial, agricultural, brokers and
dealers....................................... $ 6,786,089 $ 6,257,931
Real estate construction......................... 1,002,341 736,525
Real estate mortgages............................ 10,738,310 9,364,500
Installment...................................... 4,159,491 3,751,985
Direct lease financing........................... 35,051 18,427
Foreign loans:
Banks and other financial institutions........... -- --
Other, primarily commercial and industrial....... 250,093 89,625
----------- -----------
Total loans................................... 22,971,375 20,218,993
Less allowance for loan losses..................... 317,777 316,575
----------- -----------
Loans, net of allowance for loan losses..... $22,653,598 $19,902,418
=========== ===========
Nonaccrual loans, restructured loans and other nonperforming assets are
summarized below:
YEARS ENDED DECEMBER 31
----------------------------
2005 2004 2003
-------- -------- --------
(IN THOUSANDS)
Nonaccrual loans............................... $130,655 $140,536 $193,538
Restructured loans............................. -- -- --
-------- -------- --------
Total nonperforming loans...................... 130,655 140,536 193,538
Other assets received in satisfaction of debt.. 2,530 1,693 2,452
-------- -------- --------
Total nonperforming assets................ $133,185 $142,229 $195,990
======== ======== ========
Gross amount of interest income that would have
been recorded if year-end nonperforming loans
had been accruing interest at their original
terms........................................ $ 10,650 $ 8,901 $ 13,625
Interest income actually recognized............ -- -- --
-------- -------- --------
Interest shortfall........................... $ 10,650 $ 8,901 $ 13,625
======== ======== ========
90-day past due loans, still accruing interest
(all domestic)............................... $ 47,083 $ 59,309 $ 24,627
======== ======== ========
At December 31, 2005 and 2004, the Bank had no aggregate public and private
sector outstandings to any single country experiencing a liquidity problem which
exceeded one percent of the Bank's consolidated assets. At December 31, 2005 and
2004 commercial loans with a carrying value of $2.91 billion and $2.90 billion,
respectively, were pledged to secure potential borrowings with the Federal
Reserve.
53
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. ALLOWANCE FOR LOAN LOSSES
The changes in the allowance for loan losses are as follows:
YEARS ENDED DECEMBER 31
-----------------------------
2005 2004 2003
-------- -------- ---------
(IN THOUSANDS)
Balance, beginning of year..................... $316,575 $323,776 $ 284,852
-------- -------- ---------
Charge-offs.................................... (41,127) (64,211) (109,454)
Recoveries..................................... 23,888 33,864 18,852
-------- -------- ---------
Net charge-offs.............................. (17,239) (30,347) (90,602)
Provisions charged to operations............... 16,327 21,920 129,526
Acquired reserve............................... 2,114 1,226 --
-------- -------- ---------
Balance, end of year........................... $317,777 $316,575 $ 323,776
======== ======== =========
Details on impaired loans and related allowance are as follows:
IMPAIRED LOANS IMPAIRED LOANS
FOR WHICH THERE FOR WHICH THERE TOTAL
IS A RELATED IS NO RELATED IMPAIRED
ALLOWANCE ALLOWANCE LOANS
--------------- --------------- --------
(IN THOUSANDS)
December 31, 2005
Balance.................................. $92,555 $38,100 $130,655
Related allowance........................ 44,667 -- 44,667
------- ------- --------
Balance, net of allowance................ $47,888 $38,100 $ 85,988
======= ======= ========
December 31, 2004
Balance.................................. $83,474 $57,062 $140,536
Related allowance........................ 37,202 -- 37,202
------- ------- --------
Balance, net of allowance................ $46,272 $57,062 $103,334
======= ======= ========
YEARS ENDED DECEMBER 31
--------------------------------
2005 2004 2003
-------- -------- --------
(IN THOUSANDS)
Average impaired loans........................ $143,839 $160,184 $204,512
======== ======== ========
Total interest income on impaired loans
recorded on a cash basis.................... $ -- $ -- $ --
======== ======== ========
54
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. A summary of these accounts is set forth below:
DECEMBER 31
------------------
2005 2004
-------- --------
(IN THOUSANDS)
Land................................................... $ 68,331 $ 78,113
Premises............................................... 222,895 353,572
Equipment.............................................. 470,456 465,504
Leasehold improvements................................. 65,790 60,902
-------- --------
Total................................................ 827,472 958,091
Accumulated depreciation and amortization.............. 410,894 502,880
-------- --------
Premises and equipment............................... $416,578 $455,211
======== ========
Depreciation and amortization expense was $54.5 million in 2005, $56.2
million in 2004 and $55.3 million in 2003.
On March 1, 2005, the Bank sold to a third party the land and building
located at 111 W. Monroe Street, Chicago, Illinois. Upon sale, the Bank entered
into a leaseback agreement for approximately 50 percent of the building space
with an average lease term of 16 years. The leaseback agreement meets the
criteria to be recorded as an operating lease. The sale resulted in a gain of
$57.0 million, all of which was deferred and is being amortized into income over
the term of the leaseback. $2.7 million of deferred gain was amortized into
income in 2005.
On December 17, 2001, the Bank closed on the sale of its operations center
containing approximately 415,000 gross square feet located at 311 West Monroe
Street, Chicago, Illinois, and leased back approximately 259,000 rentable square
feet. The lease ends on December 31, 2011. The Bank has rights of first offering
to lease additional space and options to extend to December 31, 2026. The
remainder of the building was occupied by third-party tenants. The sale resulted
in a realized gain of $1 million and a deferred gain, which is being amortized
into income over the remaining life of the lease, of $10.5 million and $12.2
million as of December 31, 2005 and 2004, respectively. $1.7 million of deferred
gain was amortized into income in both 2005 and 2004.
In addition, the Bank owns or leases premises at other locations to conduct
branch banking activities.
6. GOODWILL AND OTHER INTANGIBLE ASSETS
The Bank records goodwill and other intangible assets in connection with
the acquisition of assets from unrelated parties or the acquisition of new
subsidiaries. Goodwill and other intangible assets that have indefinite useful
lives are not subject to amortization while intangible assets with finite lives
are amortized. Goodwill is periodically assessed for impairment, at least
annually.
The Bank's goodwill was subject to the annual impairment test in the fourth
quarter of 2005. The fair value of the reporting unit was estimated using a
valuation technique based on discounted cash flow analyses. The test did not
identify potential impairment and no impairment loss was recognized in 2005 or
2004.
The carrying value of the Bank's goodwill was $252 million and $214 million
at December 31, 2005 and December 31, 2004, respectively. The increase was
primarily due to the acquisition completed during the year. See Note 23 to the
Consolidated Financial Statements for additional information on business
combinations. Changes in
55
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the carrying amount of the Bank's goodwill for the years ended December 31, 2005
and December 31, 2004 are included in the following table:
2005 2004
-------- --------
(IN THOUSANDS)
Goodwill at beginning of year.......................... $213,625 $193,346
Acquisitions during the year........................... 38,386 20,279
Other(1)............................................... 280 --
-------- --------
Goodwill at end of year................................ $252,291 $213,625
======== ========
--------
(1) Includes the effect of purchase accounting adjustments related to prior
year purchases.
Besides goodwill, the Bank did not have any intangible assets not subject
to amortization as of December 31, 2005 and 2004.
As of December 31, 2005, the gross carrying amount and accumulated
amortization of the Bank's amortizable intangible assets are included in the
following table:
DECEMBER 31
--------------------------
DECEMBER 31, 2005 2005 2004
---------------------------- ------------ ------------
GROSS CARRYING ACCUMULATED NET CARRYING NET CARRYING
AMOUNT AMORTIZATION VALUE VALUE
-------------- ------------ ------------ ------------
(IN THOUSANDS)
Branch network................... $145,000 $ (91,833) $53,167 $62,833
Core deposits.................... 58,431 (28,840) 29,591 30,302
-------- --------- ------- -------
Total finite life intangibles.. $203,431 $(120,673) $82,758 $93,135
======== ========= ======= =======
Total amortization expense for the Bank's intangible assets was $16.4
million in 2005, $16.3 million in 2004 and $16.1 million in 2003.
Estimated intangible asset amortization expense for existing intangible
assets for the years ending December 31, 2006, 2007, 2008, 2009 and 2010 is
$17.3 million, $17.2 million, $17.1 million, $14.1 million and $10.4 million,
respectively.
MORTGAGE SERVICING RIGHTS
The carrying amount of mortgage servicing rights ("MSR") was $16.0 million
and $14.8 million at December 31, 2005 and 2004, respectively. The fair value of
MSR was $19.9 million and $14.8 million at December 31, 2005 and 2004,
respectively. MSR, included in other assets, of $2.5 million and $4.3 million
were capitalized during 2005 and 2004, respectively. Amortization expense
associated with MSR was $2.1 million and $7.0 million in 2005 and 2004,
respectively. The carrying amount of the MSR valuation allowance was zero and
$0.8 million at December 31, 2005 and 2004, respectively. There were no direct
write-downs in 2005 or 2004.
The Corporation accounts for MSR at the lower of cost or fair value, in
accordance with SFAS No. 140. Fair value of MSR is estimated using discounted
cash flow analyses. The analyses consider portfolio characteristics, servicing
fees, prepayment assumptions, delinquency rates, late charges, other ancillary
revenues, costs to service and other economic factors. The estimated fair value
of MSR is sensitive to changes in interest rates, including their effect on
prepayment speeds. The Corporation stratifies its portfolio on the basis of
market interest rates, loan type and repricing interval. MSR impairment is
considered temporary and recognized as an expense through a valuation allowance
to the extent that the carrying value exceeds estimated fair value.
56
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. DEPOSITS
The following table summarizes deposit balances by category:
DECEMBER 31
------------------------
2005 2004
----------- -----------
(DOLLARS IN THOUSANDS)
Demand deposits.................................... $ 6,077,792 $ 5,432,999
Interest-bearing checking deposits................. 501,108 504,435
Money market accounts.............................. 5,311,203 5,017,448
Statement savings accounts......................... 3,605,195 4,019,737
Savings certificates............................... 4,182,809 3,628,999
Other time deposits................................ 3,148,795 2,476,071
Deposits in foreign offices........................ 1,270,741 1,677,428
----------- -----------
Total deposits................................... $24,097,643 $22,757,117
=========== ===========
Certificates of deposit in denominations of $100,000 or more issued by
domestic offices totaled $5.07 billion and $2.94 billion at December 31, 2005
and 2004, respectively. All time deposits in foreign offices were in
denominations of $100,000 or more.
8. SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE
At various times the Bank enters into sales of U.S. Treasury and Federal
agency securities under agreements to repurchase identical securities. The
amounts received under these agreements represent short-term borrowings and are
reflected as liabilities in the Consolidated Statements of Condition. Securities
sold under agreement to repurchase totaled $2.49 billion and $3.41 billion at
December 31, 2005 and 2004, respectively. Securities sold under agreement to
repurchase are transferred via book-entry to the counterparty, if transacted
with a financial institution or a broker-dealer, or are delivered to customer
safekeeping accounts. The Bank monitors the market value of these securities and
adjusts the level of collateral for repurchase agreements, as appropriate. The
Bank maintains effective control over the securities sold under agreement to
repurchase and accounts for the transactions as secured borrowings.
SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE
2005 2004
---------- ----------
(DOLLARS IN THOUSANDS)
Amount outstanding at end of year.................... $2,485,650 $3,405,296
Highest amount outstanding as of any month-end during
the year........................................... $3,320,402 $3,930,203
Daily average amount outstanding during the year..... $2,974,135 $3,321,449
Daily average annualized rate of interest............ 3.01% 1.22%
57
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. SENIOR NOTES AND LONG-TERM NOTES
The following table summarizes the Bank's long-term notes:
DECEMBER 31
------------------
2005 2004
-------- --------
(IN THOUSANDS)
Floating rate subordinated note to Bankcorp due
December 23, 2012.................................... $ 28,500 $ 28,500
Floating rate subordinated note to Bankcorp due May 30,
2013................................................. 34,000 34,000
Floating rate subordinated note to Bankcorp due
November 26, 2013.................................... 24,000 24,000
Floating rate subordinated note to Bankcorp due
February 26, 2014.................................... 6,250 6,250
Floating rate subordinated note to Bankcorp due May 31,
2014................................................. 100,000 100,000
Floating rate subordinated note to Bankcorp due May 31,
2016................................................. 100,000 100,000
-------- --------
Total subordinated notes............................. 292,750 292,750
Floating rate senior note to BMO subsidiary due June
15, 2010............................................. 250,000 --
-------- --------
Total subordinated and senior notes.................... $542,750 $292,750
======== ========
All of the Bank's subordinated notes are unsecured obligations, ranking on
a parity with all unsecured and subordinated indebtedness of the Bank. Neither
the subordinated notes nor the senior notes are subject to redemption prior to
maturity at the election of the debtholders. The interest rate on the
subordinated note due December 23, 2012, May 30, 2013, November 26, 2013, and
February 26, 2014 reprice quarterly and float at 50 basis points above 90 day
London Interbank Offering Rate ("LIBOR"). The interest rate on the floating rate
note due May 31, 2014 reprices quarterly and floats at 35 basis points above 90
day LIBOR. The interest rate on the floating rate note due May 31, 2016 reprices
quarterly and floats at 37.5 basis points above 90 day LIBOR. The interest rate
on the senior note due June 15, 2010 reprices quarterly and floats at 12 basis
points above 90 day LIBOR. At year-end 2005, 90 day LIBOR was 4.54 percent.
The scheduled principal payment on long-term notes for the years ending
December 2006, 2007, 2008, 2009, 2010, 2011 and thereafter is $0.0 million, $0.0
million, $0.0 million, $0.0 million, $250.0 million and $292.8 million
respectively.
The Bank offers to institutional investors from time to time, unsecured
short-term and medium-term bank notes in an aggregate principal amount of up to
$1.50 billion outstanding at any time. The term of each note could range from 14
days to 15 years. These senior notes are subordinated to deposits and rank pari
passu with all other unsecured senior indebtedness of the Bank. As of December
31, 2005, two $100 million senior short-term notes were outstanding with an
original maturity of 365 days (remaining maturity of 68 days) and stated
interest rate of 4.32 percent. A $50 million senior short-term note was
outstanding with an original maturity of 62 days (remaining maturity of 39 days)
and stated interest rate of 4.33 percent, a $250 million senior short-term note
was outstanding with an original maturity of 32 days (remaining maturity of 9
days) and stated interest rate of 4.28 percent and a $300 million senior short-
term note was outstanding with an original maturity of 63 days (remaining
maturity of 18 days) and variable interest rate of 4.42 percent. As of December
31, 2004, a $200 million senior short-term note was outstanding with an original
maturity of 32 days (remaining maturity of 28 days) and stated interest rate of
2.34 percent.
10. FAIR VALUE OF FINANCIAL INSTRUMENTS
Generally accepted accounting principles require the disclosure of
estimated fair values for both on and off-balance-sheet financial instruments.
The Bank's fair values are based on quoted market prices when available. For
financial instruments not actively traded, such as certain loans, deposits, off-
balance-sheet transactions and long-term borrowings, fair values have been
estimated using various valuation methods and assumptions. Although
58
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
management used its best judgment in estimating these values, there are inherent
limitations in any estimation methodology. In addition, accounting
pronouncements require that fair values be estimated on an item-by-item basis,
thereby ignoring the impact a large sale would have on a thin market and
intangible values imbedded in established lines of business. Therefore, the fair
value estimates presented herein are not necessarily indicative of the amounts
the Bank could realize in an actual transaction. The fair value estimation
methodologies employed by the Bank were as follows:
The carrying amounts for cash and demand balances due from banks along
with short-term money market assets and liabilities (including interest
bearing deposits at banks, Federal funds sold, Federal funds purchased and
securities sold under agreement to repurchase) reported on the Bank's
Consolidated Statements of Condition were considered to be the best
estimates of fair value for these financial instruments due to the short
term nature of the assets and liabilities. Fair values of trading account
assets and available-for-sale securities were based on quoted market
prices.
A variety of methods were used to estimate the fair value of loans.
Changes in estimated fair value of loans reflect changes in credit risk and
general interest rates that have occurred since the loans were originated.
Fair values of floating rate loans, including commercial, broker dealer,
financial institution, construction, consumer and home equity, were assumed
to be the same as carrying value since the loans' interest rates
automatically reprice to market. Fair values of residential mortgages were
based on current prices for securities backed by similar loans. For long-
term fixed rate loans, including consumer installment and commercial
mortgage loans, fair values were estimated based on the present value of
future cash flows with current market rates as discount rates.
Additionally, management considered estimated values of collateral when
nonperforming loans were secured by real estate.
The fair values of accrued interest receivable and payable approximate
carrying values due to the short-term nature of these assets and
liabilities.
The fair values of bank-owned insurance approximate carrying value,
because upon liquidation of these investments the Bank would receive the
cash surrender value that equals carrying value.
The fair value of loans held for sale is based on future mortgage-
backed security prices corresponding to the mortgage loan pools.
The fair values of demand deposits, savings accounts, interest-bearing
checking deposits and money market accounts were the amounts payable on
demand at the reporting date, or the carrying amounts. The fair value of
time deposits was estimated using a discounted cash flow calculation with
current market rates offered by the Bank as discount rates.
The fair value of short-term borrowings and short-term senior notes
approximates carrying value because the average maturity is less than one
year.
The fair value of minority interest -- preferred stock of subsidiary
(Harris Preferred Capital Corporation) approximates carrying value as the
preferred stock has a liquidation preference that equals book value.
The fair value of preferred stock issued to Harris Bankcorp, Inc. is
equal to its May 2005 payoff amount.
The fair value of floating rate long-term notes was assumed to be the
same as carrying value since the notes' interest rates automatically
reprice to market.
The fair value of credit facilities approximates their carrying value
(i.e. deferred income) or estimated cost that would be incurred to induce
third parties to assume these commitments.
59
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The estimated fair values of the Bank's financial instruments at December
31, 2005 and 2004 are presented in the following table. See Note 11 to
Consolidated Financial Statements for additional information regarding fair
values of off-balance-sheet financial instruments.
DECEMBER 31
--------------------------------------------------
2005 2004
------------------------ ------------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
----------- ----------- ----------- -----------
(IN THOUSANDS)
ASSETS
Cash and demand balances due from
banks............................... $ 1,303,916 $ 1,303,916 $ 947,580 $ 947,580
Money market assets:
Interest-bearing deposits at banks.. 1,007,212 1,007,212 662,366 662,366
Federal funds sold.................. 303,130 303,130 94,950 94,950
Securities available-for-sale......... 6,398,367 6,398,367 7,154,743 7,154,743
Trading account assets................ 181,121 181,121 90,130 90,130
Loans, net of unearned income and
allowance for loan losses........... 22,653,598 22,558,166 19,902,418 19,848,160
Accrued interest receivable........... 155,093 155,093 122,830 122,830
Bank-owned insurance.................. 1,115,172 1,115,172 1,072,660 1,072,660
Loans held for sale................... 32,364 32,897 43,423 43,916
----------- ----------- ----------- -----------
Total on-balance-sheet financial
assets......................... $33,149,973 $33,055,074 $30,091,100 $30,037,335
=========== =========== =========== ===========
LIABILITIES
Deposits:
Demand deposits..................... $15,354,432 $15,354,432 $14,951,510 $14,951,510
Time deposits....................... 8,743,211 8,743,211 7,805,607 7,809,066
Federal funds purchased............... 975,990 975,990 1,114,400 1,114,400
Securities sold under agreement to
repurchase.......................... 2,485,650 2,485,650 3,405,296 3,405,296
Short-term borrowings................. 2,041,715 2,041,715 214,145 214,145
Short-term senior notes............... 800,000 800,000 200,000 200,000
Accrued interest payable.............. 57,857 57,857 31,791 31,791
Minority interest -- preferred stock
of subsidiary....................... 250,000 250,000 250,000 250,000
Preferred stock issued to Harris
Bankcorp, Inc. ..................... -- -- 5,000 5,000
Long-term notes -- senior............. 250,000 250,000 -- --
Long-term notes -- subordinated....... 292,750 292,750 292,750 292,720
----------- ----------- ----------- -----------
Total on-balance-sheet financial
liabilities.................... $31,251,605 $31,251,605 $28,270,499 $28,273,928
=========== =========== =========== ===========
OFF-BALANCE-SHEET CREDIT FACILITIES
(POSITIVE POSITIONS/(OBLIGATIONS))
Loan commitments...................... $ 1,186 $ 1,186 $ (8,293) $ (8,293)
Standby letters of credit............. (1,633) (1,633) (1,378) (1,378)
----------- ----------- ----------- -----------
Total off-balance-sheet credit
facilities..................... $ (447) $ (447) $ (9,671) $ (9,671)
=========== =========== =========== ===========
60
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Bank utilizes various financial instruments with off-balance-sheet risk
in the normal course of business to meet its customers' financing and risk
management needs. The Bank's major categories of financial instruments with off-
balance-sheet risk include credit facilities, financial guarantees and various
securities-related activities.
CREDIT FACILITIES
Credit facilities with off-balance-sheet risk include commitments to extend
credit and commercial letters of credit.
Commitments to extend credit are contractual agreements to lend to a
customer as long as contract terms have been met. They generally require payment
of a fee and have fixed expiration dates. The Bank's commitments serve both
business and individual customer needs, and include commercial loan commitments,
home equity lines, commercial real estate loan commitments and mortgage loan
commitments. The maximum potential amount of undiscounted future payments the
Bank could be required to make is represented by the total contractual amount of
commitments, which was $13.7 billion and $11.7 billion at December 31, 2005 and
2004, respectively. Since only a portion of commitments will ultimately be drawn
down, the Bank does not expect to provide funds for the total contractual
amount. Risks associated with certain commitments are reduced by participations
to third parties, which at December 31, 2005, totaled $909 million and at
December 31, 2004, totaled $970 million.
Commercial letters of credit are commitments to make payments on behalf of
customers when letter of credit terms have been met. Maximum risk of accounting
loss is represented by total commercial letters of credit outstanding of $31
million at December 31, 2005 and $30 million at December 31, 2004.
Credit risks associated with all of these facilities are mitigated by
reviewing customers' creditworthiness on a case-by-case basis, obtaining
collateral, limiting loans to individual borrowers, setting restrictions on
long-duration maturities and establishing stringent covenant terms outlining
performance expectations which, if not met, may cause the Bank to terminate the
contract. Credit risks are further mitigated by monitoring and maintaining
portfolios that are well-diversified.
Collateral is required to support certain of these credit facilities when
they are drawn down and may include equity and debt securities, commodities,
inventories, receivables, certificates of deposit, savings instruments, fixed
assets, real estate, life insurance policies and memberships on national or
regional stock and commodity exchanges. Requirements are based upon the risk
inherent in the credit and are more stringent for firms and individuals with
greater default risks. The Bank monitors collateral values and appropriately
perfects its security interest. Periodic evaluations of collateral adequacy are
performed by Bank personnel.
The fair value of credit facilities (i.e. deferred income net of deferred
expense) is approximately equal to their carrying value of a $1.2 million asset
at December 31, 2005 and an $8.3 million obligation at December 31, 2004.
FINANCIAL GUARANTEES
Financial guarantees with off-balance-sheet risk include standby letters of
credit, loans sold with recourse and written put options.
Standby letters of credit are unconditional commitments that guarantee the
obligation of a customer to a third party should that customer default. They are
issued to support financial and performance-related obligations including
brokers' margin maintenance, industrial revenue bond repayment, debt repayment,
construction contract performance and trade agreement performance. The Bank's
maximum risk of accounting loss for these items is represented by the total
commitments outstanding of $2.58 billion at December 31, 2005 and $2.99 billion
at December 31, 2004. Risks associated with standby letters of credit are
reduced by participations to third parties which totaled $0.73 billion at
December 31, 2005 and $1.07 billion at December 31, 2004. In most cases, these
commitments expire within three years without being drawn upon. The fair value
of standby letters of credit (i.e.
61
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
deferred income) approximates their carrying value of $1.6 million at December
31, 2005 and $1.4 million at December 31, 2004.
The Bank has sold mortgage loans with limited recourse. The recourse
provisions require the Bank to reimburse the buyer, based on pre-determined
rates, upon the occurrence of certain credit-related events. The maximum amount
payable under the recourse provisions is $7.0 million at December 31, 2005 and
2004. The carrying amount of the recourse liability is $0.3 million at December
31, 2005 and $0.5 million at December 31, 2004.
Written put options are contracts that provide the buyer the right (but not
the obligation) to sell a financial instrument at a specified price, either
within a specified period of time or on a certain date. The Bank writes put
options, providing the buyer the right to require the Bank to buy the specified
assets per the contract terms. The maximum amount payable for the written put
options is equal to their notional amount of $923 million and $930 million at
December 31, 2005 and 2004, respectively. The fair value of the derivative
liability is $8.3 million at December 31, 2005 and $4.7 million at December 31,
2004.
SECURITIES ACTIVITIES
The Bank's securities activities that have off-balance-sheet risk include
municipal bond underwriting and short selling of securities.
Through its municipal bond underwriting activities, the Bank commits to buy
and offer for resale newly issued bonds. The Bank is exposed to market risk
because it may be unable to resell its inventory of bonds profitably as a result
of unfavorable market conditions. In syndicate arrangements, the Bank is
obligated to fulfill syndicate members' commitments should they default. The
syndicates of which the Bank was a member had underwriting commitments totaling
$137 million at December 31, 2005 and $59 million at December 31, 2004.
Security short selling, defined as selling of securities not yet owned,
exposes the Bank to off-balance-sheet market risk because the Bank may be
required to buy securities at higher prevailing market prices to cover its short
positions. The Bank had no short position at December 31, 2005 and a short
position of $0.1 million at December 31, 2004.
COMMITMENTS TO INVEST IN EQUITY SECURITIES
The Corporation's commitments to invest in equity securities that have off-
balance-sheet risk relate to uncalled capital commitments for security
investments. The Corporation's commitment to invest in equity securities was $6
million at December 31, 2005 and $9 million at December 31, 2004.
12. DERIVATIVE FINANCIAL INSTRUMENTS
The Bank utilizes various derivative financial instruments in the normal
course of business to a) meet its customers' financing and risk management
needs, b) reduce its own risk exposure, and c) produce fee income and trading
profits. Fair values of derivative financial instruments are based on market
prices of comparable instruments, pricing models using year-end rates and
counterparty credit ratings.
All derivative instruments are recognized at fair value in the Consolidated
Statements of Condition. All derivative instruments are designated either as
hedges or held for trading or non-hedging purposes.
The Bank uses various interest rate, foreign exchange, equity, and
commodity derivative contracts as part of its dealer and trading activities or
in the management of its risk strategy. Interest rate contracts may include
futures, forwards, forward rate agreements, option contracts, caps, floors,
collars and swaps. Foreign exchange contracts may include spot, futures,
forwards, option contracts and swaps. Equity contracts and commodity contracts
may include options and swaps. The Bank enters into derivative contracts with
BMO to facilitate a more efficient use of
62
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
combined resources and to better serve customers. See Note 24 for additional
information on related party transactions.
At December 31, 2005, the Bank recorded, for dealer and trading activities
and for risk management activities that do not otherwise qualify for hedge
accounting, the fair value of derivative instrument assets of $76 million in
other assets and derivative instrument liabilities of $75 million in other
liabilities. At December 31, 2004, the Bank recorded the fair value of
derivative instrument assets of $174 million in other assets and derivative
instrument liabilities of $173 million in other liabilities. These amounts
reflect the netting of certain derivative instrument assets and liabilities when
the conditions in FASB Interpretation ("FIN") No. 39, "Offsetting of Amounts
Related to Certain Contracts," have been met.
DEALER AND TRADING ACTIVITY
Interest rate contracts
As dealer, the Bank serves customers seeking to manage interest rate risk
by entering into contracts as counterparty to their (customer) transactions. In
its trading activities, the Bank uses interest rate contracts to profit from
expected future market movements.
These contracts may create exposure to both credit and market risk.
Replacement risk, the primary component of credit risk, is the risk of loss
should a counterparty default following unfavorable market movements and is
measured as the Bank's cost of replacing contracts at current market rates. The
Bank manages credit risk by establishing credit limits for customers and
products through an independent corporate-wide credit review process and by
continually monitoring exposure against those limits to ensure they are not
exceeded. Credit risk is, in many cases, further mitigated by the existence of
netting agreements that provide for netting of contractual receivables and
payables in the event of default or bankruptcy. Netting agreements apply to
situations where the Bank is engaged in more than one outstanding derivative
transaction with the same counterparty and also has a legally enforceable master
netting agreement with that counterparty.
Market risk is the potential for loss arising from potential adverse
changes in underlying market factors, including interest and foreign exchange
rates. The Bank manages market risk through the imposition of integrated value-
at-risk limits and an active, independent monitoring process.
Value-at-risk methodology is used for measuring the market risk of the
Bank's trading positions. This statistical methodology uses recent market
volatility to estimate the maximum daily trading loss that the Bank would expect
to incur, on average, 99 percent of the time. The model also measures the effect
of correlation among the various trading instruments to determine how much risk
is eliminated by offsetting positions.
Futures and forward contracts are agreements in which the Bank is obligated
to make or take delivery, at a specified future date, of a specified instrument,
at a specified price or yield. Futures contracts are exchange traded and,
because of exchange requirements that gains and losses be settled daily, create
negligible exposure to credit risk.
Forward rate agreements are arrangements between two parties to exchange
amounts, at a specified future date, based on the difference between an agreed
upon interest rate and reference rate applied to a notional principal amount.
These agreements enable purchasers and sellers to fix interest costs and
returns.
Options are contracts that provide the buyer the right (but not the
obligation) to purchase or sell a financial instrument, at a specified price,
either within a specified period of time or on a certain date. Interest rate
guarantees (caps, floors and collars) are agreements between two parties that,
in general, establish for the purchaser a maximum level of interest expense or a
minimum level of interest revenue based on a notional principal amount for a
specified term. Options and interest rate guarantees written create exposure to
market risk. As a writer of interest rate options and guarantees, the Bank
receives a premium at the outset of the agreement and bears the risk of an
unfavorable change in the price of the financial instrument underlying the
option or interest rate guarantee. Options
63
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and interest rate guarantees purchased create exposure to credit risk and, to
the extent of the premium paid or unrealized gain recognized, market risk.
Interest rate swaps are contracts involving the exchange of interest
payments based on a notional amount for a specified period. Most of the Bank's
activity in swaps is as intermediary in the exchange of interest payments
between customers, although the Bank also uses swaps to manage its own interest
rate exposure (see discussion of risk management activity).
Foreign exchange contracts
The Bank is a dealer in foreign exchange ("FX") contracts. FX contracts may
create exposure to market and credit risk, including replacement risk and
settlement risk. Credit risk is managed by establishing limits for customers
through an independent corporate-wide credit approval process and continually
monitoring exposure against those limits. In addition, both settlement and
replacement risk are reduced through netting by novation, agreements with
counterparties to offset certain related obligations. Market risk is managed
through establishing exposure limits by currency and monitoring actual exposure
against those limits, entering into offsetting positions, and closely monitoring
price behavior.
The Bank and BMO combine their U.S. FX revenues. Under this arrangement, FX
net profit is shared by the Bank and BMO in accordance with a specific formula
set forth in the agreement. This agreement expires on October 31, 2006, but may
be extended at that time. Either party may terminate the arrangement at its
option. FX revenues are reported net of expenses. Net gains (losses) from
dealer/trading foreign exchange contracts, for the years ended December 31, 2005
and December 31, 2004, totaled $5.6 million and $5.9 million, respectively, of
net profit under the aforementioned agreement with BMO.
At December 31, 2005, approximately 98 percent of the Bank's gross notional
positions in foreign currency contracts are represented by seven currencies:
Eurodollar, Canadian dollar, British pound, Australian dollar, Swedish krona,
Japanese yen and the Mexican peso.
Foreign exchange contracts include spot, futures, forwards, options and
swaps that enable customers to manage their foreign exchange risk. Spot, future
and forward contracts are agreements to exchange currencies at a future date, at
a specified rate of exchange. Foreign exchange option contracts give the buyer
the right and the seller an obligation (if the buyer asserts his right) to
exchange currencies during a specified period (or on a certain date in the case
of "European" options) at a specified exchange rate. Cross currency swap
contracts are agreements to exchange principal denominated in two different
currencies at the spot rate and to repay the principal at a specified future
date and exchange rate.
Equity contracts
The Bank enters into equity contracts that enable customers to manage the
risk associated with equity price fluctuations. Equity contracts include options
and swaps.
Commodity contracts
The Bank enters into commodity contracts that enable customers to manage
the risk associated with commodity price fluctuations. Commodity contracts
include options and swaps.
RISK MANAGEMENT ACTIVITY
In addition to its dealer and trading activities, the Bank uses interest
rate contracts, primarily swaps, and foreign exchange contracts to reduce the
level of financial risk inherent in mismatches between the interest rate
sensitivities and foreign currency exchange rate fluctuations of certain assets
and liabilities. For non-trading risks, market risk is controlled by actively
managing the asset and liability mix, either directly through the balance sheet
64
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
or with off-balance sheet derivative instruments. Measures also focus on
interest rate exposure gaps and sensitivity to rate changes.
The Bank has an interest rate risk management strategy that incorporates
the use of derivative instruments to minimize significant unplanned fluctuations
in earnings that may be caused by interest rate volatility. The Bank manages
interest rate sensitivity by modifying the repricing or maturity characteristics
of certain assets and liabilities so that net interest margin is not adversely
affected, on a material basis, by movements in interest rates. As a result of
interest rate fluctuations, fixed rate assets will appreciate or depreciate in
market value. The effect of the unrealized appreciation or depreciation will
generally be offset by the gains or losses on the derivative instruments.
The Bank has a foreign currency risk management strategy that incorporates
the use of derivative instruments to minimize significant unplanned fluctuations
in earnings that may be caused by foreign currency exchange rate fluctuations.
Certain assets and liabilities are denominated in foreign currency, creating
exposure to changes in exchange rates. The Bank uses cross currency interest
rate swaps and foreign exchange forward contracts to hedge the risk.
Risk management activities include the following derivative transactions
that qualify for hedge accounting.
Fair value hedges
The Bank uses interest rate swaps to alter the character of 1) revenue
earned on certain long-term, fixed rate loans and available-for-sale securities
and 2) interest paid on certain long-term, fixed rate deposits. Interest rate
swaps convert the loans, securities and deposits from fixed rate to variable
rate. Interest rate swap contracts generally involve the exchange of fixed and
variable rate interest payments between two parties, based on a common notional
amount and maturity date.
For fair value hedges, as of December 31, 2005 the Bank recorded the fair
value of derivative instrument assets of $0.1 million in other assets and
liabilities of $75.4 million in other liabilities. For fair value hedges, as of
December 31, 2004 the Bank recorded the fair value of derivative instrument
liabilities of $38.0 million in other liabilities. No hedge ineffectiveness was
recorded to earnings for the years ended December 31, 2005 and December 31,
2004. Gains or losses resulting from hedge ineffectiveness are recorded in
noninterest income.
Cash flow hedges
The Bank uses interest rate swaps to reduce the variability associated with
future interest payments on floating-rate prime-based loans and available-for-
sale securities. Interest rate swaps convert the expected cash flows on the
loans and securities from variable to fixed. Changes in the fair value of the
swaps that are effective hedges are recorded in other comprehensive income.
Gains or losses resulting from hedge ineffectiveness are recorded in noninterest
income.
For cash flow hedges, as of December 31, 2005 the Bank recorded the fair
value of derivative instrument liabilities of $0.8 million in other liabilities.
A loss of $0.6 million (after-tax) in hedge ineffectiveness was recorded to
earnings for the year ended December 31, 2005. The unrealized gains (losses) in
accumulated other comprehensive income ("AOCI") related to the interest rate
swaps are reclassified to earnings in the same period that the interest on the
floating-rate assets affect earnings. Approximately $5.7 million (after-tax) of
net losses is expected to be reclassified to earnings over the next twelve
months.
For cash flow hedges, as of December 31, 2004 the Bank recorded the fair
value of derivative instrument liabilities of $8.6 million in other liabilities.
No hedge ineffectiveness was recorded to earnings for the year ended December
31, 2004. As of September 30, 2004 certain swaps were dedesignated as hedges in
order to comply with FAS 133 Implementation Issue No. G25, "Cash Flow Hedges:
Using the First-Payments-Received Technique in Hedging the Variable Interest
Payments on a Group of Non-Benchmark-Rate-Based Loans." Losses from the hedge
65
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
dedesignation were reclassified from AOCI and recorded in noninterest income for
the year ended December 31, 2004 but were not material to the consolidated
financial statements of the Bank.
Risk management activities also include the following derivative
transactions that do not otherwise qualify for hedge accounting.
Foreign exchange contracts are used to stabilize any currency exchange rate
fluctuation for certain senior notes and certain loans. The derivative
instruments, primarily cross currency interest rate swaps and to a lesser extent
forward contracts, do not qualify for hedge accounting and are accounted for at
fair value.
The Bank has qualifying mortgage loan commitments that are intended to be
sold in the secondary market. These loan commitments are derivatives and are
recorded as liabilities at fair value. The Bank enters into forward sales of
mortgage-backed securities to minimize its exposure to interest rate volatility.
These forward sales of mortgage-backed securities are also derivatives and are
accounted for at fair value.
Interest rate swaps are used to modify exposure to variability in cash
flows for certain syndication arrangements, where the Bank is agent. The
derivative instruments do not qualify for hedge accounting and are accounted for
at fair value.
13. CONCENTRATIONS OF CREDIT RISK IN FINANCIAL INSTRUMENTS
The Bank had one major concentration of credit risk arising from financial
instruments at December 31, 2005 and 2004. This concentration was the Midwest
geographic area. This concentration exceeded 10 percent of the Bank's total
credit exposure, which is the total potential accounting loss should all
customers fail to perform according to contract terms and all collateral prove
to be worthless.
MIDWESTERN GEOGRAPHIC AREA
A majority of the Bank's customers are located in the Midwestern region of
the United States, defined here to include Illinois, Indiana, Iowa, Michigan,
Minnesota, Missouri, Ohio and Wisconsin. The Bank provides credit to these
customers through a broad array of banking and trade financing products
including commercial loans, commercial loan commitments, commercial real estate
loans, consumer installment loans, mortgage loans, home equity loans and lines,
standby and commercial letters of credit and banker's acceptances. The financial
viability of customers in the Midwest is, in part, dependent on the region's
economy. The Bank's maximum risk of accounting loss, should all customers making
up the Midwestern concentration fail to perform according to contract terms and
all collateral prove to be worthless, was approximately $31.7 billion or 66
percent of the Bank's total credit exposure at December 31, 2005 and $30.2
billion or 67 percent of the Bank's total credit exposure at December 31, 2004.
The Bank manages this exposure by continually reviewing local market
conditions and customers, adjusting individual and industry exposure limits
within the region and by obtaining or closely monitoring collateral values. See
Note 11 to Financial Statements for information on collateral supporting credit
facilities.
14. EMPLOYEE BENEFIT PLANS
The Bank has noncontributory defined benefit pension plans covering
virtually all its employees as of December 31, 2005. Most of the employees
participating in retirement plans were included in one primary plan ("primary
plan") during the three-year period ended December 31, 2005. The plan is a
multiple-employer plan covering the Bank's employees as well as persons employed
by certain affiliated entities.
Certain employees participating in the primary plan are also covered by a
supplemental unfunded retirement plan. The purpose of this plan is to extend
full retirement benefits to individuals without regard to statutory limitations
for qualified funded plans.
66
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Effective January 1, 2002, the plan's benefit formula for new employees was
changed to an account-based formula from a final average pay formula. The
account-based benefit formula is based upon eligible pay, age and length of
service. Prior to January 1, 2002, the plan's benefit formula was a final
average pay formula, based upon length of service and an employee's highest
qualifying compensation during five consecutive years of active employment less
an estimated Social Security benefit. For employees who were employed as of
December 31, 2001 and leave the Corporation on or after January 1, 2002,
benefits are initially calculated two ways: under the account-based formula for
service beginning January 1, 2002 and under the final average pay formula for
all service. This latter group of employees will receive that retirement benefit
which yields the highest return.
The policy for this plan is to have the participating entities, at a
minimum, fund annually an amount necessary to satisfy the requirements under
ERISA, without regard to prior years' contributions in excess of the minimum.
For 2006 (plan year 2006), the estimated pension contribution is approximately
$22.5 million. The total consolidated pension expense of the Bank, including the
supplemental unfunded retirement plan (excluding settlement losses and
curtailment gains), for 2005, 2004, and 2003 was $39.3 million, $37.3 million
and $31.7 million, respectively. The qualified pension accumulated benefit
obligation as of December 31, 2005, 2004, and 2003 was $366 million, $327
million and $296 million, respectively.
For the supplemental unfunded retirement plan, no settlement losses were
recorded in 2005 or 2004 and a $2.6 million settlement loss was recognized in
2003.
In addition to pension benefits, the Bank provides medical care benefits
for retirees (and their dependents) who have attained age 55 and have at least
10 years of service. The Bank also provides medical care benefits for disabled
employees and widows of former employees (and their dependents). The Bank
provides these medical care benefits through a self-insured plan. Under the
terms of the plan, the Bank contributes to the cost of coverage based on
employees' length of service. Cost sharing with plan participants is
accomplished through deductibles, coinsurance and out-of-pocket limits. Funding
for the plan largely comes from the general assets of the Bank supplemented by
contributions to a trust fund created under Internal Revenue Code Section
401(h).
Effective July 1, 2004 the Bank adopted FASB Staff Position No. 106-2,
"Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement, and Modernization Act of 2003." The Bank elected retroactive
application to December 31, 2003. Under the Act, an employer is eligible for a
federal subsidy if the prescription drug benefit available under its
postretirement medical plan is "actuarially equivalent" to the Medicare Part D
benefit. The Bank recorded a reduction to postretirement medical expense in the
amount of $1.6 million in 2005 and $0.7 million in 2004, as determined by the
Bank's actuarial consultants. Based on their analysis, the Bank's postretirement
benefit medical plan would pass the test for actuarial equivalence and would
qualify for the subsidy.
67
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following tables set forth the change in benefit obligation and plan
assets for the pension and postretirement medical care benefit plans for the
Bank:
POSTRETIREMENT MEDICAL
PENSION BENEFITS BENEFITS
------------------------------- ----------------------------
2005** 2004** 2003** 2005** 2004** 2003**
--------- --------- --------- -------- -------- --------
(IN THOUSANDS)
CHANGE IN BENEFIT OBLIGATION*
Benefit obligation at
beginning of year.......... $ 399,814 $ 384,344 $ 352,983 $ 57,568 $ 64,849 $ 53,846
Service cost................. 19,636 21,717 18,706 2,148 2,536 2,209
Interest cost................ 24,446 21,890 21,794 3,198 3,481 3,532
Plan Amendments.............. -- -- -- -- -- --
Acquisitions/transfers....... -- 40 -- -- -- --
Medicare drug legislation.... -- -- -- (7,491) (11,971) --
Benefits paid (net of
participant
contributions)............. (29,851) (31,500) (42,600) (2,624) (2,265) (2,227)
Actuarial (gain) or loss..... 28,975 3,323 33,461 11,716 938 7,489
--------- --------- --------- -------- -------- --------
Benefit obligation at end of
year....................... $ 443,020 $ 399,814 $ 384,344 $ 64,515 $ 57,568 $ 64,849
========= ========= ========= ======== ======== ========
CHANGE IN PLAN ASSETS
Fair value of plan assets at
beginning of year.......... $ 247,480 $ 225,830 $ 216,870 $ 43,208 $ 37,258 $ 31,325
Actual return on plan
assets..................... 41,435 34,694 36,408 7,107 5,950 5,933
Acquisitions/transfers....... -- 358 -- -- -- --
Employer contribution........ 34,772 18,098 15,152 -- -- --
Benefits paid................ (29,851) (31,500) (42,600) -- -- --
--------- --------- --------- -------- -------- --------
Fair value of plan assets at
end of year ***............ $ 293,836 $ 247,480 $ 225,830 $ 50,315 $ 43,208 $ 37,258
========= ========= ========= ======== ======== ========
Funded Status................ $(149,184) $(152,334) $(158,514) $(14,201) $(14,360) $(27,590)
Contributions made between
measurement date (September
30) and end of year........ 6,041 -- -- -- -- --
Unrecognized actuarial (gain)
or loss.................... 133,126 139,031 162,363 (5,180) (5,664) 8,097
Unrecognized transition
(asset) or obligation...... -- -- -- 11,787 13,890 15,641
Unrecognized prior service
cost....................... 3,395 3,116 2,836 657 846 1,015
--------- --------- --------- -------- -------- --------
Net amount at year-end....... $ (6,622) $ (10,187) $ 6,685 $ (6,937) $ (5,288) $ (2,837)
========= ========= ========= ======== ======== ========
68
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
POSTRETIREMENT MEDICAL
PENSION BENEFITS BENEFITS
------------------------------- ----------------------------
2005** 2004** 2003** 2005** 2004** 2003**
--------- --------- --------- -------- -------- --------
(IN THOUSANDS)
AMOUNTS RECOGNIZED IN THE
STATEMENT OF CONDITION
CONSIST OF:
Prepaid benefit cost......... $ -- $ -- $ -- $ -- $ -- $ --
Accrued benefit liability.... (45,068) (51,950) (45,916) (6,937) (5,288) (2,837)
Intangible asset............. 3,392 3,114 2,836 -- -- --
Accumulated other
comprehensive income (gross
of tax).................... 35,054 38,649 49,765 -- -- --
--------- --------- --------- -------- -------- --------
Net amount recognized at
year-end................... $ (6,622) $ (10,187) $ 6,685 $ (6,937) $ (5,288) $ (2,837)
========= ========= ========= ======== ======== ========
Other comprehensive income
attributable to change in
additional minimum
liability (gross of tax)... $ (3,595) $ (11,116) $ 7,953 $ -- $ -- $ --
COMPONENTS OF NET PERIODIC
BENEFIT COST
Service cost................. $ 19,636 $ 21,717 $ 18,706 $ 2,148 $ 2,536 $ 2,209
Interest cost................ 24,446 21,890 21,794 3,198 3,481 3,532
Expected return on plan
assets..................... (15,302) (15,794) (18,017) (2,913) (2,939) (2,426)
Amortization of prior service
cost....................... (279) (279) (280) 169 169 169
Amortization of transition
(asset) or obligation...... -- -- -- 1,751 1,751 1,751
Amortization of actuarial
(gain) or loss............. 8,747 7,444 4,194 -- (8) --
--------- --------- --------- -------- -------- --------
Net periodic benefit cost.... $ 37,248 $ 34,978 $ 26,397 $ 4,353 $ 4,990 $ 5,235
========= ========= ========= ======== ======== ========
--------
* Benefit obligation is projected for Pension Benefits and accumulated for
Postretirement Medical Benefits.
** Plan assets and obligation measured as of September 30.
*** The actual allocation of plan assets by category are as follows:
2005 2004 2003
---- ---- ----
Pension:
Equity securities....................................... 68% 72% 73%
Fixed income securities................................. 30% 28% 27%
Cash Equivalents........................................ 2% -- --
Postretirement Medical:
Equity securities....................................... 68% 72% 73%
Fixed income securities................................. 30% 28% 27%
Cash Equivalents........................................ 2% -- --
69
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2005 over one-half of the plan assets consisted of
investments in mutual funds administered by Harris Investment Management,
Inc., a subsidiary of Bankcorp.
Investment objectives include the achievement of a total account return
(net of fees) which meets or exceeds over a long time horizon the expected
return on plan assets, the inflation rate as measured by the Consumer
Price Index, and the median performance in a comparable manager universe.
The return on asset assumption is based upon management's review of the
current rate environment, historical trend analysis and the mix of asset
categories represented in the Plan's portfolio. The performance benchmark
includes the asset classes of equities and fixed income securities. Plan
asset and liability studies are presented to the Investment Committee
periodically. The current portfolio target allocation is as follows:
Equity securities.................................................. 65%
Fixed income securities............................................ 35%
POSTRETIREMENT
PENSION BENEFITS MEDICAL BENEFITS
------------------- -------------------
2005 2004 2003 2005 2004 2003
----- ----- ----- ----- ----- -----
WEIGHTED-AVERAGE ASSUMPTIONS USED TO
DETERMINE BENEFIT OBLIGATIONS AS OF
DECEMBER 31
Discount rate........................... 5.50% 6.00% 6.00% 5.50% 6.00% 6.00%
Rate of compensation increase........... 3.80% 3.80% 4.20% N/A N/A N/A
WEIGHTED-AVERAGE ASSUMPTIONS USED TO
DETERMINE NET BENEFIT COST FOR YEARS
ENDED DECEMBER 31
Discount rate........................... 6.00% 6.00% 6.75% 6.00% 6.00% 6.75%
Expected return on plan assets.......... 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
Rate of compensation increase........... 3.80% 3.80% 4.20% N/A N/A N/A
For measurement purposes, a 9 percent annual rate of increase for pre 65
and a 10 percent annual rate of increase for post 65 in the per capita cost of
covered health care benefits was assumed for 2005. The rate will be graded down
to 5.0 percent for pre 65 and 5.5 percent for post 65 in 2013 and 2012,
respectively, and remain level thereafter.
Assumed health care cost trend rates have a significant effect on the
amounts reported for the health care plans. A one-percentage-point change in
assumed health care cost trend rates would have the following effects:
1-PERCENTAGE 1-PERCENTAGE
POINT INCREASE POINT DECREASE
-------------- --------------
(IN THOUSANDS)
Effect on total of service and interest cost
components...................................... $ 919 $ (724)
Effect on postretirement benefit obligation....... $9,909 $(7,965)
70
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table sets forth the status of the supplemental unfunded
retirement plan:
SUPPLEMENTAL UNFUNDED
RETIREMENT BENEFITS
----------------------------
2005 2004 2003
-------- -------- --------
(IN THOUSANDS)
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year............... $ 17,063 $ 15,803 $ 25,696
Service cost.......................................... 1,364 1,507 1,401
Interest cost......................................... 916 744 1,078
Settlement loss....................................... -- -- 1,545
Plan amendments/merger................................ -- -- --
Benefits paid (net of participant contributions)...... (2,367) (3,784) (180)
Settlement payments................................... -- -- (10,872)
Actuarial (gain) or loss.............................. (35) 2,793 (2,865)
-------- -------- --------
Benefit obligation at end of year..................... $ 16,941 $ 17,063 $ 15,803
======== ======== ========
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year........ $ -- $ -- $ --
Actual return on plan assets.......................... -- -- --
Employer contribution................................. 2,367 3,784 11,052
Benefits paid......................................... (2,367) (3,784) (11,052)
-------- -------- --------
Fair value of plan assets at end of year.............. $ -- $ -- $ --
======== ======== ========
Funded Status......................................... $(16,941) $(17,063) $(15,803)
Contributions made between measurement date (September
30) and end of year................................. 575 28 916
Unrecognized actuarial (gain) or loss................. 5,510 5,667 3,086
Unrecognized transition (asset) or obligation......... -- -- --
Unrecognized prior service cost....................... (2,671) (3,001) (2,978)
-------- -------- --------
(Accrued) prepaid benefit cost........................ $(13,527) $(14,369) $(14,779)
======== ======== ========
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost.......................................... $ 1,364 $ 1,507 $ 1,401
Interest cost......................................... 916 744 1,078
Expected return on plan assets........................ -- -- --
Amortization of prior service cost.................... (330) 23 97
Amortization of transition (asset) or obligation...... -- -- 12
Amortization of actuarial (gain) or loss.............. 122 67 95
-------- -------- --------
Net periodic benefit cost............................. $ 2,072 $ 2,341 $ 2,683
======== ======== ========
Additional loss recognized due to:
Settlement.......................................... $ -- $ -- $ 2,597
71
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SUPPLEMENTAL UNFUNDED
RETIREMENT BENEFITS
----------------------------
2005 2004 2003
-------- -------- --------
(IN THOUSANDS)
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE BENEFIT
OBLIGATIONS AS OF DECEMBER 31
Discount rate......................................... 4.75% 5.25% 5.25%
Rate of compensation increase......................... 3.80% 3.80% 4.20%
WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE NET
BENEFIT COST FOR YEARS ENDED DECEMBER 31
Discount rate......................................... 5.25% 5.25% 5.50%
Rate of compensation increase......................... 3.80% 3.80% 4.20%
The benefits expected to be paid in each of the next five years and the
aggregate for the five years thereafter are as follows:
POSTRETIREMENT SUPPLEMENTAL UNFUNDED
YEAR PENSION BENEFITS MEDICAL BENEFITS RETIREMENT BENEFITS
---- ---------------- ---------------- ---------------------
(IN THOUSANDS)
2006............................... $ 23,161 $ 3,679 $ 932
2007............................... 26,333 3,927 1,229
2008............................... 27,657 4,000 1,188
2009............................... 29,448 4,148 1,318
2010............................... 30,382 4,240 1,303
2011-2015.......................... 187,008 22,823 9,705
The Bank has a defined contribution plan that is available to virtually all
employees. The 401(k) matching contribution is based on the amount of eligible
employee contributions. The profit sharing contribution was based on the annual
financial performance of the Bank relative to predefined targets. The Bank's
total expense for this plan was $11.9 million, $12.2 million and $11.9 million
in 2005, 2004 and 2003, respectively.
15. STOCK OPTIONS
The Bank has three stock-based compensation plans: an options program, a
performance incentive plan and an employee share purchase plan. The option plans
are accounted for under the fair value based method of accounting and are
described below.
STOCK OPTION PROGRAM
The Stock Option Program was established under the Bank of Montreal Stock
Option Plan for certain designated executives and other employees of the Bank
and affiliated companies in order to provide incentive to attain long-term
strategic goals and to attract and retain services of key employees.
The Bank has two types of option plans. The Fixed Stock Option Plan
consists of standard stock options with a ten-year term which are exercisable
only during the second five years of their term, assuming cumulative performance
goals are met. The Performance Based Option Plan consists of standard and
performance conditioned stock options with a ten-year term and a four-year
vesting period, which are exercisable twenty-five percent per annum. The
standard options may be exercised at any time once vested. The performance-
conditioned options may be exercised provided the BMO shares trade at fifty
percent over the price of the stock at date of grant for twenty consecutive
days, after the vesting date. The stock options are exercisable for BMO common
stock equal to the market price on the date of grant. The compensation expense
related to this program totaled $3.0 million, $4.9 million and $6.8 million in
2005, 2004 and 2003, respectively.
72
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes the stock option activity for 2005, 2004 and
2003 and provides details of stock options outstanding at December 31, 2005:
2005 2004 2003
-------------------------- -------------------------- --------------------------
WTD. AVG. WTD. AVG. WTD. AVG.
OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------- --------- -------------- --------- -------------- --------- --------------
Outstanding at beginning of
year..................... 4,000,143 $33.96 4,131,021 $33.08 4,671,259 $33.17
Granted.................... 194,300 54.39 443,800 44.09 -- --
Exercised.................. (672,540) 35.47 (582,878) 35.47 (540,238) 33.85
Forfeited, cancelled....... (50,184) 31.54 -- -- -- --
Transferred................ -- -- 8,200 37.01 -- --
Expired.................... -- -- -- -- -- --
--------- --------- ---------
Outstanding at end of
year..................... 3,471,719 34.85 4,000,143 33.96 4,131,021 33.08
========= ========= =========
Options exercisable at
year-end................. 2,931,004 $32.98 3,071,053 $34.42 2,904,631 $35.40
Weighted-average fair value
of options granted during
the year................. $ 8.93 $ 8.65 N/A
--------
N/A -- There were no stock options granted during fiscal 2003.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------- ----------------------------
NUMBER NUMBER
OUTSTANDING WTD. AVG. EXERCISABLE
RANGE OF DECEMBER 31, REMAINING WTD. AVG. DECEMBER 31, WTD. AVG.
EXERCISE PRICES 2005 CONTRACTUAL LIFE EXERCISE PRICE 2005 EXERCISE PRICE
--------------- ------------ ---------------- -------------- ------------ --------------
$22-30...................... 1,622,740 5.93 years $23.66 1,529,925 $23.51
34-42...................... 857,384 4.65 38.34 748,334 37.84
46-55...................... 991,595 6.47 50.14 652,745 49.60
--------- ---------
22-55...................... 3,471,719 5.77 34.85 2,931,004 32.98
========= =========
The fair value of the stock options granted has been estimated using a
trinomial option pricing model. The weighted-average fair value of options
granted during the years ended December 31, 2005 and 2004 was $8.93 and $8.65,
respectively. No stock options were granted during the year ended December 31,
2003. The following weighted-average assumptions were used to determine the fair
value of options on the date of grant:
2005 2004 2003
----- ----- ----
Risk-free interest rate................................ 4.00% 4.51% N/A
Expected life, in years................................ 7.1 7.0 N/A
Expected volatility.................................... 20.12% 23.08% N/A
Compound annual dividend growth........................ 11.95% 9.45% N/A
MID-TERM INCENTIVE PLAN
The Bank maintains the Mid-Term Incentive Plan which was established in
January 2000. The plan is intended to enhance the Bank's ability to attract and
retain high quality employees and to provide a strong incentive to employees to
achieve BMO's governing objective of maximizing value for its shareholders.
73
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During 2005 the Bank was party to an agreement made between BMO and a third
party to assume most of the Bank's obligation related to the 2005 Mid-Term
Incentive Plan. The Bank's share of the payment was $12.2 million. A similar
agreement was entered into in 2004 and 2003 to assume the full obligation
related to the 2004 and 2003 Mid-Term Incentive Plans for a payment of $15.1
million and $17.7 million, respectively. These amounts will be recorded as
compensation expense over the three year performance cycle of the plan on a
straight-line basis. Any future payments required under these plans will be the
responsibility of the third party.
For the remaining obligations relating to the 2005 Mid-Term Incentive Plan
for which BMO has not entered into agreements with third parties, the amount of
compensation expense is amortized over the period until payment to employees to
reflect the current market value of BMO's common shares and BMO's total
shareholder return compared with that of our competitors.
Payouts under the plan to participants depend on the achievement of
specific performance criteria that are set at the grant date. The right to
receive distributions under the plan vest and are paid out after three years
based on various factors including the BMO share price. Compensation expense for
this plan totaled $13.9 million, $13.9 million and $24.1 million in 2005, 2004
and 2003, respectively.
EMPLOYEE SHARE PURCHASE PLAN
The Bank of Montreal ("BMO") Employee Share Purchase Plan offers employees
the opportunity to purchase BMO common shares at a discount of 15 percent from
market value. Full-time and part-time employees of the Bank are eligible to
participate in the plan. Employees can elect to contribute up to 15 percent of
their salary toward the purchase of BMO common shares. The Bank contributes the
difference between the employee cost and the market price. The shares in the
plan are purchased on the open market and the plan reinvests all cash dividends
in additional common shares. The Bank's contribution is recorded as compensation
expense over each three-month offering period. Compensation expense for the
employee share purchase plan totaled $0.5 million, $0.6 million and $0.4 million
in 2005, 2004 and 2003, respectively.
16. LEASE EXPENSE AND OBLIGATIONS
Rental expense for all operating leases was $28.6 million in 2005, $18.6
million in 2004, and $18.4 million in 2003. These amounts include real estate
taxes, maintenance and other rental-related operating costs of $5.2 million,
$6.4 million, and $7.9 million for 2005, 2004, and 2003, respectively, paid
under net lease arrangements. Lease commitments are primarily for office space.
Minimum rental commitments as of December 31, 2005 for all noncancelable
operating leases are as follows:
(IN THOUSANDS)
2006......................................................... $ 31,970
2007......................................................... 30,230
2008......................................................... 27,114
2009......................................................... 26,558
2010......................................................... 25,940
2011 and thereafter.......................................... 515,109
--------
Total minimum future rentals................................. $656,921
========
Occupancy expenses for 2005, 2004, and 2003 have been reduced by $4.6
million, $19.2 million, and $18.3 million, respectively, for rental income from
leased premises.
74
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
17. INCOME TAXES
The 2005, 2004 and 2003 applicable income tax expense (benefit) were as
follows:
FEDERAL STATE TOTAL
-------- ------- --------
(IN THOUSANDS)
2005:
Current............................................. $ 86,837 $ 9,610 $ 96,447
Deferred............................................ (8,819) (2,950) (11,769)
-------- ------- --------
Total............................................ $ 78,018 $ 6,660 $ 84,678
======== ======= ========
2004:
Current............................................. $100,900 $13,307 $114,207
Deferred............................................ 4,936 1,395 6,331
-------- ------- --------
Total............................................ $105,836 $14,702 $120,538
======== ======= ========
2003:
Current............................................. $ 76,147 $ 7,774 $ 83,921
Deferred............................................ 2,545 (198) 2,347
-------- ------- --------
Total............................................ $ 78,692 $ 7,576 $ 86,268
======== ======= ========
Deferred tax assets (liabilities) are comprised of the following at
December 31, 2005, 2004 and 2003:
DECEMBER 31
----------------------------
2005 2004 2003
-------- -------- --------
(IN THOUSANDS)
Deferred tax assets:
Allowance for loan losses.......................... $128,880 $126,827 $128,085
Deferred expense and prepaid income................ 30,461 13,651 13,186
Deferred employee compensation..................... 22,369 24,955 23,777
Pension and medical trust.......................... 10,755 2,231 --
Other assets....................................... -- 261 882
-------- -------- --------
Gross deferred tax assets....................... 192,465 167,925 165,930
-------- -------- --------
Deferred tax liabilities:
Depreciable assets................................. (60,510) (42,542) (45,283)
Amortizable intangibles............................ (28,012) (26,995) (26,135)
Other liabilities.................................. (2,398) (5,159) (8,759)
-------- -------- --------
Gross deferred tax liabilities.................. (90,920) (74,696) (80,177)
-------- -------- --------
Deferred tax assets................................ 101,545 93,229 85,753
The tax effect of fair value adjustments on
available-for-sale securities, minimum pension
liabilities and hedging transactions recorded
directly to stockholder's equity................... 37,665 24,005 (12,384)
-------- -------- --------
Net deferred tax assets.............................. $139,210 $117,234 $ 73,369
======== ======== ========
At December 31, 2005 and 2004, the respective deferred tax assets of $101.5
million and $91.8 million included $88.6 million and $81.6 million for Federal
taxes and $12.9 million and $10.2 million for state taxes,
75
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
respectively. Management believes that the realization of the recognized net
deferred tax asset is more likely than not based on existing carryback ability
and expectations as to future taxable income.
Total income tax expense of $84.7 million for 2005, $120.5 million for 2004
and $86.3 million for 2003 reflects effective tax rates of 29.4 percent, 32.5
percent and 29.1 percent, respectively. The reconciliation between actual tax
expense and the amount determined by applying the federal statutory rate of 35
percent to income before income taxes were as follows:
YEARS ENDED DECEMBER 31
----------------------------------------------------------------
2005 2004 2003
-------------------- -------------------- --------------------
PERCENT OF PERCENT OF PERCENT OF
PRETAX PRETAX PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
-------- ---------- -------- ---------- -------- ----------
(DOLLARS IN THOUSANDS)
Computed tax expense........... $100,818 35.0% $129,978 35.0% $103,673 35.0%
Increase (reduction) in income
tax expense due to:
Tax-exempt income from loans
and investments net of
municipal interest expense
disallowance.............. (7,837) (2.7) (6,943) (1.9) (7,538) (2.5)
Bank-owned insurance......... (14,964) (5.2) (14,082) (3.8) (15,253) (5.2)
State income taxes........... 4,329 1.5 9,556 2.6 4,924 1.7
Other, net................... 2,332 0.8 2,029 0.6 462 0.1
-------- ---- -------- ---- -------- ----
Actual tax expense............. $ 84,678 29.4% $120,538 32.5% $ 86,268 29.1%
======== ==== ======== ==== ======== ====
18. REGULATORY CAPITAL
The Bank, as a federally-chartered bank, must adhere to the capital
adequacy guidelines of The Office of the Comptroller of the Currency ("OCC").
The guidelines specify minimum ratios for Tier 1 capital to risk-weighted assets
of 4 percent and total regulatory capital to risk-weighted assets of 8 percent.
Risk-based capital guidelines define total capital to consist primarily of
Tier 1 (core) and Tier 2 (supplementary) capital. In general, Tier 1 capital is
comprised of stockholder's equity, including certain types of preferred stock,
less goodwill and certain other intangibles. Core capital must comprise at least
50 percent of total capital. Tier 2 capital basically includes subordinated debt
(less a discount factor during the five years prior to maturity), other types of
preferred stock and the allowance for loan losses. The portion of the allowance
for loan losses includable in Tier 2 capital is limited to 1.25 percent of risk-
weighted assets.
The OCC also requires an additional measure of capital adequacy, the Tier 1
leverage ratio, which is evaluated in conjunction with risk-based capital
ratios. The Tier 1 leverage ratio is computed by dividing period-end Tier 1
capital by adjusted quarterly average assets. The OCC established a minimum
ratio of 3 percent applicable only to the strongest banking organizations
having, among other things, excellent asset quality, high liquidity, good
earnings and no undue interest rate risk exposure. Other institutions are
expected to maintain a minimum ratio of 4 percent.
The Federal Deposit Insurance Corporation Improvement Act of 1991 contains
prompt corrective action provisions that established five capital categories for
all Federal Deposit Insurance Corporation ("FDIC")-insured institutions ranging
from "well capitalized" to "critically undercapitalized." Classification within
a category is based primarily on the three capital adequacy measures. An
institution is considered "well capitalized" if its capital level significantly
exceeds the required minimum levels, "adequately capitalized" if it meets the
minimum levels, "undercapitalized" if it fails to meet the minimum levels,
"significantly undercapitalized" if it is significantly below
76
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the minimum levels and "critically undercapitalized" if it has a ratio of
tangible equity to total assets of 2 percent or less.
Noncompliance with minimum capital requirements may result in regulatory
corrective actions that could have a material effect on the Bank's financial
statements. Depending on the level of noncompliance, regulatory corrective
actions may include the following: requiring a plan for restoring the
institution to an acceptable capital category, restricting or prohibiting
certain activities and appointing a receiver or conservator for the institution.
As of December 31, 2005, the most recent notification from the FDIC
categorized the Bank as "well capitalized" under the regulatory framework for
prompt corrective action. Management is not aware of any conditions or events
since December 31, 2005 that have changed the capital category of the Bank.
At December 31, 2005 the Bank had $250 million of minority interest in
preferred stock of a subsidiary. The preferred stock is noncumulative,
exchangeable Series A preferred stock with dividends payable at the rate of
7 3/8% per annum. During both 2005 and 2004, $18 million of dividends were paid
on the preferred stock. The preferred stock qualifies as Tier 1 capital for the
Bank under U.S. banking regulatory guidelines.
The following table summarizes the Bank's risk-based capital ratios and
Tier 1 leverage ratio for the past two years as well as the minimum amounts and
ratios as per capital adequacy guidelines and FDIC prompt corrective action
provisions.
TO BE WELL
CAPITALIZED
UNDER PROMPT
FOR CAPITAL CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
------------------- ------------------- -------------------
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
---------- ------- ---------- ------- ---------- -------
(IN THOUSANDS)
As of December 31, 2005:
Total Capital to Risk-
Weighted Assets.... $3,380,783 11.40% $2,372,479 8.00% $2,965,599 10.00%
Tier 1 Capital to
Risk-Weighted
Assets............. $2,769,827 9.34% $1,186,221 4.00% $1,779,332 6.00%
Tier 1 Capital to
Average Assets..... $2,769,827 8.27% $1,339,699 4.00% $1,674,623 5.00%
As of December 31, 2004:
Total Capital to Risk-
Weighted Assets.... $3,215,700 12.30% $2,091,512 8.00% $2,614,390 10.00%
Tier 1 Capital to
Risk-Weighted
Assets............. $2,606,363 9.97% $1,045,682 4.00% $1,568,523 6.00%
Tier 1 Capital to
Average Assets..... $2,606,363 8.40% $1,241,125 4.00% $1,551,407 5.00%
19. INVESTMENTS IN SUBSIDIARIES AND STATUTORY RESTRICTIONS
Harris N.A.'s investment in the combined net assets of its wholly-owned
subsidiaries was $725 million and $777 million at December 31, 2005 and 2004,
respectively.
Provisions of both Illinois and Federal banking laws place restrictions
upon the amount of dividends that can be paid to Bankcorp by its bank
subsidiaries. Illinois law requires that no dividends may be paid in an amount
greater than the net profits then on hand, reduced by certain loan losses (as
defined). In addition to these restrictions, Federal Reserve member banking
subsidiaries (including all national banks) require prior approval of
appropriate banking authorities if dividends declared by a subsidiary bank, in
any calendar year, will exceed its net profits (as
77
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
defined in the applicable statute) for that year, combined with its retained net
profits, as so defined, for the preceding two years. Based on these and certain
other prescribed regulatory limitations, the Bank could have declared, without
regulatory approval, $414 million of dividends at December 31, 2005. Actual
dividends paid, however, would be subject to prudent capital maintenance. Cash
and non-cash dividends paid to Bankcorp by the Bank amounted to $90 million and
$70 million in 2005 and 2004, respectively.
The Bank is required by the Federal Reserve Act to maintain reserves
against certain of their deposits. Reserves are held either in the form of vault
cash or balances maintained with the Federal Reserve Bank. Required reserves are
essentially a function of daily average deposit balances and statutory reserve
ratios prescribed by type of deposit. During 2005 and 2004, daily average
reserve balances of $265 million and $263 million, respectively, were required
for the Bank. At year-end 2005 and 2004, balances on deposit at the Federal
Reserve Bank totaled $185 million and $213 million, respectively.
20. CONTINGENT LIABILITIES
Harris N.A. and certain subsidiaries are defendants in various legal
proceedings arising in the normal course of business. In the opinion of
management, based on the advice of legal counsel, the ultimate resolution of
these matters will not have a material adverse effect on the Bank's financial
position or results of operations.
21. OTHER COMPREHENSIVE INCOME
The following table summarizes the components of other comprehensive income
(loss) shown in stockholder's equity:
TOTAL
UNREALIZED MINIMUM UNREALIZED ACCUMULATED
GAIN (LOSS) ON PENSION GAIN (LOSS) OTHER
AVAILABLE-FOR- LIABILITY ON DERIVATIVE COMPREHENSIVE
SALE SECURITIES ADJUSTMENT INSTRUMENTS INCOME (LOSS)
--------------- ---------- ------------- -------------
(IN THOUSANDS)
Balance at December 31, 2003..... $ 49,668 $(29,986) $ 35 $ 19,717
======== ======== ======== ========
Balance at December 31, 2004..... $(13,612) $(25,122) $ (5,274) $(44,008)
======== ======== ======== ========
Balance at December 31, 2005..... $(26,307) $(22,785) $(19,102) $(68,194)
======== ======== ======== ========
78
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
22. FOREIGN ACTIVITIES (BY DOMICILE OF CUSTOMER)
Income and expenses identifiable with foreign and domestic operations are
summarized in the table below:
FOREIGN DOMESTIC CONSOLIDATED
---------- ----------- ------------
(IN THOUSANDS)
2005
Total operating income.................... $ 19,846 $ 1,793,913 $ 1,813,759
Total expenses............................ 78,420 1,447,289 1,525,709
---------- ----------- -----------
(Loss) income before taxes................ (58,574) 346,624 288,050
Applicable income taxes................... (23,280) 107,958 84,678
---------- ----------- -----------
Net (loss) income......................... $ (35,294) $ 238,666 $ 203,372
========== =========== ===========
Identifiable assets at year-end........... $1,274,658 $33,203,090 $34,477,748
========== =========== ===========
2004
Total operating income.................... $ 15,772 $ 1,571,187 $ 1,586,959
Total expenses............................ 68,483 1,147,110 1,215,593
---------- ----------- -----------
(Loss) income before taxes................ (52,711) 424,077 371,366
Applicable income taxes................... (20,950) 141,488 120,538
---------- ----------- -----------
Net (loss) income......................... $ (31,761) $ 282,589 $ 250,828
========== =========== ===========
Identifiable assets at year-end........... $ 756,654 $30,624,706 $31,381,360
========== =========== ===========
2003
Total operating income.................... $ 17,790 $ 1,569,151 $ 1,586,941
Total expenses............................ 27,425 1,263,308 1,290,733
---------- ----------- -----------
(Loss) income before taxes................ (9,635) 305,843 296,208
Applicable income taxes................... (3,829) 90,097 86,268
---------- ----------- -----------
Net (loss) income......................... $ (5,806) $ 215,746 $ 209,940
========== =========== ===========
Identifiable assets at year-end........... $ 523,206 $29,518,181 $30,041,387
========== =========== ===========
Determination of rates for foreign funds generated or used are based on the
actual external costs of specific interest-bearing sources or uses of funds for
the periods. Internal allocations for certain unidentifiable income and expenses
were distributed to foreign operations based on the percentage of identifiable
foreign income to total income. As of December 31, 2005, 2004 and 2003,
identifiable foreign assets accounted for 4 percent, 2 percent and 2 percent,
respectively, of total consolidated assets.
23. BUSINESS COMBINATIONS
At December 31, 2005 and 2004, intangible assets, including goodwill
resulting from business combinations, amounted to $335 million and $307 million,
respectively. Amortization of these intangibles amounted to $16.4 million in
2005, $16.3 million in 2004 and $16.1 million in 2003.
In December 2005, Villa Park Trust and Savings Bank ("Villa Park"), a
wholly-owned subsidiary of Harris Bankcorp, Inc., was merged with and into the
Bank. At that time, Villa Park total assets were $327 million and total deposits
were $260 million. The impact to the Bank's stockholder's equity was an increase
of $64 million. The combination was recorded using historical carrying values
for Villa Park as recognized by Bankcorp. In consideration of this contribution
to its capital, the Bank issued 61,256 shares of common stock to Bankcorp.
79
HARRIS N.A AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In June 2004, Harris Bank Round Lake, a wholly-owned subsidiary of Harris
Bankcorp, Inc., was merged with and into the Bank. Harris Bank Round Lake total
assets were $189 million and total deposits were $151 million. The impact to the
Bank's stockholder's equity was an increase of $37 million. The combination was
recorded using historical carrying values for Harris Bank Round Lake as
recognized by Bankcorp. In consideration of this contribution to its capital,
the Bank issued 100,000 shares of common stock to Bankcorp.
During 2005 Bankcorp announced its plan to merge one of its bank
subsidiaries, NLSB Bank ("NLSB"), with and in to the Bank. This transaction was
completed on February 17, 2006. At December 31, 2005 NLSB had assets of $1.10
billion, deposits of $926 million and equity of $158 million.
24. RELATED PARTY TRANSACTIONS
During 2005, 2004 and 2003, the Bank engaged in various transactions with
BMO and its subsidiaries. These transactions included the payment and receipt of
service fees and occupancy expenses; purchasing and selling Federal funds;
repurchase and reverse repurchase agreements; short and long-term borrowings;
time deposit issuance; interest rate and foreign exchange rate contracts. The
purpose of these transactions was to facilitate a more efficient use of combined
resources and to better serve customers. Fees for these services were determined
in accordance with applicable banking regulations. During 2005, 2004 and 2003,
the Bank received from BMO approximately $16.5 million, $14.0 million and $17.3
million, respectively, primarily for data processing, other operations support
and corporate support provided by the Bank. Excluding interest expense payments
disclosed below, the Bank made payments for services to BMO of approximately
$59.5 million, $47.5 million and $30.4 million in 2005, 2004 and 2003,
respectively.
At December 31, 2005, derivative contracts with BMO represent $63.8 million
and $26.3 million of unrealized gains and unrealized losses, respectively. At
December 31, 2004, derivative contracts with BMO represented $37.6 million and
$45.5 million of unrealized gains and unrealized losses, respectively.
The Bank and BMO combine their U.S. foreign exchange activities. Under this
arrangement, the Bank and BMO share FX net profit in accordance with a specific
formula set forth in the agreement. This agreement expires in October 2006 but
may be extended at that time. Either party may terminate the arrangement at its
option. FX revenues are reported net of expenses. 2005, 2004 and 2003 foreign
exchange revenues included $5.6 million, $5.9 million and $5.1 million of net
profit, respectively, under this agreement.
On July 3, 2003, the Bank issued a $1.0 billion certificate of deposit
("CD") to a subsidiary of BMO, BMO (Barbados) Limited. The certificate matures
June 30, 2008 and bears a 2.84 percent fixed rate of interest, payable
quarterly. On August 28, 2003, the Bank issued a $427.7 million CD to BMO
(Barbados) Limited. The certificate matures March 31, 2009 and bears a 4.30
percent fixed rate of interest, payable semi-annually. On September 22, 2003,
the Bank issued a $570 million CD to BMO (Barbados) Limited. The certificate
matures September 24, 2007 and bears a 3.28 percent fixed rate of interest,
payable quarterly. On August 29, 2005 the Bank issued a $500 million CD to BMO
(Barbados) Limited. The certificate matures March 18, 2008 and bears interest at
three month LIBOR plus 8 basis points, payable quarterly. Interest expense
recognized on these CD's in 2005, 2004 and 2003 was $73.4 million, $66.6 million
and $25.4 million, respectively.
On June 9, 2005 the Bank borrowed $250 million from BMO (US) Funding, LLC,
a Delaware limited liability company, indirectly owned by Bank of Montreal. The
loan is a senior note with a variable interest rate equal to the three month
LIBOR rate plus 12 basis points and a maturity date of June 15, 2010. Interest
expense recognized in 2005 was $5.1 million.
The Bank has loans outstanding to certain executive officers and directors.
These loans totaled $6.1 million and $3.9 million at December 31, 2005 and 2004,
respectively.
On June 18, 2004, the Bank issued a dividend to Harris Bankcorp, Inc.
consisting of a wholly-owned U.S. subsidiary, Harris Bank International Corp.
("HBIC"). At the time of the dividend, HBIC had assets of $7.1 million and
equity of $5.4 million.
80