UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2011
or
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 000-26719
MERCANTILE BANK CORPORATION
(Exact name of registrant as specified in its charter)
Michigan | 38-3360865 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
310 Leonard Street NW, Grand Rapids, Michigan |
49504 | |
(Address of principal executive offices) | (Zip Code) |
(616) 406-3000
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class |
Name of each exchange on which registered | |
Common Stock | The Nasdaq Stock Market LLC |
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
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants 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 the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer | ¨ | Accelerated filer | ¨ | |||
Non-accelerated filer | ¨ | Smaller reporting company | 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 aggregate value of the common equity held by non-affiliates (persons other than directors and executive officers) of the registrant, computed by reference to the closing price of the common stock as of the last business day of the registrants most recently completed second fiscal quarter, was approximately $69.1 million.
As of February 1, 2012, there were issued and outstanding 8,605,007 shares of the registrants common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the proxy statement for the 2012 annual meeting of shareholders (Portions of Part III).
PART I
Item 1. | Business. |
The Company
Mercantile Bank Corporation is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the Bank Holding Company Act). Unless the text clearly suggests otherwise, references to us, we, our, or the company include Mercantile Bank Corporation and its wholly-owned subsidiaries. As a bank holding company, we are subject to regulation by the Board of Governors of the Federal Reserve System (the Federal Reserve Board). We were organized on July 15, 1997, under the laws of the State of Michigan, primarily for the purpose of holding all of the stock of Mercantile Bank of Michigan (our bank), and of such other subsidiaries as we may acquire or establish. Our bank commenced business on December 15, 1997.
Mercantile Bank Mortgage Company initiated business in October 2000 as a subsidiary of our bank, and was reorganized as Mercantile Bank Mortgage Company, LLC (our mortgage company), on January 1, 2004. Mercantile Insurance Center, Inc. (our insurance company), a subsidiary of our bank, commenced operations during 2002 to offer insurance products. Mercantile Bank Real Estate Co., L.L.C., (our real estate company), a subsidiary of our bank, was organized on July 21, 2003, principally to develop, construct and own our facility in downtown Grand Rapids which serves as our banks main office and Mercantile Bank Corporations headquarters. Mercantile Bank Capital Trust I (our trust), a business trust subsidiary, was formed in September 2004 to issue trust preferred securities.
To date we have raised capital from our initial public offering of common stock in October 1997, a public offering of common stock in July 1998, three private placements of common stock during 2001, a public offering of common stock in August 2001 and a public offering of common stock in September 2003. In addition, we raised capital through a public offering of $16.0 million of trust preferred securities in 1999, which was refinanced as part of a $32.0 million private placement of trust preferred securities in 2004. In May 2009, we raised $21.0 million from the sale of preferred stock and a warrant for common stock to the United States Treasury Department under the Capital Purchase Program. Our expenses have generally been paid using the proceeds of the capital sales and dividends from our bank. Our principal source of future operating funds is expected to be dividends from our bank.
We filed an election to become a financial holding company, which election became effective March 23, 2000. Effective June 1, 2009, we withdrew our election to be a financial holding company.
Our Bank
Our bank is a state banking company that operates under the laws of the State of Michigan, pursuant to a charter issued by the Michigan Office of Financial and Insurance Regulation. Our banks deposits are insured to the maximum extent permitted by law by the Federal Deposit Insurance Corporation (FDIC). Our bank, through its seven offices, provides commercial banking services primarily to small- to medium-sized businesses and retail banking services in and around the Grand Rapids, Holland and Lansing areas. These offices consist of a main office located at 310 Leonard Street NW, Grand Rapids, Michigan, a combination branch and retail loan center located at 4613 Alpine Avenue NW, Comstock Park, Michigan, a combination branch and operations center located at 5610 Byron Center Avenue SW, Wyoming, Michigan, and branches located at 4860 Broadmoor Avenue SE, Kentwood, Michigan, 3156 Knapp Street NE, Grand Rapids, Michigan, 880 East 16th Street, Holland, Michigan, and 3737 Coolidge Road, East Lansing, Michigan.
Our bank makes secured and unsecured commercial, construction, mortgage and consumer loans, and accepts checking, savings and time deposits. Our bank owns seven automated teller machines (ATM), located at each of our office locations, that participate in the MAC, NYCE and PLUS regional network systems, as well as other ATM networks throughout the country. Our bank also enables customers to conduct certain loan and deposit transactions by telephone and personal computer. Courier service is provided to certain commercial customers, and safe deposit facilities are available at each of our office locations. Our bank does not have trust powers.
1.
Our Mortgage Company
Our mortgage companys predecessor, Mercantile Bank Mortgage Company, commenced operations on October 24, 2000, when our bank contributed most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans to Mercantile Bank Mortgage Company. On the same date, our bank also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company, which is 99% owned by our bank and 1% owned by our insurance company. The reorganization had no impact on the companys financial position or results of operations. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement.
Our Insurance Company
Our insurance company acquired an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent.
Our Real Estate Company
Our real estate company was organized on July 21, 2003, principally to develop, construct and own our facility in downtown Grand Rapids that serves as our banks main office and Mercantile Bank Corporations headquarters. This facility was placed into service during the second quarter of 2005. Our real estate company is 99% owned by our bank and 1% owned by our insurance company.
Our Trust
In 2004, we formed our trust, a Delaware business trust. Our trusts business and affairs are conducted by its property trustee, a Delaware trust company, and three individual administrative trustees who are employees and officers of the company. Our trust was established for the purpose of issuing and selling its Series A and Series B trust preferred securities and common securities, and used the proceeds from the sales of those securities to acquire Series A and Series B Floating Rate Notes issued by the company. Substantially all of the net proceeds received by the company from the Series A transaction were used to redeem the trust preferred securities that had been issued by MBWM Capital Trust I in September 1999. We established MBWM Capital Trust I in 1999 to issue the trust preferred securities that were redeemed. Substantially all of the net proceeds received by the company from the Series B transaction were contributed to our bank as capital. The Series A and Series B Floating Rate Notes are categorized on our consolidated financial statements as subordinated debentures. Additional information regarding our trust is incorporated by reference to Note 17 Subordinated Debentures and Note 18 Regulatory Matters of the Notes to Consolidated Financial Statements included in this Annual Report.
Effect of Government Monetary Policies
Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States Government, its agencies, and the Federal Reserve Board. The Federal Reserve Boards monetary policies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation, maintain employment, and mitigate economic recessions. The policies of the Federal Reserve Board have a major effect upon the levels of bank loans, investments and deposits through its open market operations in United States Government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. Our bank maintains reserves directly with the Federal Reserve Bank of Chicago to the extent required by law. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies.
2.
Regulation and Supervision
As a bank holding company under the Bank Holding Company Act, we are required to file an annual report with the Federal Reserve Board and such additional information as the Federal Reserve Board may require. We are also subject to examination by the Federal Reserve Board.
The Bank Holding Company Act limits the activities of bank holding companies that are not qualified as financial holding companies to banking and the management of banking organizations, and to certain non-banking activities. These non-banking activities include those activities that the Federal Reserve Board found, by order or regulation as of the day prior to enactment of the Gramm-Leach-Bliley Act, to be so closely related to banking as to be a proper incident to banking. These non-banking activities include, among other things: operating a mortgage company, finance company, or factoring company; performing certain data processing operations; providing certain investment and financial advice; acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, nonoperating basis; and providing discount securities brokerage services for customers. With the exception of the activities of our mortgage company discussed above, neither we nor any of our subsidiaries engages in any of the non-banking activities listed above.
Our bank is subject to restrictions imposed by federal law and regulation. Among other things, these restrictions apply to any extension of credit to us or to our other subsidiaries, to investments in stock or other securities that we issue, to the taking of such stock or securities as collateral for loans to any borrower, and to acquisitions of assets or services from, and sales of certain types of assets to, us or our other subsidiaries. Federal law restricts our ability to borrow from our bank by limiting the aggregate amount we may borrow and by requiring that all loans to us be secured in designated amounts by specified forms of collateral.
With respect to the acquisition of banking organizations, we are generally required to obtain the prior approval of the Federal Reserve Board before we can acquire all or substantially all of the assets of any bank, or acquire ownership or control of any voting shares of any bank or bank holding company, if, after the acquisition, we would own or control more than 5% of the voting shares of the bank or bank holding company. Acquisitions of banking organizations across state lines are subject to restrictions imposed by federal and state laws and regulations.
The scope of existing regulation and supervision of various aspects of our business has expanded, and continues to expand, as a result of the adoption in July, 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), and of implementing regulations that are being adopted by federal regulators. For additional information on this legislation and its potential impact, refer to the Risk Factor entitled The effect of financial services legislation and regulations remains uncertain in Item 1A- Risk Factors in this Annual Report.
Employees
As of December 31, 2011, we employed 206 full-time and 55 part-time persons. Management believes that relations with employees are good.
Lending Policy
As a routine part of our business, we make loans to businesses and individuals located within our market areas. Our lending policy states that the function of the lending operation is twofold: to provide a means for the investment of funds at a profitable rate of return with an acceptable degree of risk, and to meet the credit needs of the creditworthy businesses and individuals who are our customers. We recognize that in the normal business of lending, some losses on loans will be inevitable and should be considered a part of the normal cost of doing business.
3.
Our lending policy anticipates that priorities in extending loans will be modified from time to time as interest rates, market conditions and competitive factors change. The policy sets forth guidelines on a nondiscriminatory basis for lending in accordance with applicable laws and regulations. The policy describes various criteria for granting loans, including the ability to pay; the character of the customer; evidence of financial responsibility; purpose of the loan; knowledge of collateral and its value; terms of repayment; source of repayment; payment history; and economic conditions.
The lending policy further limits the amount of funds that may be loaned against specified types of real estate collateral. For certain loans secured by real estate, the policy requires an appraisal of the property offered as collateral by a state certified independent appraiser. The policy also provides general guidelines for loan to value for other types of collateral, such as accounts receivable and machinery and equipment. In addition, the policy provides general guidelines as to environmental analysis, loans to employees, executive officers and directors, problem loan identification, maintenance of an allowance for loan losses, loan review and grading, mortgage and consumer lending, and other matters relating to our lending practices.
The Board of Directors has delegated significant lending authority to officers of our bank. The Board of Directors believes this empowerment, supported by our strong credit culture and the significant experience of our commercial lending staff, enables us to be responsive to our customers. The loan policy specifies lending authority for our lending officers with amounts based on the experience level and ability of each lender. Loan officers authorities are generally $1.0 million or less, while loan managers are able to approve loans up to $2.5 million. We have established higher limits for our banks Senior Lender, President, and Chairman of the Board and Chief Executive Officer, ranging from $5.0 million up to $10.0 million. These lending authorities, however, are typically used only in rare circumstances where timing is of the essence. Generally, loan requests exceeding $2.5 million require approval by the Officers Loan Committee, and loan requests exceeding $4.0 million, up to the legal lending limit of approximately $38.4 million, require approval by the Board of Directors. In most circumstances, we apply an in-house lending limit that is significantly less than our banks legal lending limit.
Provisions of recent legislation, including the Dodd-Frank Act, when fully implemented by regulations to be adopted by federal agencies, may have a significant impact on our lending policy, especially in the areas of single-family residential real estate and other consumer lending. For additional information on this legislation and its potential impact, refer to the Risk Factor entitled The effect of financial services legislation and regulations remains uncertain in Item 1A- Risk Factors in this Annual Report.
Lending Activity
Commercial Loans. Our commercial lending group originates commercial loans primarily in our market areas. Our commercial lenders have extensive commercial lending experience, with most having at least ten years experience. Loans are originated for general business purposes, including working capital, accounts receivable financing, machinery and equipment acquisition, and commercial real estate financing, including new construction and land development.
Working capital loans are often structured as a line of credit and are reviewed periodically in connection with the borrowers year-end financial reporting. These loans are generally secured by substantially all of the assets of the borrower and have a floating interest rate tied to the Mercantile Bank Prime Rate, Wall Street Journal Prime Rate or 30-day Libor rate. Loans for machinery and equipment purposes typically have a maturity of three to five years and are fully amortizing, while commercial real estate loans are usually written with a five-year maturity and amortize over a 15 to 20 year period. Commercial loans typically have an interest rate that is fixed to maturity or is tied to the Mercantile Bank Prime Rate, Wall Street Journal Prime Rate or 30-day Libor rate.
4.
We evaluate many aspects of a commercial loan transaction in order to minimize credit and interest rate risk. Underwriting includes an assessment of the management, products, markets, cash flow, capital, income and collateral. This analysis includes a review of the borrowers historical and projected financial results. Appraisals are generally required to be performed by certified independent appraisers where real estate is the primary collateral, and in some cases, where equipment is the primary collateral. In certain situations, for creditworthy customers, we may accept title reports instead of requiring lenders policies of title insurance.
Commercial real estate lending involves more risk than residential lending because loan balances are typically greater and repayment is dependent upon the borrowers business operations. We attempt to minimize the risks associated with these transactions by generally limiting our commercial real estate lending to owner-operated properties and to owners of non-owner occupied properties who have an established profitable history and satisfactory tenant structure. In many cases, risk is further reduced by requiring personal guarantees, limiting the amount of credit to any one borrower to an amount considerably less than our legal lending limit and avoiding certain types of commercial real estate financings.
We have no material foreign loans, and only limited exposure to companies engaged in energy producing and agricultural-related activities.
Single-Family Residential Real Estate Loans. Our mortgage company originates single-family residential real estate loans in our market areas, usually according to secondary market underwriting standards. Loans not conforming to those standards are made in limited circumstances. Single-family residential real estate loans provide borrowers with a fixed or adjustable interest rate with terms up to 30 years and are generally sold to certain investors.
Our bank has a home equity line of credit program. Home equity credit is generally secured by either a first or second mortgage on the borrowers primary residence. The program provides revolving credit at a rate tied to the Wall Street Journal Prime Rate.
Consumer Loans. We originate consumer loans for a variety of personal financial needs, including new and used automobiles, boats, credit cards and overdraft protection for our checking account customers. Consumer loans generally have shorter terms and higher interest rates and usually involve more credit risk than single-family residential real estate loans because of the type and nature of the collateral.
We believe our consumer loans are underwritten carefully, with a strong emphasis on the amount of the down payment, credit quality, employment stability and monthly income of the borrower. These loans are generally repaid on a monthly repayment schedule with the source of repayment tied to the borrowers periodic income. In addition, consumer lending collections are dependent on the borrowers continuing financial stability, and are thus likely to be adversely affected by job loss, illness and personal bankruptcy. In many cases, repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of depreciation of the underlying collateral.
We believe that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans, and that consumer loans are important to our efforts to serve the credit needs of the communities and customers that we serve.
Loan Portfolio Quality
We utilize a comprehensive grading system for our commercial loans as well as for our residential mortgage and consumer loans. All commercial loans are graded on a ten grade rating system. The rating system utilizes standardized grade paradigms that analyze several critical factors such as cash flow, operating performance, financial condition, collateral, industry condition and management. All commercial loans are graded at inception and reviewed at various intervals. Residential mortgage and consumer loans are graded on a random sampling basis after the loan has been made using a separate standardized grade paradigm that analyzes several critical factors such as debt-to-income and credit and employment histories.
5.
Our independent loan review program is primarily responsible for the administration of the grading system and ensuring adherence to established lending policies and procedures. The loan review program is an integral part of maintaining our strong asset quality culture. The loan review function works closely with senior management, although it functionally reports to the Board of Directors. All commercial loan relationships equal to or exceeding $1.5 million are formally reviewed every twelve months, with a random sampling performed on credits under $1.5 million. Our watch list credits are reviewed monthly by our Board of Directors and our Watch List Committee, the latter of which is comprised of personnel from the administration, lending and loan review functions.
Loans are placed in a nonaccrual status when, in our opinion, uncertainty exists as to the ultimate collection of principal and interest. As of December 31, 2011, loans placed in nonaccrual status totaled $45.1 million, or 4.2% of total loans. We had no loans past due 90 days or more and still accruing interest at year-end 2011.
Additional detail and information relative to the loan portfolio is incorporated by reference to Managements Discussion and Analysis of Financial Condition and Results of Operations (Managements Discussion and Analysis) and Note 3 of the Notes to Consolidated Financial Statements in this Annual Report.
Allowance for Loan Losses
In each accounting period, we adjust the allowance for loan losses (allowance) to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish specific portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Allowance Analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions.
The Allowance Analysis applies reserve allocation factors to non-impaired outstanding loan balances, which is combined with specific reserves to calculate an overall allowance dollar amount. For non-impaired commercial loans, which continue to comprise a vast majority of our total loans, reserve allocation factors are based upon loan ratings as determined by our standardized grade paradigms and by loan purpose. We have divided our commercial loan portfolio into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; lending concentrations; and other external factors, including competition and regulatory environment. Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the Allowance Analysis and make adjustments periodically based upon identifiable trends and experience.
A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired commercial loans. Our migration analysis takes into account various time periods, and while we generally place most weight on the eight-quarter time frame as that period is close to the average duration of our loan portfolio, consideration is given to the other time periods as part of our assessment. Although the migration analysis provides an accurate historical accounting of our loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our commercial loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data.
6.
Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and relative aggressiveness in assigning and revising commercial loan risk ratings. Although we have been consistent in our approach to commercial loan ratings, ongoing stressed economic conditions have resulted in an even higher sense of aggressiveness with regards to the downgrading of lending relationships. In addition, we made revisions to our grading paradigms in early 2009 that mathematically resulted in commercial loan relationships being more quickly downgraded when signs of stress are noted, such as slower sales activity for construction and land development commercial real estate relationships and reduced operating performance/cash flow coverage for commercial and industrial relationships. These changes, coupled with the stressed economic environment, have resulted in significant downgrades and the need for substantial provisions to the allowance over the past several years. To more effectively manage our commercial loan portfolio, we created a specific group tasked with managing our higher exposure lending relationships.
The most significant external environmental factor is the assessment of the current economic environment and the resulting implications on our commercial loan portfolio. Currently, we believe conditions remain especially stressed for non-owner occupied commercial real estate; however, recent data and performance reflect a level of stability in the commercial and industrial class of our loan portfolio.
The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers and employ a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors rights in order to preserve our collateral position.
Reflecting the stressed economic conditions and resulting negative impact on our loan portfolio, we have substantially increased the allowance as a percent of the loan portfolio over the past several years. The allowance equaled $36.5 million, or 3.4% of total loans outstanding, as of December 31, 2011, compared to 3.6%, 3.1%, 1.5% and 1.4% at year-end 2010, 2009, 2008 and 2007, respectively. Although we believe the allowance is adequate to absorb losses as they arise, there can be no assurance that we will not sustain losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.
Additional detail regarding the allowance is incorporated by reference to Managements Discussion and Analysis and Note 3 of the Notes to Consolidated Financial Statements included in this Annual Report.
Investments
Bank Holding Company Investments. The principal investments of our bank holding company are the investments in the common stock of our bank and the common securities of Mercantile trust. Other funds of our bank holding company may be invested from time to time in various debt instruments.
As a bank holding company, we are also permitted to make portfolio investments in equity securities and to make equity investments in subsidiaries engaged in a variety of non-banking activities, which include real estate-related activities such as community development, real estate appraisals, arranging equity financing for commercial real estate, and owning and operating real estate used substantially by our bank or acquired for its future use. Our bank holding company has no plans at this time to make directly any of these equity investments at the bank holding company level. Our Board of Directors may, however, alter the investment policy at any time without shareholder approval.
7.
Our Banks Investments. Our bank may invest its funds in a wide variety of debt instruments and may participate in the federal funds market with other depository institutions. Subject to certain exceptions, our bank is prohibited from investing in equity securities. Among the equity investments permitted for our bank under various conditions and subject in some instances to amount limitations, are shares of a subsidiary insurance agency, mortgage company, real estate company, or Michigan business and industrial development company, such as our insurance company, our mortgage company, or our real estate company. Under another such exception, in certain circumstances and with prior notice to or approval of the FDIC, our bank could invest up to 10% of its total assets in the equity securities of a subsidiary corporation engaged in the acquisition and development of real property for sale, or the improvement of real property by construction or rehabilitation of residential or commercial units for sale or lease. Our bank has no present plans to make such an investment. Real estate acquired by our bank in satisfaction of or foreclosure upon loans may be held by our bank for specified periods. Our bank is also permitted to invest in such real estate as is necessary for the convenient transaction of its business. Our banks Board of Directors may alter the banks investment policy without shareholder approval at any time.
Additional detail and information relative to the securities portfolio is incorporated by reference to Managements Discussion and Analysis and Note 2 of the Notes to Consolidated Financial Statements included in this Annual Report.
Competition
Our primary markets for loans and core deposits are the Grand Rapids, Holland and Lansing metropolitan areas. We face substantial competition in all phases of our operations from a variety of different competitors. We compete for deposits, loans and other financial services with numerous Michigan-based and out-of-state banks, savings banks, thrifts, credit unions and other financial institutions as well as from other entities that provide financial services. Some of the financial institutions and financial service organizations with which we compete are not subject to the same degree of regulation as we are. Many of our primary competitors have been in business for many years, have established customer bases, are larger, have substantially higher lending limits than we do, and offer larger branch networks and other services which we do not. Most of these same entities have greater capital resources than we do, which, among other things, may allow them to price their services at levels more favorable to the customer and to provide larger credit facilities than we do. Under specified circumstances (that have been modified by the Dodd-Frank Act), securities firms and insurance companies that elect to become financial holding companies under the Bank Holding Company Act may acquire banks and other financial institutions. Federal banking law affects the competitive environment in which we conduct our business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services.
Selected Statistical Information
Managements Discussion and Analysis beginning on Page F-4 in this Annual Report includes selected statistical information.
Return on Equity and Assets
Return on Equity and Asset information is included in Managements Discussion and Analysis beginning on Page F-4 in this Annual Report.
Available Information
We maintain an internet website at www.mercbank.com. We make available on or through our website, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practical after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We do not intend the address of our website to be an active link or to otherwise incorporate the contents of our website into this Annual Report.
8.
Item 1A. | Risk Factors. |
The following risk factors could affect our business, financial condition or results of operations. These risk factors should be considered in connection with evaluating the forward-looking statements contained in this Annual Report because they could cause the actual results and conditions to differ materially from those projected in forward-looking statements. Before you buy our common stock, you should know that investing in our common stock involves risks, including the risks described below. The risks that are highlighted here are not the only ones we face. If the adverse matters referred to in any of the risks actually occur, our business, financial condition or operations could be adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.
Difficult market conditions have adversely affected our industry.
Declines in the housing market over the past several years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values by financial institutions. These write-downs, initially of asset-backed securities but spreading to other securities and loans, have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets have adversely affected our business, financial condition and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. During 2011, economic conditions in our markets, the United States and worldwide did generally improve; however, there can be no assurance that this improvement will continue.
Significant declines in the value of commercial real estate adversely impact us.
Many of our loans relate to commercial real estate. Stressed economic conditions have significantly reduced the value of commercial real estate and have strained the financial condition of our commercial real estate borrowers, especially in the land development and non-owner occupied commercial real estate segments of our loan portfolio. Those difficulties have adversely affected us and could produce additional losses and other adverse effects on our business.
Market volatility may adversely affect us.
The capital and credit markets have been experiencing volatility and disruption. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without apparent regard to those issuers underlying financial strength. The current levels of market disruption and volatility have an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
9.
Adverse changes in economic conditions or interest rates may negatively affect our earnings, capital and liquidity.
The results of operations for financial institutions, including our bank, have been materially and adversely affected by changes in prevailing local and national economic conditions, including declines in real estate market values and the related declines in value of our real estate collateral, increases or decreases in interest rates and changes in the monetary and fiscal policies of the federal government. Our profitability is heavily influenced by the spread between the interest rates we earn on loans and investments and the interest rates we pay on deposits and other interest-bearing liabilities, as well as provisions to the allowance for loan losses. Substantially all of our loans are to businesses and individuals in the cities and surrounding areas of Grand Rapids, Holland and Lansing, Michigan, and declines in the economies of these areas have adversely affected us. Continued stress on our financial condition is likely even as economic conditions begin to improve within our markets. Like most banking institutions, our net interest spread and margin will be affected by general economic conditions and other factors that influence market interest rates and our ability to respond to changes in these rates. At any given time, our assets and liabilities may be such that they will be affected differently by a given change in interest rates.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Even routine funding transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
The effect of the U.S. Governments response to the financial crisis remains uncertain.
In response to the turmoil in the financial services sector and the severe recession in the broader economy, the U.S. Government has taken legislative and other action intended to restore financial stability and economic growth. In October, 2008, then President Bush signed the Emergency Economic Stabilization Act of 2008 (the EESA). Among other things, the EESA established the Troubled Asset Relief Program (TARP). Under TARP, the United States Treasury Department (the Treasury Department) was given the authority, among other things, to purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions and others for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On October 14, 2008, the Treasury Department announced a program under EESA pursuant to which it would make senior preferred stock investments in qualifying financial institutions (the Capital Purchase Program). In February, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 (the ARRA). The ARRA contained, among other things, a further package of economic stimulus measures and amendments to EESAs restrictions on compensation of executives of financial institutions and others participating in the TARP. In addition to legislation, the Federal Reserve Board eased short-term interest rates and implemented a series of emergency programs to furnish liquidity to the financial markets and credit to various participants in those markets, as well as programs of quantitative easing through direct purchases of certain Treasury securities. The FDIC and the Treasury Department also implemented further measures to address the crisis in the financial services sector. Further legislation providing tax relief and other economic stimulus was adopted by Congress in 2010 and 2011. There can be no assurance as to the actual impact of these laws, and their respective implementing regulations, the programs of the government agencies, or any further legislation or regulations, on the financial markets or the broader economy. A failure to stabilize the financial markets, and a continuation or worsening of the current financial market conditions, could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.
10.
The effect of financial services legislation and regulations remains uncertain.
In response to the financial crisis, on July 21, 2010, President Obama signed the Dodd-Frank Act, the most comprehensive reform of the regulation of the financial services industry since the Great Depression of the 1930s. Among many other things, the Dodd-Frank Act provides for increased supervision of financial institutions by regulatory agencies, more stringent capital requirements for financial institutions, major changes to deposit insurance assessments by the FDIC, prohibitions on proprietary trading and sponsorship or investment in hedge funds and private equity funds by insured depository institutions and their affiliates, heightened regulation of hedging and derivatives activities, a greater focus on consumer protection issues, in part through the formation of a new Consumer Financial Protection Bureau having powers formerly split among different regulatory agencies, extensive changes to the regulation of mortgage lending, imposition of limits on interchange transaction and network fees for electronic debit transactions, repeal of the prohibition on payment of interest on demand deposits, the effective winding up of additional expenditures of funds under the TARP, and the imposition of a sunset date of December 31, 2012 on expenditures under the ARRA. Many of the Dodd-Frank Acts provisions have delayed effective dates, some of which have not yet occurred. In addition, other provisions require implementing regulations of various federal agencies, some of which have not yet been adopted in final form. There can be no assurance that the Dodd-Frank Act and its implementing regulations will not limit our ability to pursue business opportunities, impose additional costs on us, impact our revenues or the value of our assets, or otherwise adversely affect our business.
The U.S. Governments legislative and regulatory response to the financial crisis and our participation in its programs may have adverse effects on us.
The programs established or to be established under the EESA, TARP, the ARRA, the Dodd-Frank Act or other legislation or regulations may have adverse effects upon us. We face increased regulation in our industry. Compliance with such regulations may increase our costs and limit our ability to pursue business opportunities. Also, our participation in specific programs may subject us to additional restrictions. For example, we participated in the TARP Capital Purchase Program by selling preferred stock and a warrant for common stock to the Treasury Department for $21.0 million in May of 2009. That participation limits our ability, without the consent of the Treasury Department, to increase the cash dividend on, or to repurchase, our common stock. It also subjects us to restrictions on the compensation we may pay to our executives. The restrictions may adversely affect the trading price of our common stock or our ability to recruit and retain executives.
Our credit losses could increase and our allowance may not be adequate to cover actual loan losses.
The risk of nonpayment of loans is inherent in all lending activities, and nonpayment, when it occurs, may have a materially adverse effect on our earnings and overall financial condition as well as the value of our common stock. Our focus on commercial lending may result in a larger concentration of loans to small businesses. As a result, we may assume different or greater lending risks than other banks. We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for losses based on several factors. If our assumptions are wrong, our allowance may not be sufficient to cover our losses, which would have an adverse effect on our operating results. The actual amounts of future provisions for loan losses cannot be determined at this time and may exceed the amounts of past provisions. Additions to our allowance decrease our net income.
We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations.
We are and will continue to be dependent upon the services of our management team, including Michael H. Price, Chairman of the Board, President and Chief Executive Officer, and our other senior managers. The loss of Mr. Price, or any of our other senior managers, could have an adverse effect on our growth and performance. We have entered into employment contracts with Mr. Price and two other executive officers. The contracts provide for a three-year employment period that is extended for an additional year each year unless a notice is given indicating that the contract will not be extended.
11.
In addition, we continue to depend on our key commercial loan officers. Several of our commercial loan officers are responsible, or share responsibility, for generating and managing a significant portion of our commercial loan portfolio. Our success can be attributed in large part to the relationships these officers as well as members of our management team have developed and are able to maintain with our customers as we continue to implement our community banking philosophy. The loss of any of these commercial loan officers could adversely affect our loan portfolio and performance, and our ability to generate new loans. Many of our key employees have signed agreements with us agreeing not to compete with us in one or more of our markets for specified time periods if they leave employment with us.
Some of the other financial institutions in our markets also require their key employees to sign agreements that preclude or limit their ability to leave their employment and compete with them or solicit their customers. These agreements make it more difficult for us to hire loan officers with experience in our markets who can immediately solicit their former or new customers on our behalf.
Decline in the availability of out-of-area deposits could cause liquidity or interest rate margin concerns, or limit our growth.
We have utilized, and expect to continue to utilize, out-of-area or wholesale deposits to support our assets. These deposits are generally a lower cost source of funds when compared to the interest rates that we would have to offer in our local markets to generate a commensurate level of funds. In addition, the overhead costs associated with wholesale deposits are considerably less than the overhead costs we would incur to obtain and administer a similar level of local deposits. A decline in the availability of these wholesale deposits would require us to fund our growth with more costly funding sources, which could reduce our net interest margin, limit our growth, reduce our asset size, or increase our overhead costs. Wholesale deposits include deposits obtained through brokers. If a bank is not well capitalized, regulatory approval is required to accept brokered deposits.
Future sales of our common stock or other securities may dilute the value of our common stock.
In many situations, our Board of Directors has the authority, without any vote of our shareholders, to issue shares of our authorized but unissued preferred or common stock, including shares authorized and unissued under our Stock Incentive Plan of 2006. In the future, we may issue additional securities, through public or private offerings, in order to raise additional capital. Any such issuance would dilute the percentage of ownership interest of existing shareholders and may dilute the per share book value of the common stock. In addition, option holders under our stock-based incentive plans may exercise their options at a time when we would otherwise be able to obtain additional equity capital on more favorable terms.
We are subject to significant government regulation, and any regulatory changes may adversely affect us.
The banking industry is heavily regulated under both federal and state law. These regulations are primarily intended to protect customers, not our creditors or shareholders. Existing state and federal banking laws subject us to substantial limitations with respect to the making of loans, the purchase of securities, the payment of dividends and many other aspects of our business. Some of these laws may benefit us, others may increase our costs of doing business, or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition. Federal economic and monetary policy may also affect our ability to attract deposits, make loans and achieve satisfactory interest spreads.
12.
Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.
We face substantial competition in all phases of our operations from a variety of different competitors. Our future growth and success will depend on our ability to compete effectively in this highly competitive environment. We compete for deposits, loans and other financial services with numerous Michigan-based and out-of-state banks, thrifts, credit unions and other financial institutions as well as other entities that provide financial services, including securities firms and mutual funds. Some of the financial institutions and financial service organizations with which we compete are not subject to the same degree of regulation as we are. Most of our competitors have been in business for many years, have established customer bases, are larger, have substantially higher lending limits than we do and offer branch networks and other services which we do not, including trust and international banking services. Most of these entities have greater capital and other resources than we do, which, among other things, may allow them to price their services at levels more favorable to the customer and to provide larger credit facilities than we do. This competition may limit our growth or earnings. Under specified circumstances (that have been modified by the Dodd-Frank Act), securities firms and insurance companies that elect to become financial holding companies under the Bank Holding Company Act may acquire banks and other financial institutions. Federal banking law affects the competitive environment in which we conduct our business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties.
Minimum capital requirements may increase.
The provisions of the Dodd-Frank Act relating to capital to be maintained by financial institutions approach convergence with the standards (generally known as Basel III) adopted in December, 2010 by the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision. Among other things, those standards contain a narrower definition of elements qualifying for inclusion as Tier 1 capital, and higher minimum risk-based capital levels, than those required under current U.S. law and regulations. Responsible officials of the federal bank regulatory agencies have suggested that the agencies may issue proposed regulations, possibly as early as 2012, that would impose increased minimum risk-based capital requirements applicable to all insured depository institutions comparable to those required under Basel III. There can be no assurance when or if such regulatory changes may be proposed or if proposed, become effective.
We may need to raise additional capital in the future, and such capital may not be available when needed or at all.
We may need or want to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, particularly if our asset quality or earnings were to deteriorate significantly. Our ability to raise additional capital will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. Economic conditions and any loss of confidence in financial institutions generally may increase our cost of funding and limit access to certain customary sources of capital.
There can be no assurance that capital will be available on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of equity or debt purchasers, or counterparties participating in the capital markets, may adversely affect our capital costs and our ability to raise capital and, potentially, our liquidity. Also, if we need to raise capital in the future, we may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on our business, financial condition and results of operations.
13.
We continually encounter technological change, and we may have fewer resources than our competitors to continue to invest in technological improvements.
The banking industry is undergoing 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. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements than we do. There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.
Our Articles of Incorporation and By-laws and the laws of the State of Michigan contain provisions that may discourage or prevent a takeover of our company and reduce any takeover premium.
Our Articles of Incorporation and By-laws, and the corporate laws of the State of Michigan, include provisions which are designed to provide our Board of Directors with time to consider whether a hostile takeover offer is in our and our shareholders best interest. These provisions, however, could discourage potential acquisition proposals and could delay or prevent a change in control. The provisions also could diminish the opportunities for a holder of our common stock to participate in tender offers, including tender offers at a price above the then-current market price for our common stock. These provisions could also prevent transactions in which our shareholders might otherwise receive a premium for their shares over then-current market prices, and may limit the ability of our shareholders to approve transactions that they may deem to be in their best interests.
The Michigan Business Corporation Act contains provisions intended to protect shareholders and prohibit or discourage various types of hostile takeover activities. In addition to these provisions and the provisions of our Articles of Incorporation and By-laws, federal law requires the Federal Reserve Boards approval prior to acquiring control of a bank holding company. All of these provisions may delay or prevent a change in control without action by our shareholders and could adversely affect the price of our common stock.
There is a limited trading market for our common stock.
The price of our common stock has been, and will likely continue to be, subject to fluctuations based on, among other things, economic and market conditions for bank holding companies and the stock market in general, as well as changes in investor perceptions of our company. The issuance of new shares of our common stock also may affect the market for our common stock.
Our common stock is traded on the Nasdaq Global Select Market under the symbol MBWM. The development and maintenance of an active public trading market depends upon the existence of willing buyers and sellers, the presence of which is beyond our control. While we are a publicly-traded company, the volume of trading activity in our stock is still relatively limited. Even if a more active market develops, there can be no assurance that such a market will continue, or that our shareholders will be able to sell their shares at or above the offering price.
At present we are not paying any dividends on our common stock. For more information on the suspension of our cash dividend, see Item 5 of this Annual Report. Our ability to pay cash and stock dividends is subject to limitations under various laws and regulations, to prudent and sound banking practices, and to contractual provisions relating to our subordinated debentures and participation in the Capital Purchase Program.
14.
Our business is subject to operational risks.
We, like most financial institutions, are exposed to many types of operational risks, including the risk of fraud by employees or outsiders, unauthorized transactions by employees or operational errors. Operational errors may include clerical or record keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Given our volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully corrected. Our necessary dependence upon automated systems to record and process our transaction volume may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect.
We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, including, for example, computer viruses or electrical or telecommunications outages, which may give rise to losses in service to customers and to loss or liability to us. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations to us, or will be subject to the same risk of fraud or operational errors by their respective employees as are we, and to the risk that our or our vendors business continuity and data security systems prove not to be adequate. We also face the risk that the design of our controls and procedures proves inadequate or are circumvented, causing delays in detection or errors in information. Although we maintain a system of controls designed to keep operational risk at appropriate levels, there can be no assurance that we will not suffer losses from operational risks in the future that may be material in amount.
Item 1B. | Unresolved Staff Comments |
We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more before the end of our 2011 fiscal year and that remain unresolved.
Item 2. | Properties. |
During 2005, our bank placed into service a new four-story facility located approximately two miles north from the center of downtown Grand Rapids. This facility serves as our headquarters and our banks main office, and houses the administration function, our banks commercial lending and review function, our banks loan operations function, a full service branch, and portions of our banks retail lending and business development function. The facility consists of approximately 55,000 square feet of usable space and contains multiple drive-through lanes with ample parking. The land and building are owned by our real estate company. The address of this facility is 310 Leonard Street NW, Grand Rapids, Michigan.
Our bank designed and constructed a full service branch and retail loan facility which opened in July of 1999 in Alpine Township, a northwest suburb of Grand Rapids. The facility is one story and has approximately 8,000 square feet of usable space. The land and building are owned by our bank. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 4613 Alpine Avenue NW, Comstock Park, Michigan.
During 2001, our bank designed and constructed two facilities on a 4-acre parcel of land located in the City of Wyoming, a southwest suburb of Grand Rapids. The land had been purchased by our bank in 2000. The larger of the two buildings is a full service branch and deposit operations facility which opened in September of 2001. The facility is two-stories and has approximately 25,000 square feet of usable space. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 5610 Byron Center Avenue SW, Wyoming, Michigan. The other building is a single-story facility with approximately 11,000 square feet of usable space. Our banks accounting, audit, loss prevention and wire transfer functions are housed in this building, which underwent a renovation in 2005 that almost doubled its size. The address of this facility is 5650 Byron Center Avenue SW, Wyoming, Michigan.
15.
During 2002, our bank designed and constructed a full service branch which opened in December of 2002 in the City of Kentwood, a southeast suburb of Grand Rapids. The land had been purchased by our bank in 2001. The facility is one story and has approximately 10,000 square feet of usable space. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 4860 Broadmoor Avenue SW, Kentwood, Michigan.
During 2003, our bank designed and constructed a full service branch in the northeast quadrant of the City of Grand Rapids. The land had been purchased by our bank in 2002. The facility is one story and has approximately 3,500 square feet of usable space. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 3156 Knapp Street NE, Grand Rapids, Michigan.
During 2003, our bank designed and started construction of a new two-story facility located in Holland, Michigan. This facility, which was completed during the fourth quarter of 2004, serves as a full service banking center for the Holland area, including commercial lending, retail lending and a full service branch. The facility, which is owned by our bank, consists of approximately 30,000 square feet of usable space and contains multiple drive-through lanes with ample parking. The address of this facility is 880 East 16th Street, Holland, Michigan.
During 2006, our bank purchased approximately 3 acres of vacant land and designed and initiated construction of a new three-story facility in East Lansing, Michigan. This facility was completed during the second quarter of 2007, and serves as a full service banking center for the greater Lansing area, including commercial lending, retail lending, and a full service branch. The facility consists of approximately 27,000 square feet of usable space and contains multiple drive-through lanes with ample parking. The address of this facility is 3737 Coolidge Road, East Lansing, Michigan.
Item 3. | Legal Proceedings. |
From time to time, we may be involved in various legal proceedings that are incidental to our business. In the opinion of management, we are not a party to any legal proceedings that are material to our financial condition, either individually or in the aggregate.
Item 4. | Mine Safety Disclosures. |
Not applicable.
PART II
Item 5. | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. |
Our common stock is traded on the Nasdaq Global Select Market under the symbol MBWM. At February 1, 2012, there were 342 record holders of our common stock. In addition, we estimate that there were approximately 4,000 beneficial owners of our common stock who own their shares through brokers or banks. The following table shows the high and low sales prices for our common stock as reported by the Nasdaq Global Select Market for the periods indicated and the quarterly cash dividends paid by us during those periods.
16.
High | Low | Dividend | ||||||||||
2011 |
||||||||||||
First Quarter |
$ | 10.26 | $ | 7.82 | $ | 0.00 | ||||||
Second Quarter |
9.85 | 7.60 | 0.00 | |||||||||
Third Quarter |
10.09 | 7.72 | 0.00 | |||||||||
Fourth Quarter |
9.99 | 7.51 | 0.00 | |||||||||
2010 |
||||||||||||
First Quarter |
$ | 4.06 | $ | 3.10 | $ | 0.01 | ||||||
Second Quarter |
6.66 | 3.95 | 0.00 | |||||||||
Third Quarter |
5.99 | 3.99 | 0.00 | |||||||||
Fourth Quarter |
8.40 | 3.87 | 0.00 |
Holders of our common stock are entitled to receive dividends that the Board of Directors may declare from time to time. We may only pay dividends out of funds that are legally available for that purpose. We are a holding company and substantially all of our assets are held by our subsidiaries. Our ability to pay dividends to our shareholders depends primarily on our banks ability to pay dividends to us. Dividend payments and extensions of credit to us from our bank are subject to legal and regulatory limitations, generally based on capital levels and current and retained earnings, imposed by law and regulatory agencies with authority over our bank. The ability of our bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. In addition, under the terms of our subordinated debentures, we would be precluded from paying dividends on our common stock if an event of default has occurred and is continuing under the subordinated debentures, or if we exercised our right to defer payments of interest on the subordinated debentures, until the deferral ended. Also, in connection with our participation in the Treasury Departments Capital Purchase Program, we agreed that we would not, without the Treasury Departments consent, increase our cash dividend rate on our common stock, or with certain exceptions, repurchase any shares of our common stock. These restrictions relating to the Capital Purchase Program remain in effect until the earlier of (i) May 15, 2012, or (ii) when all of the preferred stock that we sold to the Treasury Department has been redeemed by us or transferred by the Treasury Department to third parties.
On July 9, 2010, we announced via a Form 8-K filed with the Securities and Exchange Commission that we were deferring regularly scheduled quarterly interest payments on our subordinated debentures beginning with the quarterly interest payment scheduled to have been paid on July 18, 2010. The deferral of interest payments on the subordinated debentures resulted in the deferral of distributions on our trust preferred securities. We also announced that we were deferring regularly scheduled quarterly dividend payments on our preferred stock beginning with the quarterly dividend payment scheduled to have been paid on August 15, 2010. On October 18, 2011, we announced via a Form 8-K filed with the Securities and Exchange Commission that we were bringing all of the accrued and unpaid interest (approximately $1.28 million) current on the subordinated debentures on that date, thereby providing for the distributions on our trust preferred securities to also be brought current on that date. We also announced that on October 19, 2011, we intended to bring current all accrued and unpaid dividends (approximately $1.36 million) on our preferred stock through October 18, 2011, which in fact we did consummate as planned. We had been accruing during the deferral period for the unpaid interest under the subordinated debentures and undeclared dividends under the preferred stock. We have made all scheduled payments on our subordinated debentures and preferred stock since, and we expect to make the scheduled payments in future periods.
17.
We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Our banks ability to pay cash and stock dividends is subject to limitations under various laws and regulations, to prudent and sound banking practices, and to contractual provisions relating to our subordinated debentures and participation in the Capital Purchase Program. During 2009, we paid a cash dividend on our common stock each calendar quarter. However, reflecting our financial results and the poor and weakening economy, we lowered the dollar amount of the cash dividends paid during the year. During the first quarter of 2009, our cash dividend was $0.04 per share, but was lowered to $0.01 per share for the second, third and fourth quarters. Our cash dividend on our common stock was also $0.01 per common share during the first quarter of 2010. In April 2010, we suspended future payments of cash dividends on our common stock until economic conditions and our financial condition improve. In addition, from July 2010 through October 2011, we were precluded from paying cash dividends on our common stock and preferred stock because, under the terms of our subordinated debentures, we could not pay cash dividends during periods when we had deferred the payment of interest on our subordinated debentures. Also, pursuant to our Articles of Incorporation, we were precluded from paying dividends on our common stock while any dividends accrued on our preferred stock had not been declared and paid. As discussed above, those restrictions were removed on October 18 and 19, 2011, when we terminated the deferral of interest on our subordinated debentures and brought current the dividends on our preferred stock, respectively.
Issuer Purchases of Equity Securities
We did not purchase any shares of our common stock during the fourth quarter of 2011.
Shareholder Return Performance Graph
Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on our common stock (based on the last reported sales price of the respective year) with the cumulative total return of the Nasdaq Composite Index and the SNL Bank Nasdaq Index from December 31, 2006 through December 31, 2011. The following is based on an investment of $100 on December 31, 2006 in our common stock, the Nasdaq Composite Index and the SNL Bank Nasdaq Index, with dividends reinvested where applicable.
18.
Period Ending | ||||||||||||||||||||||||
Index |
12/31/06 | 12/31/07 | 12/31/08 | 12/31/09 | 12/31/10 | 12/31/11 | ||||||||||||||||||
Mercantile Bank Corporation |
100.00 | 44.22 | 12.62 | 9.20 | 24.55 | 29.20 | ||||||||||||||||||
NASDAQ Composite |
100.00 | 110.66 | 66.42 | 96.54 | 114.06 | 113.16 | ||||||||||||||||||
SNL Bank NASDAQ |
100.00 | 78.51 | 57.02 | 46.25 | 54.57 | 48.42 |
Item 6. | Selected Financial Data. |
The Selected Financial Data in this Annual Report is incorporated here by reference.
Item 7. | Managements Discussion and Analysis of Financial Condition and Results of Operations. |
Managements Discussion and Analysis included in this Annual Report is incorporated here by reference.
Item 7A. | Quantitative and Qualitative Disclosures About Market Risk. |
The information under the heading Market Risk Analysis included in this Annual Report is incorporated here by reference.
Item 8. | Financial Statements and Supplementary Data. |
The Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Reports of Independent Registered Public Accounting Firm included in this Annual Report are incorporated here by reference.
19.
Item 9. | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. |
None
Item 9A. | Controls and Procedures. |
As of December 31, 2011, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2011.
There have been no significant changes in our internal control over financial reporting during the quarter ended December 31, 2011, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). There are inherent limitations in the effectiveness of any system of internal control. Accordingly, even an effective system of internal control can provide only reasonable assurance with respect to financial statement preparation.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2011. This evaluation was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2011. Refer to page F-38 for managements report.
Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting which is included in this Annual Report.
Item 9B. | Other Information. |
None
PART III
Item 10. | Directors, Executive Officers and Corporate Governance. |
The information presented under the captions Election of Directors, Executive Officers, Section 16(a) Beneficial Ownership Reporting Compliance and Corporate Governance Code of Ethics in the definitive Proxy Statement of Mercantile for our April 26, 2012 Annual Meeting of Shareholders (the Proxy Statement), a copy of which will be filed with the Securities and Exchange Commission before the meeting date, is incorporated here by reference.
20.
We have a separately-designated standing audit committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of the Audit Committee consist of David M. Cassard, John F. Donnelly, Calvin D. Murdock, and Timothy O. Schad. The Board of Directors has determined that Messrs. Cassard, Murdock and Schad, members of the Audit Committee, are qualified as audit committee financial experts, as that term is defined in the rules of the Securities and Exchange Commission. Messrs. Cassard, Donnelly, Murdock, and Schad are independent, as independence for audit committee members is defined in the Nasdaq listing standards and the rules of the Securities and Exchange Commission.
Item 11. | Executive Compensation. |
The information presented under the captions Executive Compensation, Corporate Governance Compensation Committee Interlocks and Insider Participation and Compensation Committee Report in the Proxy Statement is incorporated here by reference.
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. |
The information presented under the caption Stock Ownership of Certain Beneficial Owners and Management in the Proxy Statement is incorporated here by reference.
Equity Compensation Plan Information
The following table summarizes information, as of December 31, 2011, relating to compensation plans under which equity securities are authorized for issuance.
Plan Category |
Number of securities to be issued upon exercise of outstanding options, warrants and rights |
Weighted-average exercise price of outstanding options, warrants and rights |
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) |
|||||||||
(a) | (b) | (c) | ||||||||||
Equity compensation plans approved by security holders (1) |
214,903 | $ | 22.40 | 429,000 | (2) | |||||||
Equity compensation plans not approved by security holders |
0 | 0 | 0 | |||||||||
Total |
214,903 | $ | 22.40 | 429,000 |
(1) | These plans are Mercantiles 1997 Employee Stock Option Plan, 2000 Employee Stock Option Plan, 2004 Employee Stock Option Plan, Independent Director Stock Option Plan and the Stock Incentive Plan of 2006. |
(2) | These securities are available under the Stock Incentive Plan of 2006. Incentive awards may include, but are not limited to, stock options, restricted stock, stock appreciation rights and stock awards. |
21.
Item 13. | Certain Relationships and Related Transactions, and Director Independence. |
The information presented under the captions Transactions with Related Persons and Corporate Governance Director Independence in the Proxy Statement is incorporated here by reference.
Item 14. | Principal Accountant Fees and Services. |
The information presented under the caption Principal Accountant Fees and Services in the Proxy Statement is incorporated here by reference.
PART IV
Item 15. | Exhibits and Financial Statement Schedules |
(a) (1) Financial Statements. The following financial statements and reports of the independent registered public accounting firm of Mercantile Bank Corporation and its subsidiaries are filed as part of this report:
The Consolidated Financial Statements, the Notes to the Consolidated Financial Statements, and the Reports of Our Independent Registered Public Accounting Firm listed above are incorporated by reference in Item 8 of this report.
(2) Financial Statement Schedules
Not applicable
(b) Exhibits:
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
3.1 | Our Articles of Incorporation are incorporated by reference to exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2009 | |
3.2 | Our Amended and Restated By-laws dated as of January 16, 2003 are incorporated by reference to exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003 |
22.
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
10.1 | Our 1997 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 * | |
10.2 | Our 2000 Employee Stock Option Plan is incorporated by reference to exhibit 10.14 of our Form 10-K for the year ended December 31, 2000 * | |
10.3 | Our 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 10-Q for the quarter ended September 30, 2004 * | |
10.4 | Form of Stock Option Agreement for options under the 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.2 of our Form 10-Q for the quarter ended September 30, 2004 * | |
10.5 | Our Independent Director Stock Option Plan is incorporated by reference to exhibit 10.26 of our Form 10-K for the year ended December 31, 2002 * | |
10.6 | Form of Stock Option Agreement for options under the Independent Director Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 8-K filed October 22, 2004 * | |
10.7 | Mercantile Bank of Michigan Amended and Restated Deferred Compensation Plan for Members of the Board of Directors dated June 29, 2006 is incorporated by reference to exhibit 10.9 of our Form 10-K for the year ended December 31, 2007 * | |
10.8 | First Amendment dated October 25, 2007 to the Mercantile Bank of Michigan Amended and Restated Deferred Compensation Plan for Members of the Board of Directors dated June 29, 2006 is incorporated by reference to exhibit 10.10 of our Form 10-K for the year ended December 31, 2007 * | |
10.9 | Second Amendment dated October 23, 2008 to the Mercantile Bank of Michigan Amended and Restated Deferred Compensation Plan for Members of the Board of Directors dated June 29, 2007 is incorporated by reference to exhibit 10.9 of our Form 10-K for the year ended December 31, 2008 * | |
10.10 | Agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.3 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 | |
10.11 | Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated May 12, 2000 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.15 of our Form 10-K for the year ended December 31, 2000 | |
10.12 | Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated November 21, 2002 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.5 of our Form 10-K for the year ended December 31, 2002 |
23.
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
10.13 | Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated December 20, 2006 extending the agreements between Fiserv Solutions, Inc. and our bank dated September 10, 1997 and November 21, 2002 is incorporated by reference to exhibit 10.14 of our Form 10-K for the year ended December 31, 2007 | |
10.14 | Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2001 * | |
10.15 | Employment Agreement dated as of October 18, 2001, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * | |
10.16 | Employment Agreement dated as of October 18, 2001, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * | |
10.17 | Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2002 * | |
10.18 | Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2002 * | |
10.19 | Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.24 of our Form 10-K for the year ended December 31, 2002 * | |
10.20 | Amendment to Employment Agreement dated as of October 28, 2004, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2004 * | |
10.21 | Junior Subordinated Indenture between us and Wilmington Trust Company dated September 16, 2004 providing for the issuance of the Series A and Series B Floating Rate Junior Subordinated Notes due 2034 is incorporated by reference to exhibit 10.1 of our Form 8-K filed December 15, 2004 | |
10.22 | Amended and Restated Trust Agreement dated September 16, 2004 for Mercantile Bank Capital Trust I is incorporated by reference to exhibit 10.2 of our Form 8-K filed December 15, 2004 | |
10.23 | Placement Agreement between us, Mercantile Bank Capital Trust I, and SunTrust Capital Markets, Inc. dated September 16, 2004 is incorporated by reference to exhibit 10.3 of our Form 8-K filed December 15, 2004 | |
10.24 | Guarantee Agreement dated September 16, 2004 between Mercantile as Guarantor and Wilmington Trust Company as Guarantee Trustee is incorporated by reference to exhibit 10.4 of our Form 8-K filed December 15, 2004 | |
10.25 | Form of Agreement Amending Stock Option Agreement, dated November 17, 2005 issued under our 2004 Employee Stock Option Plan, is incorporated by reference to exhibit 10.1 of our Form 8-K filed December 14, 2005 * |
24.
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
10.26 | Second Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Michael H. Price is incorporated by reference to exhibit 10.29 of our Form 10-K for the year ended December 31, 2005 * | |
10.27 | Third Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Robert B. Kaminski, Jr. is incorporated by reference to exhibit 10.30 of our Form 10-K for the year ended December 31, 2005 * | |
10.28 | Second Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Charles E. Christmas is incorporated by reference to exhibit 10.31 of our Form 10-K for the year ended December 31, 2005 * | |
10.29 | Form of Mercantile Bank of Michigan Amended and Restated Executive Deferred Compensation Agreement dated November 18, 2006, that has been entered into between our bank and each of Gerald R. Johnson, Jr., Michael H. Price, Robert B. Kaminski, Jr., Charles E. Christmas, and certain other officers of our bank is incorporated by reference to exhibit 10.34 of our Form 10-K for the year ended December 31, 2007 * | |
10.30 | Form of First Amendment to the Mercantile Bank of Michigan Executive Deferred Compensation Agreement dated November 18, 2006, that has been entered into between our bank and each of Gerald R. Johnson, Jr., Michael H. Price, Robert B. Kaminski, Jr., Charles E. Christmas, and certain other officers of our bank, dated October 25, 2007 is incorporated by reference to exhibit 10.35 of our Form 10-K for the year ended December 31, 2007 * | |
10.31 | Form of Second Amendment to the Mercantile Bank of Michigan Executive Deferred Compensation Agreement dated November 18, 2006, that has been entered into between our bank and each of Michael H. Price, Robert B. Kaminski, Charles E. Christmas, and certain other officers of our bank, dated October 23, 2008 is incorporated by reference to exhibit 10.34 of our Form 10-K for the year ended December 31, 2008 * | |
10.32 | Form of Mercantile Bank of Michigan Split Dollar Agreement that has been entered into between our bank and each of Gerald R. Johnson, Jr., Michael H. Price, Robert B. Kaminski, Jr., Charles E. Christmas, and certain other officers of our bank is incorporated by reference to exhibit 10.33 of our Form 10-K for the year ended December 31, 2005 * | |
10.33 | Director Fee Summary * | |
10.34 | Stock Incentive Plan of 2006 is incorporated by reference to Appendix A of our proxy statement for our April 27, 2006 annual meeting of shareholders that was filed with the Securities and Exchange Commission * | |
10.35 | Amendment and Restatement of Stock Incentive Plan of 2006 dated November 18, 2008 is incorporated by reference to exhibit 10.39 of our Form 10-K for the year ended December 31, 2008 * |
25.
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
10.36 | Form of Notice of Grant of Incentive Stock Option and Stock Option Agreement for incentive stock options granted in 2006 under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.1 of our Form 8-K filed November 22, 2006 * | |
10.37 | Form of Notice of Grant of Incentive Stock Option and Stock Option Agreement for incentive stock options granted after 2006 under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.41 of our Form 10-K for the year ended December 31, 2007 * | |
10.38 | Form of Restricted Stock Award Agreement Notification of Award and Terms and Conditions of Award for restricted stock granted in 2006 under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.2 of our Form 8-K filed November 22, 2006 * | |
10.39 | Form of Restricted Stock Award Agreement Notification of Award and Terms and Conditions of Award for restricted stock granted after 2006 under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.43 of our Form 10-K for the year ended December 31, 2007 * | |
10.40 | Mercantile Bank Corporation Employee Stock Purchase Plan of 2002 is incorporated by reference to exhibit 10.47 of our Form 10-K for the year ended December 31, 2008 | |
10.41 | First Amendment to Mercantile Bank Corporation Employee Stock Purchase Plan of 2002 is incorporated by reference to exhibit 4(c) of our Registration Statement on Form S-8 (Commission File No. 333-158280) that became effective on March 30, 2009 | |
10.42 | Second Amendment to Mercantile Bank Corporation Employee Stock Purchase Plan of 2002 is incorporated by reference to exhibit 4(d) of our Registration Statement on Form S-8 (Commission File No. 333-158280) that became effective on March 30, 2009 | |
10.43 | Letter Agreement, dated as of May 15, 2009, between Mercantile Bank Corporation and the United States Department of the Treasury, including the Securities Purchase Agreement Standard Terms and Schedules is incorporated by reference to exhibit 10.1 of our Form 8-K filed May 15, 2009 | |
10.44 | Side Letter Agreement, dated as of May 15, 2009, between Mercantile Bank Corporation and the United States Department of the Treasury regarding the American Recovery and Reinvestment Act of 2009 is incorporated by reference to exhibit 10.2 of our Form 8-K filed May 15, 2009 | |
10.45 | Amendment to Employment Agreements, dated May 15, 2009, by and among Mercantile Bank Corporation, Mercantile Bank of Michigan, Michael H. Price, Robert B. Kaminski, Jr. and Charles E. Christmas is incorporated by reference to exhibit 10.3 of our Form 8-K filed May 15, 2009 * | |
10.46 | Form of Waiver executed by each of Michael H. Price, Robert B. Kaminski, Jr. and Charles E. Christmas is incorporated by reference to exhibit 10.4 of our Form 8-K filed May 15, 2009 |
26.
EXHIBIT NO. |
EXHIBIT DESCRIPTION | |
10.47 | Warrant to Purchase Common Stock of Mercantile Bank Corporation, dated May 15, 2009 is incorporated by reference to exhibit 4.2 of our Form 8-K filed May 15, 2009 | |
21 | Subsidiaries of the company is incorporated by reference to exhibit 21 of our Form 10-K for the year ended December 31, 2008 | |
23 | Consent of BDO USA, LLP | |
31 | Rule 13a-14(a) Certifications | |
32.1 | Section 1350 Chief Executive Officer Certification | |
32.2 | Section 1350 Chief Financial Officer Certification | |
99.1 | Certification of our principal executive officer and principal financial officer relating to our participation in the Capital Purchase Program of the Troubled Asset Relief Program | |
101 | The following information from Mercantiles Annual Report on Form 10-K for the year ended December 31, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statements of Changes in Shareholders Equity, (iv) the Consolidated Statements of Cash Flows, and (v) the Notes to Consolidated Financial Statements ** |
* | Management contract or compensatory plan. |
** | Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections. |
(c) Financial Statements Not Included In Annual Report
Not applicable
27.
MERCANTILE BANK CORPORATION
FINANCIAL INFORMATION
December 31, 2011 and 2010
F-1
MERCANTILE BANK CORPORATION
FINANCIAL INFORMATION
December 31, 2011 and 2010
CONTENTS
F-3 | ||||
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
F-4 | |||
F-36 | ||||
REPORT BY MERCANTILE BANK CORPORATIONS MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING |
F-38 | |||
CONSOLIDATED FINANCIAL STATEMENTS |
||||
F-39 | ||||
F-40 | ||||
F-41 | ||||
F-44 | ||||
F-46 |
F-2
2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
(Dollars in thousands except per share data) | ||||||||||||||||||||
Consolidated Results of Operations: |
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Interest income |
$ | 71,069 | $ | 88,143 | $ | 104,909 | $ | 121,072 | $ | 144,181 | ||||||||||
Interest expense |
19,832 | 31,794 | 53,576 | 74,863 | 88,624 | |||||||||||||||
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Net interest income |
51,237 | 56,349 | 51,333 | 46,209 | 55,557 | |||||||||||||||
Provision for loan losses |
6,900 | 31,800 | 59,000 | 21,200 | 11,070 | |||||||||||||||
Noninterest income |
7,282 | 9,244 | 7,558 | 7,282 | 5,870 | |||||||||||||||
Noninterest expense |
41,495 | 47,156 | 46,488 | 42,126 | 38,356 | |||||||||||||||
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Income (loss) before income tax expense (benefit) |
10,124 | (13,363 | ) | (46,597 | ) | (9,835 | ) | 12,001 | ||||||||||||
Income tax expense (benefit) |
(27,361 | ) | (47 | ) | 5,490 | (4,876 | ) | 3,035 | ||||||||||||
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Net income (loss) |
37,485 | (13,316 | ) | (52,087 | ) | (4,959 | ) | 8,966 | ||||||||||||
Preferred stock dividends and accretion |
1,343 | 1,295 | 802 | 0 | 0 | |||||||||||||||
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Net income (loss) attributable to common shares |
$ | 36,142 | $ | (14,611 | ) | $ | (52,889 | ) | $ | (4,959 | ) | $ | 8,966 | |||||||
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Consolidated Balance Sheet Data: |
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Total assets |
$ | 1,433,229 | $ | 1,632,421 | $ | 1,906,208 | $ | 2,208,010 | $ | 2,121,403 | ||||||||||
Cash and cash equivalents |
76,372 | 64,198 | 21,735 | 25,804 | 29,430 | |||||||||||||||
Securities |
184,953 | 235,175 | 257,384 | 242,787 | 211,736 | |||||||||||||||
Loans |
1,072,422 | 1,262,630 | 1,539,818 | 1,856,915 | 1,799,880 | |||||||||||||||
Allowance for loan losses |
36,532 | 45,368 | 47,878 | 27,108 | 25,814 | |||||||||||||||
Bank owned life insurance |
48,520 | 46,743 | 45,024 | 42,462 | 39,118 | |||||||||||||||
Deposits |
1,112,075 | 1,273,832 | 1,401,627 | 1,599,575 | 1,591,181 | |||||||||||||||
Securities sold under agreements to repurchase |
72,569 | 116,979 | 99,755 | 94,413 | 97,465 | |||||||||||||||
Federal Home Loan Bank advances |
45,000 | 65,000 | 205,000 | 270,000 | 180,000 | |||||||||||||||
Subordinated debentures |
32,990 | 32,990 | 32,990 | 32,990 | 32,990 | |||||||||||||||
Shareholders equity |
164,999 | 125,936 | 140,104 | 174,372 | 178,155 | |||||||||||||||
Consolidated Financial Ratios: |
||||||||||||||||||||
Return on average assets |
2.36 | % | (0.80 | %) | (2.51 | %) | (0.23 | %) | 0.43 | % | ||||||||||
Return on average shareholders equity |
27.28 | % | (10.62 | %) | (29.91 | %) | (2.87 | %) | 5.10 | % | ||||||||||
Average shareholders equity to average assets |
8.66 | % | 7.56 | % | 8.40 | % | 8.01 | % | 8.44 | % | ||||||||||
Nonperforming loans to total loans |
4.20 | % | 5.50 | % | 5.52 | % | 2.66 | % | 1.66 | % | ||||||||||
Allowance for loan losses to total loans |
3.41 | % | 3.59 | % | 3.11 | % | 1.46 | % | 1.43 | % | ||||||||||
Tier 1 leverage capital |
12.09 | % | 9.09 | % | 8.64 | % | 9.17 | % | 9.97 | % | ||||||||||
Tier 1 leverage risk-based capital |
14.19 | % | 11.17 | % | 9.92 | % | 9.68 | % | 10.14 | % | ||||||||||
Total risk-based capital |
15.46 | % | 12.45 | % | 11.18 | % | 10.93 | % | 11.39 | % | ||||||||||
Per Common Share Data: |
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Net income (loss): |
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Basic |
$ | 4.20 | $ | (1.72 | ) | $ | (6.23 | ) | $ | (0.59 | ) | $ | 1.06 | |||||||
Diluted |
4.07 | (1.72 | ) | (6.23 | ) | (0.59 | ) | 1.05 | ||||||||||||
Book value at end of period |
16.73 | 12.20 | 13.86 | 20.29 | 20.89 | |||||||||||||||
Dividends declared |
0.00 | 0.01 | 0.07 | 0.31 | 0.55 | |||||||||||||||
Dividend payout ratio |
NA | NA | NA | NA | 52.16 | % |
F-3
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
The following discussion and other portions of this Annual Report contain forward-looking statements that are based on managements beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about our company. Words such as anticipates, believes, estimates, expects, forecasts, intends, is likely, plans, projects, and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (Future Factors) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.
Future Factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation or actions by bank regulators; changes in tax laws; changes in prices, levies, and assessments; impact of technological advances; governmental and regulatory policy changes; outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economies; and other risk factors described in Item 1A of this Annual Report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Managements Discussion and Analysis of Financial Condition and Results of Operations (Managements Discussion and Analysis) is based on Mercantile Bank Corporations consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and income tax accounting, and actual results could differ from those estimates. Management has reviewed the analyses with the Audit Committee of our Board of Directors.
Allowance For Loan Losses: The allowance for loan losses (allowance) is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on operating earnings.
F-4
The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual principal and interest payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loans existing interest rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the as is value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors are able to provide repayments, a recovery would be recorded upon receipt. Loans are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected.
Income Tax Accounting: Current income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. Deferred income tax liabilities and assets are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward (used) in future years. The valuation of our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state taxing authorities, and the extent of future taxable income will not differ from our current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings.
Accounting guidance requires us to assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a more likely than not standard. In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors that may impact future operating results. Significant weight is given to evidence that can be objectively verified. During 2011, we returned to pre-tax profitability for four consecutive quarters. Additionally, we experienced lower provision expense, continued declines in nonperforming assets and problem asset administration costs, a higher net interest margin, a further strengthening of our regulatory capital ratios and additional reductions in wholesale funding. This positive evidence allowed us to conclude that, as of December 31, 2011, it was more likely than not that we returned to sustainable profitability in amounts sufficient to allow for realization of our deferred tax assets in future years. Consequently, we reversed the valuation allowance that we had previously determined necessary to carry against our entire net deferred tax asset as of December 31, 2010 and 2009.
F-5
INTRODUCTION
This Managements Discussion and Analysis should be read in conjunction with the consolidated financial statements contained in this Annual Report. This discussion provides information about the consolidated financial condition and results of operations of Mercantile Bank Corporation and its consolidated subsidiary, Mercantile Bank of Michigan (our bank), and of Mercantile Bank Mortgage Company, LLC (our mortgage company), Mercantile Bank Real Estate Co., L.L.C. (our real estate company) and Mercantile Insurance Center, Inc. (our insurance company), which are subsidiaries of our bank. Unless the text clearly suggests otherwise, references to us, we, our, or the company include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above. We were incorporated on July 15, 1997 as a bank holding company to establish and own our bank. Our bank, after receiving all necessary regulatory approvals, began operations on December 15, 1997. Our bank has a strong commitment to community banking and offers a wide range of financial products and services, primarily to small- to medium-sized businesses, as well as individuals. Our banks lending strategy focuses on commercial lending, and, to a lesser extent, residential mortgage and consumer lending. Our bank also offers a broad array of deposit products, including checking, savings, money market, and certificates of deposit, as well as security repurchase agreements. Our primary markets are the Grand Rapids, Holland and Lansing areas. Our bank utilizes deposits from customers located outside of our primary market areas to assist in funding assets.
We formed a business trust, Mercantile Bank Capital Trust I (our trust), in 2004 to issue trust preferred securities. We issued subordinated debentures to our trust in return for the proceeds raised from the issuance of the trust preferred securities. In accordance with accounting guidelines, our trust is not consolidated, but instead we report the subordinated debentures issued to our trust as a liability.
Our mortgage companys predecessor, Mercantile Bank Mortgage Company, was formed to increase the profitability and efficiency of our mortgage loan operations. Mercantile Bank Mortgage Company initiated business on October 24, 2000 from our banks contribution of most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans. On the same date, our bank had also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement.
Our insurance company acquired, at nominal cost, an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent.
Our real estate company was organized on July 21, 2003, principally to develop, construct and own our facility in downtown Grand Rapids which serves as our banks main office and Mercantile Bank Corporations headquarters. Construction was completed during the second quarter of 2005.
FINANCIAL OVERVIEW
Over the past several years, our earnings performance has been negatively impacted by substantial provisions to the allowance and problem asset administration costs. Ongoing state, regional and national economic struggles negatively impacted some of our borrowers cash flows and underlying collateral values, leading to increased nonperforming assets, higher loan charge-offs and increased overall credit risk within our loan portfolio. We have worked with our borrowers to develop constructive dialogue to strengthen our relationships and enhance our ability to resolve complex issues. Although we experienced significant improvement in our asset quality during the latter part of 2010 and throughout 2011, the environment for the banking industry will likely remain stressed until economic conditions improve. Credit quality will continue to be our major concern, especially within our non-owner occupied commercial real estate loan portfolio.
F-6
We recorded a net profit during 2011, after having recorded net losses during the previous three years. A significantly lower provision expense primarily provided for the positive earnings performance; however, our improved earnings performance also reflects the many positive steps we have taken over the past several years to not only partially mitigate the impact of asset quality-related costs in the near term, but to benefit us on a longer-term basis as well. First, our net interest margin has improved as we have lowered local non-CD deposit rates and have replaced maturing high-rate deposits and borrowed funds with lower-costing funds, while at the same time our commercial loan pricing initiatives have significantly offset the negative impact of a relatively high level of nonaccrual loans. In addition, we are increasing our local deposit balances, reflecting the successful implementation of various initiatives, campaigns and product enhancements. The local deposit growth, combined with the reduction of loans outstanding, are providing for a substantial reduction of, and reliance on, wholesale funds. Next, our regulatory risk-based capital ratios are increasing, reflecting the impact of the net income recorded during 2011, the 2009 sale of preferred stock under the Treasurys Capital Purchase Program and the reduction of loans outstanding, which have more than offset the impact of our net losses recorded in 2010 and 2009. Lastly, we continue to see the positive effect of our overhead cost reduction initiatives, as we continue to make strides to reduce controllable noninterest expense.
Our asset quality metrics are on an improving trend, and we are optimistic that the positive trend will continue. In aggregate dollar amounts, nonperforming asset levels have declined almost 49% since the peak level at March 31, 2010, and at year-end 2011 were at the lowest level since December 31, 2008. Progress in the stabilization of economic and real estate market conditions has provided for numerous loan rating upgrades and significantly lower volumes of loan rating downgrades, providing for a substantially lower provision expense during 2011. We expect a continuation of improved market conditions will provide for lower future period provision expense and problem asset administration costs when compared to levels over the past several years.
FINANCIAL CONDITION
Reflecting strategies employed in regards to our financial condition and the continued weak economic environments within our markets, we shrunk our balance sheet during the past three years. Total assets declined from $1.63 billion on December 31, 2010 to $1.43 billion on December 31, 2011, representing a decrease in total assets of $199.2 million, or 12.2%. During 2010 and 2009, we had shrunk our balance sheet by $273.8 million and $301.8 million, respectively. The decline in total assets during 2011 was primarily comprised of a $190.2 million decrease in total loans, following a decline of $277.2 million and $317.1 million during 2010 and 2009, respectively. In addition, the securities portfolio declined $50.2 million during 2011 and $22.2 million during 2010. Our total deposits declined $161.8 million and our Federal Home Loan Bank (FHLB) advances decreased $20.0 million during 2011. During 2010 and 2009, our total deposits decreased $127.8 million and $197.9 million, respectively, while FHLB advances declined $140.0 million and $65.0 million during the respective time periods.
Earning Assets
Average earning assets equaled 94.3% of average total assets during 2011, a level very similar to the 94.8% during 2010. The loan portfolio continued to comprise a majority of earning assets, followed by securities, federal funds sold and interest-bearing deposits; however, during 2011, as in 2010, securities, federal funds sold and interest-bearing deposits comprised a larger percentage of earning assets compared to prior periods, primarily reflecting our decision to operate with a larger volume of on-balance sheet liquidity given market conditions. Average total loans equaled 79.6% of average earning assets in 2011, compared to 81.8% in 2010 and 85.1% in 2009. Meanwhile, average securities, federal funds sold and interest-bearing deposits equaled a combined 20.4% of average earning assets in 2011, compared to 18.2% in 2010 and 14.9% in 2009.
F-7
Our loan portfolio is primarily comprised of commercial loans. Commercial loans declined by $179.1 million during 2011, and at December 31, 2011, totaled $996.9 million, or 93.0% of the total loan portfolio. The decline in outstanding balances primarily reflects the impact of a concerted effort on our part to reduce exposure to certain non-owner occupied commercial real estate (CRE) lending and the sluggishness in business activity in our markets that results in fewer opportunities to make quality loans. During 2011, commercial loans collateralized by non-owner occupied CRE declined $114.9 million. Our systematic approach to reducing our exposure to certain non-owner occupied CRE lending has been prolonged, given the nature of CRE lending and depressed economic conditions; however, we believe that such a reduction was in our best interest when taking into account the increased inherent credit risk and nominal deposit balances associated with targeted borrowing relationships. Our commercial and industrial (C&I) loan portfolio declined $22.0 million during 2011, in large part reflecting ongoing sluggish business activity. We would expect to see higher commercial line of credit usage, along with increased equipment financing requests, when economic conditions further improve. Also during 2011, commercial loans collateralized by owner-occupied real estate declined $13.0 million, commercial loans related to residential land development and construction decreased by $20.3 million and commercial loans related to multi-family and residential rental properties declined by $8.9 million.
The commercial loan portfolio represents loans to businesses generally located within our market areas. Approximately 73% of the commercial loan portfolio is primarily secured by real estate properties, with the remaining generally secured by other business assets such as accounts receivable, inventory, and equipment. The continued concentration of the loan portfolio in commercial loans is consistent with our strategy of focusing a substantial amount of our efforts on commercial banking. Corporate and business lending is an area of expertise for our senior management team, and our commercial lenders have extensive commercial lending experience, with most having at least ten years experience. Of each of the loan categories that we originate, commercial loans are most efficiently originated and managed, thus limiting overhead costs by necessitating the attention of fewer employees. Our commercial lending business generates the largest portion of local deposits and is our primary source of demand deposits.
The following table summarizes our loans secured by real estate, excluding residential mortgage loans representing permanent financing of owner occupied dwellings and home equity lines of credit:
12/31/11 | 9/30/11 | 6/30/11 | 3/31/11 | 12/31/10 | ||||||||||||||||
Residential-Related: |
||||||||||||||||||||
Vacant Land |
$ | 13,124,000 | $ | 13,264,000 | $ | 13,484,000 | $ | 16,321,000 | $ | 17,201,000 | ||||||||||
Land Development |
17,007,000 | 17,441,000 | 18,134,000 | 27,171,000 | 28,147,000 | |||||||||||||||
Construction |
4,923,000 | 4,647,000 | 4,706,000 | 4,906,000 | 5,621,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
35,054,000 | 35,352,000 | 36,324,000 | 48,398,000 | 50,969,000 | ||||||||||||||||
Comml Non-Owner Occupied: |
||||||||||||||||||||
Vacant Land |
10,555,000 | 11,082,000 | 12,639,000 | 13,669,000 | 14,293,000 | |||||||||||||||
Land Development |
14,486,000 | 14,541,000 | 16,348,000 | 16,492,000 | 17,807,000 | |||||||||||||||
Construction |
13,615,000 | 11,061,000 | 10,709,000 | 10,046,000 | 31,827,000 | |||||||||||||||
Commercial Buildings |
376,805,000 | 397,279,000 | 429,708,000 | 484,629,000 | 489,371,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
415,461,000 | 433,963,000 | 469,404,000 | 524,836,000 | 553,298,000 | ||||||||||||||||
Comml Owner Occupied: |
||||||||||||||||||||
Construction |
4,213,000 | 2,986,000 | 1,517,000 | 1,404,000 | 672,000 | |||||||||||||||
Commercial Buildings |
268,479,000 | 269,776,000 | 264,848,000 | 273,739,000 | 282,388,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
272,692,000 | 272,762,000 | 266,365,000 | 275,143,000 | 283,060,000 | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Total |
$ | 723,207,000 | $ | 742,077,000 | $ | 772,093,000 | $ | 848,377,000 | $ | 887,327,000 | ||||||||||
|
|
|
|
|
|
|
|
|
|
F-8
Residential mortgage loans and consumer loans declined in aggregate $11.1 million during 2011, and at December 31, 2011, totaled $75.5 million, or 7.0% of the total loan portfolio. Although the residential mortgage loan and consumer loan portfolios may increase in future periods, we expect the commercial sector of the lending efforts and resultant assets to remain the dominant loan portfolio category.
The following table presents total loans outstanding as of December 31, 2011, according to scheduled repayments of principal on fixed rate loans and repricing frequency on variable rate loans. Floating rate loans that are currently at interest rate floors, comprising a majority of our floating rate commercial loans, are treated as fixed rate loans and are reflected using maturity date and not repricing frequency.
Less Than One Year |
One Through Five Years |
More Than Five Years |
Total | |||||||||||||
Construction and land development |
$ | 47,124,000 | $ | 31,553,000 | $ | 2,008,000 | $ | 80,685,000 | ||||||||
Real estate - residential properties |
44,392,000 | 39,638,000 | 10,167,000 | 94,197,000 | ||||||||||||
Real estate - multi-family properties |
26,870,000 | 18,719,000 | 226,000 | 45,815,000 | ||||||||||||
Real estate - commercial properties |
212,871,000 | 372,692,000 | 12,180,000 | 597,743,000 | ||||||||||||
Commercial and industrial |
173,825,000 | 72,312,000 | 3,752,000 | 249,889,000 | ||||||||||||
Consumer |
2,078,000 | 1,902,000 | 113,000 | 4,093,000 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total loans |
$ | 507,160,000 | $ | 536,816,000 | $ | 28,446,000 | $ | 1,072,422,000 | ||||||||
|
|
|
|
|
|
|
|
|||||||||
Fixed rate loans |
$ | 328,046,000 | $ | 524,734,000 | $ | 28,162,000 | $ | 880,942,000 | ||||||||
Floating rate loans |
179,114,000 | 12,082,000 | 284,000 | 191,480,000 | ||||||||||||
|
|
|
|
|
|
|
|
|||||||||
Total loans |
$ | 507,160,000 | $ | 536,816,000 | $ | 28,446,000 | $ | 1,072,422,000 | ||||||||
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|
|
|
|
|
|
Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on the internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically; however, we have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.
The levels of net loan charge-offs and nonperforming assets have been elevated since early 2007. The substantial and rapid country-wide collapse of the residential real estate market that started in 2007 had a significant negative impact on the residential real estate development lending portion of our business. The resulting decline in real estate prices and slowdown in sales stretched the cash flow of our local developers and eroded the value of our underlying collateral, which caused elevated levels of nonperforming assets and net loan charge-offs. Since 2007, we have also witnessed stressed economic conditions in Michigan and throughout the country. The resulting decline in business revenue negatively impacted the cash flows of many of our borrowers, some to the point where loan payments became past due. In addition, real estate prices have fallen significantly, thereby exposing us to larger-than-typical losses in those instances where the sale of collateral is the primary source of repayment. Also during this time, we have seen deterioration in guarantors financial capacities to fund deficient cash flows and reduce or eliminate collateral deficiencies. It is likely that net loan charge-offs and nonperforming assets will remain elevated in comparison to our historical levels until economic conditions further improve.
F-9
Throughout 2008, we experienced a rapid deterioration in a number of commercial loan relationships which previously had been performing satisfactorily. Analyses of certain commercial borrowers revealed a reduced capability on the part of these borrowers to make required payments as indicated by factors such as delinquent loan payments, diminished cash flow, deteriorating financial performance, or past due property taxes, and in the case of commercial and residential development projects slow absorption or sales trends. In addition, commercial real estate is the primary source of collateral for many of these borrowing relationships and updated evaluations and appraisals in many cases reflected significant declines from the original estimated values.
Throughout 2009, 2010 and 2011, we saw a continuation of the stresses caused by the poor economic conditions, especially in the non-owner occupied CRE markets. High vacancy rates or slow absorption has resulted in inadequate cash flow generated from some real estate projects we have financed, and have required guarantors to provide personal funds to make full contractual loan payments and pay other operating costs. In some cases, the guarantors cash and other liquid reserves have become seriously diminished. In other cases, sale of the collateral, either by the borrower or us, is our primary source of repayment.
We are, however, encouraged by the apparent credit quality stabilization within our loan portfolio during the latter part of 2010 and throughout 2011. After a period of significant and ongoing increases from 2007 through September 30, 2009, the level of nonperforming assets remained relatively unchanged through June 30, 2010 and then declined during the last six months of 2010 and the first nine months of 2011. We did see an increase in nonperforming assets during the fourth quarter of 2011; however, this was due primarily from one larger non-owner occupied CRE loan being placed into nonaccrual status towards the end of 2011. Of particular note are the reduced level of additions to the nonperforming asset category and an increased level of interest in, and sales of, foreclosed properties and assets securing nonaccrual loans.
As of December 31, 2011, nonperforming assets totaled $60.3 million, or 4.2% of total assets, compared to $86.1 million (5.3% of total assets) and $111.7 million (5.9% of total assets) as of December 31, 2010 and 2009, respectively. The reductions primarily reflect principal payments and charge-offs on nonaccruals loans, as well as sales proceeds and valuation write-downs on foreclosed properties. The $25.8 million reduction during 2011 and the $51.4 million reduction during the 24-month period ended December 31, 2011 equate to declines of 29.9% and 45.9%, respectively. Nonperforming loans and foreclosed properties associated with the development of residential-related real estate totaled $6.9 million as of December 31, 2011, reflecting reductions of $10.0 million and $24.9 million during 2011 and the 24-month period ended December 31, 2011, respectively. As of December 31, 2011, nonperforming loans secured by, and foreclosed properties consisting of, non-owner occupied CRE properties totaled $30.1 million, reflecting reductions of $4.1 million and $8.3 million during the respective time periods. In addition, nonperforming loans secured by, and foreclosed properties associated with, owner occupied CRE declined $4.1 million during 2011 and $9.3 million during the 24-month period ended December 31, 2011, while nonperforming commercial loans secured by non-real estate assets declined $5.2 million and $6.7 million during the respective time periods.
F-10
The following table provides a breakdown of nonperforming assets by property type:
12/31/11 | 9/30/11 | 6/30/11 | 3/31/11 | 12/31/10 | ||||||||||||||||
Residential Real Estate: |
||||||||||||||||||||
Land Development |
$ | 5,479,000 | $ | 8,139,000 | $ | 8,531,000 | $ | 14,252,000 | $ | 14,547,000 | ||||||||||
Construction |
1,397,000 | 1,418,000 | 2,089,000 | 2,268,000 | 2,333,000 | |||||||||||||||
Owner Occupied / Rental |
7,138,000 | 7,737,000 | 8,996,000 | 8,893,000 | 9,454,000 | |||||||||||||||
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|
|
|
|
|
|
|
|
|
|||||||||||
14,014,000 | 17,294,000 | 19,616,000 | 25,413,000 | 26,334,000 | ||||||||||||||||
Commercial Real Estate: |
||||||||||||||||||||
Land Development |
2,111,000 | 1,885,000 | 2,223,000 | 2,422,000 | 2,454,000 | |||||||||||||||
Construction |
409,000 | 0 | 0 | 0 | 0 | |||||||||||||||
Owner Occupied |
10,642,000 | 11,287,000 | 10,749,000 | 13,389,000 | 14,740,000 | |||||||||||||||
Non-Owner Occupied |
30,106,000 | 22,435,000 | 25,526,000 | 30,086,000 | 34,209,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
43,268,000 | 35,607,000 | 38,498,000 | 45,897,000 | 51,403,000 | ||||||||||||||||
Non-Real Estate: |
||||||||||||||||||||
Commercial Assets |
3,060,000 | 3,897,000 | 3,777,000 | 4,728,000 | 8,221,000 | |||||||||||||||
Consumer Assets |
14,000 | 29,000 | 4,000 | 51,000 | 161,000 | |||||||||||||||
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|
|
|
|
|
|
|
|
|
|||||||||||
3,074,000 | 3,926,000 | 3,781,000 | 4,779,000 | 8,382,000 | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Total |
$ | 60,356,000 | $ | 56,827,000 | $ | 61,895,000 | $ | 76,089,000 | $ | 86,119,000 | ||||||||||
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|
|
|
|
|
|
|
The following table provides a quarterly reconciliation of nonperforming assets during 2011:
4th Qtr 2011 |
3rd Qtr 2011 |
2nd Qtr 2011 |
1st Qtr 2011 |
|||||||||||||
Beginning balance |
$ | 56,827,000 | $ | 61,895,000 | $ | 76,089,000 | $ | 86,119,000 | ||||||||
Additions |
10,188,000 | 3,740,000 | 6,478,000 | 3,848,000 | ||||||||||||
Returns to performing status |
0 | 0 | 0 | (766,000 | ) | |||||||||||
Principal payments |
(2,115,000 | ) | (5,058,000 | ) | (12,067,000 | ) | (5,555,000 | ) | ||||||||
Sale proceeds |
(3,038,000 | ) | (2,670,000 | ) | (2,547,000 | ) | (2,085,000 | ) | ||||||||
Loan charge-offs |
(890,000 | ) | (476,000 | ) | (5,393,000 | ) | (4,800,000 | ) | ||||||||
Valuation write-downs |
(616,000 | ) | (604,000 | ) | (665,000 | ) | (672,000 | ) | ||||||||
|
|
|
|
|
|
|
|
|||||||||
Total |
$ | 60,356,000 | $ | 56,827,000 | $ | 61,895,000 | $ | 76,089,000 | ||||||||
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|
|
|
|
|
Net loan charge-offs during 2011 totaled $15.7 million, or 1.4% of average total loans. This level represents a significant decline from the $34.3 million (2.4% of average total loans) and $38.2 million (2.2% of average total loans) charged-off during 2010 and 2009, respectively. While we are optimistic that we will see further declines in net loan charge-offs in future periods, net loan charge-offs in at least the next few quarters are likely to remain elevated from historical averages due to the higher volume of nonperforming loans and stressed economic conditions.
F-11
The following table provides a breakdown of net loan charge-offs by collateral type:
4th Qtr 2011 |
3rd Qtr 2011 |
2nd Qtr 2011 |
1st Qtr 2011 |
Whole Year 2011 |
||||||||||||||||
Residential Real Estate: |
||||||||||||||||||||
Land Development |
$ | 15,000 | $ | 135,000 | $ | 2,496,000 | $ | (2,000 | ) | $ | 2,644,000 | |||||||||
Construction |
(90,000 | ) | (11,000 | ) | (9,000 | ) | 0 | (110,000 | ) | |||||||||||
Owner Occupied / Rental |
1,176,000 | (187,000 | ) | 1,819,000 | 1,208,000 | 4,016,000 | ||||||||||||||
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|
|
|
|
|
|
|
|
|
|||||||||||
1,101,000 | (63,000 | ) | 4,306,000 | 1,206,000 | 6,550,000 | |||||||||||||||
Commercial Real Estate: |
||||||||||||||||||||
Land Development |
(75,000 | ) | 47,000 | (62,000 | ) | (73,000 | ) | (163,000 | ) | |||||||||||
Construction |
0 | 0 | 0 | 0 | 0 | |||||||||||||||
Owner Occupied |
68,000 | (18,000 | ) | 755,000 | 1,436,000 | 2,241,000 | ||||||||||||||
Non-Owner Occupied |
4,060,000 | 639,000 | 445,000 | (40,000 | ) | 5,104,000 | ||||||||||||||
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|
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|
|
|
|
|
|||||||||||
4,053,000 | 668,000 | 1,138,000 | 1,323,000 | 7,182,000 | ||||||||||||||||
Non-Real Estate: |
||||||||||||||||||||
Commercial Assets |
(435,000 | ) | (162,000 | ) | (336,000 | ) | 2,794,000 | 1,861,000 | ||||||||||||
Consumer Assets |
0 | 26,000 | (9,000 | ) | 126,000 | 143,000 | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
(435,000 | ) | (136,000 | ) | (345,000 | ) | 2,920,000 | 2,004,000 | |||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Total |
$ | 4,719,000 | $ | 469,000 | $ | 5,099,000 | $ | 5,449,000 | $ | 15,736,000 | ||||||||||
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|
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|
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F-12
The following table summarizes changes in the allowance for loan losses for the past five years:
2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
Loans outstanding at year-end |
$ | 1,072,422,000 | $ | 1,262,630,000 | $ | 1,539,818,000 | $ | 1,856,915,000 | $ | 1,799,880,000 | ||||||||||
|
|
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|
|
|
|
|
|
|
|||||||||||
Daily average balance of loans outstanding during the year |
$ | 1,148,671,000 | $ | 1,412,555,000 | $ | 1,704,335,000 | $ | 1,829,686,000 | $ | 1,765,465,000 | ||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Balance of allowance at beginning of year |
$ | 45,368,000 | $ | 47,878,000 | $ | 27,108,000 | $ | 25,814,000 | $ | 21,411,000 | ||||||||||
Loans charged-off: |
||||||||||||||||||||
Commercial, financial and agricultural |
(12,373,000 | ) | (25,539,000 | ) | (25,978,000 | ) | (12,740,000 | ) | (4,250,000 | ) | ||||||||||
Construction and land development |
(2,919,000 | ) | (9,273,000 | ) | (9,606,000 | ) | (4,835,000 | ) | (1,353,000 | ) | ||||||||||
Residential real estate |
(4,422,000 | ) | (2,242,000 | ) | (3,797,000 | ) | (2,900,000 | ) | (1,618,000 | ) | ||||||||||
Instalment loans to individuals |
(183,000 | ) | (74,000 | ) | (240,000 | ) | (119,000 | ) | (53,000 | ) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Total charge-offs |
(19,897,000 | ) | (37,128,000 | ) | (39,621,000 | ) | (20,594,000 | ) | (7,274,000 | ) | ||||||||||
Recoveries of previously charged-off loans: |
||||||||||||||||||||
Commercial, financial and agricultural |
3,186,000 | 1,637,000 | 1,145,000 | 603,000 | 586,000 | |||||||||||||||
Construction and land development |
441,000 | 995,000 | 81,000 | 8,000 | 11,000 | |||||||||||||||
Residential real estate |
513,000 | 178,000 | 150,000 | 51,000 | 3,000 | |||||||||||||||
Instalment loans to individuals |
21,000 | 8,000 | 15,000 | 26,000 | 7,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Total recoveries |
4,161,000 | 2,818,000 | 1,391,000 | 688,000 | 607,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Net loan charge-offs |
(15,736,000 | ) | (34,310,000 | ) | (38,230,000 | ) | (19,906,000 | ) | (6,667,000 | ) | ||||||||||
Provision for loan losses |
6,900,000 | 31,800,000 | 59,000,000 | 21,200,000 | 11,070,000 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Balance of allowance at year-end |
$ | 36,532,000 | $ | 45,368,000 | $ | 47,878,000 | $ | 27,108,000 | $ | 25,814,000 | ||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Ratio of net loan charge-offs during the year to average loans outstanding during the year |
(1.37 | %) | (2.43 | %) | (2.24 | %) | (1.09 | %) | (0.38 | %) | ||||||||||
|
|
|
|
|
|
|
|
|
|
|||||||||||
Ratio of allowance to loans outstanding at year-end |
3.41 | % | 3.59 | % | 3.11 | % | 1.46 | % | 1.43 | % | ||||||||||
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F-13
The following table illustrates the breakdown of the allowance balance by loan type (dollars in thousands) and of the total loan portfolio (in percentages):
12/31/2011 | 12/31/2010 | 12/31/2009 | 12/31/2008 | 12/31/2007 | ||||||||||||||||||||||||||||||||||||
Amount | Loan Portfolio |
Amount | Loan Portfolio |
Amount | Loan Portfolio |
Amount | Loan Portfolio |
Amount | Loan Portfolio |
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Commercial, financial and agricultural |
$ | 28,913 | 83.3 | % | $ | 32,645 | 81.5 | % | $ | 37,639 | 80.1 | % | $ | 20,211 | 78.0 | % | $ | 18,976 | 77.5 | % | ||||||||||||||||||||
Construction and land development |
3,484 | 7.5 | 7,019 | 9.3 | 6,566 | 11.4 | 5,137 | 14.1 | 4,907 | 14.7 | ||||||||||||||||||||||||||||||
Residential real estate |
3,895 | 8.8 | 5,495 | 8.8 | 3,517 | 8.1 | 1,656 | 7.6 | 1,829 | 7.5 | ||||||||||||||||||||||||||||||
Instalment loans to individuals |
158 | 0.4 | 172 | 0.4 | 156 | 0.4 | 104 | 0.3 | 102 | 0.3 | ||||||||||||||||||||||||||||||
Unallocated |
82 | 0.0 | 37 | 0.0 | 0 | 0.0 | 0 | 0.0 | 0 | 0.0 | ||||||||||||||||||||||||||||||
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Total |
$ | 36,532 | 100.0 | % | $ | 45,368 | 100.0 | % | $ | 47,878 | 100.0 | % | $ | 27,108 | 100.0 | % | $ | 25,814 | 100.0 | % | ||||||||||||||||||||
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In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish specific portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Allowance Analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions.
The Allowance Analysis applies reserve allocation factors to non-impaired outstanding loan balances, which is combined with specific reserves to calculate an overall allowance dollar amount. For non-impaired commercial loans, which continue to comprise a vast majority of our total loans, reserve allocation factors are based upon loan ratings as determined by our standardized grade paradigms and by loan purpose. We have divided our commercial loan portfolio into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; lending concentrations; and other external factors, including competition and regulatory environment. Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the Allowance Analysis and make adjustments periodically based upon identifiable trends and experience.
A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired commercial loans. Our migration takes into account various time periods, and while we generally place most weight on the eight-quarter time frame as that period is close to the average duration of our loan portfolio, consideration is given to the other time periods as part of our assessment. Although the migration analysis provides an accurate historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our commercial loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data.
F-14
Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings. Although we have been consistent in our approach to commercial loan ratings, ongoing stressed economic conditions have resulted in an even higher sense of aggressiveness with regards to the downgrading of lending relationships. In addition, we made revisions to our grading paradigms in early 2009 that mathematically resulted in commercial loan relationships being more quickly downgraded when signs of stress are noted, such as slower sales activity for construction and land development CRE relationships and reduced operating performance/cash flow coverage for C&I relationships. These changes, coupled with the stressed economic environment, have resulted in significant downgrades and the need for substantial provisions to the allowance. To more effectively manage our commercial loan portfolio, we created a specific group tasked with managing our most distressed lending relationships.
The most significant external environmental factor is the assessment of the current economic environment and the resulting implications on our commercial loan portfolio. Currently, we believe conditions remain stressed for non-owner occupied CRE; however, recent data and performance reflect a level of stability in the C&I class of our loan portfolio.
The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors rights in order to preserve our collateral position.
Reflecting the stressed economic conditions and resulting negative impact on our loan portfolio, we have substantially increased the allowance as a percent of the loan portfolio over the past several years. The allowance equaled $36.5 million, or 3.4% of total loans outstanding, as of December 31, 2011, compared to 3.6%, 3.1%, 1.5% and 1.4% at year-end 2010, 2009, 2008 and 2007, respectively. As of December 31, 2011, the allowance was comprised of $17.5 million in general reserves relating to non-impaired loans and $19.0 million in specific allocations relating to impaired loans. Of the latter amount, $11.2 million are specific reserves associated with credit relationships that meet the definition of a troubled debt restructuring but are still on accrual status. Impaired loans with an aggregate carrying value of $36.6 million as of December 31, 2011 had been subject to previous partial charge-offs aggregating $27.1 million. Those partial charge-offs were recorded as follows: $11.9 million in 2011, $10.8 million in 2010, $3.5 million in 2009 and $0.9 million in 2008. As of December 31, 2011, specific reserves allocated to impaired loans that had been subject to a previous partial charge-off totaled $9.7 million.
Although we believe the allowance is adequate to absorb losses as they arise, there can be no assurance that we will not sustain losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.
Securities decreased $50.2 million during 2011, totaling $185.0 million as of December 31, 2011. The securities portfolio equaled 14.3% of average earning assets during 2011. Proceeds from called U.S. Government agency bonds during 2011 totaled $63.8 million, while $12.6 million was received from principal paydowns on mortgage-backed securities, $2.9 million from called tax-exempt municipal securities, $1.5 million from matured Michigan Strategic Fund bonds and $2.3 million from redeemed FHLB stock. Purchases during 2011, consisting almost exclusively of U.S. Government agency bonds, totaled $28.8 million. At December 31, 2011, the portfolio was comprised of U.S. Government agency issued bonds (48%), U.S. Government agency issued or guaranteed mortgage-backed securities (19%), tax-exempt municipal general obligation and revenue bonds (17%), Michigan Strategic Fund bonds (9%), FHLB stock (6%) and mutual funds (1%). We maintain the securities portfolio at levels to provide for required pledging purposes and secondary liquidity for our daily operations. In addition, the portfolio serves a primary interest rate risk management function.
F-15
The following table reflects the composition of the securities portfolio, excluding FHLB stock:
12/31/11 | 12/31/10 | 12/31/09 | ||||||||||||||||||||||
Carrying | Carrying | Carrying | ||||||||||||||||||||||
Value | Percent | Value | Percent | Value | Percent | |||||||||||||||||||
U.S. Government agency debt obligations |
$ | 88,596,000 | 51.2 | % | $ | 121,562,000 | 55.1 | % | $ | 95,544,000 | 39.6 | % | ||||||||||||
Mortgage-backed securities |
34,610,000 | 20.0 | 46,941,000 | 21.2 | 64,982,000 | 26.9 | ||||||||||||||||||
Michigan Strategic Fund bonds |
16,700,000 | 9.7 | 18,175,000 | 8.2 | 20,550,000 | 8.5 | ||||||||||||||||||
Municipal general obligations |
27,309,000 | 15.8 | 28,042,000 | 12.7 | 49,892,000 | 20.6 | ||||||||||||||||||
Municipal revenue bonds |
4,423,000 | 2.5 | 4,843,000 | 2.2 | 9,319,000 | 3.9 | ||||||||||||||||||
Mutual funds |
1,354,000 | 0.8 | 1,267,000 | 0.6 | 1,416,000 | 0.5 | ||||||||||||||||||
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Totals |
$ | 172,992,000 | 100.0 | % | $ | 220,830,000 | 100.0 | % | $ | 241,703,000 | 100.0 | % | ||||||||||||
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All of our securities are currently designated as available for sale. Historically, we had designated our tax-exempt municipal general obligation and revenue bonds as held to maturity; however, we changed the designation to available for sale immediately after the sale of certain of our tax-exempt general obligation and revenue bonds during the first quarter of 2010. Securities designated as available for sale are stated at fair value. The fair value of securities designated as available for sale at December 31, 2011 totaled $173.0 million, including a net unrealized gain of $5.8 million.
FHLB stock totaled $12.0 million as of December 31, 2011, compared to $14.3 million at December 31, 2010. The reduction reflects the FHLBs unsolicited redemption of $2.3 million during 2011. Our investment in FHLB stock is necessary to engage in their advance and other financing programs. We received a quarterly cash dividend throughout 2011 at an average rate of 2.50%, and believe a cash dividend will continue to be declared and paid in future quarters.
Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and tax-exempt general obligation and revenue municipal bonds are determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of other securities is estimated at carrying value as those financial instruments are generally bought and sold at par value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines. Reference is made to Note 15 of the Notes to Consolidated Financial Statements for additional information.
F-16
The following table shows by class of maturities as of December 31, 2011, the amounts and weighted average yields (on a fully taxable-equivalent basis) of investment securities:
Carrying | Average | |||||||
Value | Yield | |||||||
Obligations of U.S. Government agencies: |
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One year or less |
$ | 0 | NA | |||||
Over one through five years |
7,327,000 | 2.95 | % | |||||
Over five through ten years |
22,806,000 | 2.79 | ||||||
Over ten years |
58,463,000 | 4.24 | ||||||
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88,596,000 | 3.76 | |||||||
Obligations of states and political subdivisions: |
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One year or less |
177,000 | 7.79 | ||||||
Over one through five years |
2,418,000 | 6.69 | ||||||
Over five through ten years |
5,794,000 | 6.07 | ||||||
Over ten years |
23,343,000 | 6.26 | ||||||
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31,732,000 | 6.27 | |||||||
Mortgage-backed securities |
34,610,000 | 5.15 | ||||||
Michigan Strategic Fund bonds |
16,700,000 | 2.87 | ||||||
Mutual funds |
1,354,000 | 3.68 | ||||||
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Totals |
$ | 172,992,000 | 4.40 | % | ||||
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Federal funds sold, consisting of excess funds sold overnight to a correspondent bank, along with investments in interest-bearing deposits at correspondent banks, are used to manage daily liquidity needs and interest rate sensitivity. The average balance of these funds equaled 6.1%, 4.5% and 3.0% of average earning assets during 2011, 2010, and 2009, respectively, considerably higher than the historical average of less than 1.0%. Given stressed market and economic conditions, we made the decision in early 2009 to operate with a higher than traditional balance of federal funds sold and interest-bearing deposits. We expect to maintain the higher balance of federal funds sold and interest-bearing deposits, likely to average 3.0% to 4.0% of average earning assets, until market and economic conditions return to more normalized levels.
Non-Earning Assets
Cash and due from bank balances totaled $12.4 million at December 31, 2011, compared to $6.7 million on December 31, 2010. Cash and due from bank balances averaged $15.1 million during 2011. The relatively low balance as of December 31, 2010 reflected the fact that many of our business customers were closed that particular day and therefore did not make their typical deposits, resulting in a lower than typical outgoing cash letter. Net premises and equipment decreased from $27.9 million at December 31, 2010, to $26.8 million on December 31, 2011, primarily reflecting depreciation expense. Purchases of premises and equipment during 2011 were a net $0.6 million.
F-17
On December 30, 2009, all FDIC-insured financial institutions were required to pre-pay estimated FDIC deposit insurance assessments for the years 2010, 2011 and 2012. The prepaid amounts are used to offset regular quarterly deposit insurance assessments. The amount we paid equaled $16.3 million, which is being expensed over the future quarterly assessment periods. The balance at December 31, 2011 equaled $9.4 million. The Dodd-Frank Act significantly revised the program of federal deposit insurance. Among other things, the Dodd-Frank Act redefined the deposit insurance assessment base generally to equal average consolidated total assets minus average tangible equity, raised the minimum designated reserve ratio (DRR) of the Deposit Insurance Fund (DIF) to 1.35%, required the DRR to reach 1.35% by September 30, 2020 (rather than 1.15% by the end of 2016, as previously required), directed the FDIC to offset the effect of that accelerated timetable on insured institutions with consolidated assets of less than $10.0 billion, restricted any dividend from the DIF unless the DRR exceeds 1.50%, and made any declaration of dividend discretionary with the FDIC. The FDIC has adopted regulations that, among other things, set the minimum DRR at 2.00%, generally require use of a daily averaging method in calculating average consolidated total assets, define tangible equity as Tier 1 capital calculated monthly, and specify new risk-based assessment rates (effective April 1, 2011) that are subject to adjustment for institution-specific circumstances (such as an increase for most institutions having a ratio of brokered deposits to domestic deposits in excess of 10.00%) and for the level of the DRR, with rates gradually declining once the DRR reaches 2.00%. Separate assessment rates are specified for large institutions (i.e., those with total assets of more than $10.0 billion) and for highly complex institutions. With respect to the prepaid insurance assessments paid December 30, 2009, the FDIC in adopting the regulations declined to bring forward the time (the third quarter of 2013) at which any unused prepaid amounts would be returned to an institution. The FDIC stated that it would monitor its cash resources to determine whether to adopt a rule regarding earlier return of the unused prepaid amounts.
Foreclosed and repossessed assets totaled $15.3 million at December 31, 2011, compared to $16.7 million on December 31, 2010 and $26.6 million on December 31, 2009. The $1.4 million decline during 2011 consisted of $11.1 million in sales proceeds and $1.8 million in valuation writedowns and net losses on sales, which were partially offset by $11.5 million in transfers from the loan portfolio. We expect foreclosed and repossessed assets to remain at elevated levels as we move through the stressed economic environment and in certain situations elect to foreclose or respossess collateral. The State of Michigan has a relatively protracted foreclosure process that generally takes six to twelve months before deed is obtained. While we expect further transfers from loans to foreclosed and repossessed assets in future periods reflecting our collection efforts on impaired lending relationships, we are hopeful that the increased sales activity we witnessed during the latter part of 2010 and throughout 2011 will continue and limit the overall increase in, and average balance of, this nonperforming asset category.
Source of Funds
Our major sources of funds are from deposits, securities sold under agreements to repurchase (repurchase agreements) and FHLB advances. Total deposits declined from $1.27 billion at December 31, 2010 to $1.11 billion on December 31, 2011, a decrease of $161.8 million. In comparing total deposit balances as of December 31, 2011 to those at December 31, 2008, total deposits have declined by $487.5 million. Local deposits increased $311.2 million during the three-year period ended December 31, 2011, while out-of-area deposits decreased $798.7 million during the same time period. As of December 31, 2011, local deposits comprised 70.3% of total deposits, compared to 60.0% and 29.4% at December 31, 2010 and December 31, 2008, respectively.
Repurchase agreements decreased from $117.0 million at December 31, 2010 to $72.6 million on December 31, 2011, a decrease of $44.4 million. A majority of the decline is comprised of transfers to noninterest-bearing checking accounts reflecting a change in rates offered on the repurchase agreement product whereby for certain lower-balance customers, maintaining their relationship with us in a noninterest-bearing checking account was less expensive for them than keeping their funds in the repurchase agreement product when taking into account the rate paid and fees assessed. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested in overnight interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. All of our repurchase agreements are accounted for as secured borrowings.
FHLB advances declined from $65.0 million at December 31, 2010 to $45.0 million on December 31, 2011, a decline of $20.0 million. FHLB advances declined $225.0 million during the three-year period ended December 31, 2011. At December 31, 2011, local deposits and repurchase agreements equaled 69.5% of total funding liabilities, compared to 60.2% and 28.5% on December 31, 2010 and December 31, 2008, respectively.
F-18
The significant reduction in wholesale funding reliance over the past three years is primarily a result of the increase in local deposits and the decline in total loans. The increase in local deposits reflects various programs and initiatives we have implemented over the past several years, including: certificate of deposit campaign; implementation of several deposit-gathering initiatives in our commercial lending function; introduction of new deposit-related products and services; and the continuation of providing our customers with the latest in technological advances that give improved information, convenience and timeliness.
Noninterest-bearing checking deposit accounts increased during 2011 after having been relatively stable over the previous several years. Noninterest-bearing checking accounts averaged $137.0 million during 2011, compared to an average balance of $110.0 million to $120.0 million over the past several years. During the fourth quarter of 2011, noninterest-bearing checking accounts averaged close to the year-end balance of $147.0 million. A majority of the increase reflects the transfers from the repurchase agreement product during 2011 that are mentioned above.
Local interest-bearing checking accounts, in large part reflecting the strong success of our executive banking product, increased $129.5 million during the three-year period ended December 31, 2011, including a $21.6 million increase during 2011. Money market deposit accounts, which increased $120.5 million during the three-year period ended December 31, 2011, were down $5.2 million during 2011 primarily due to one relatively large customer that deposited funds in 2010 but withdrew its funds in early 2011. The net increase in both interest-bearing checking accounts and money market deposit accounts over the past three years primarily reflects the success of our enhanced marketing program and relatively aggressive rates, which resulted in many new individual, business and municipality deposits and increased balances from existing deposit account holders. Savings deposits decreased $27.7 million during 2011 after having increased $21.6 million during 2010 and declining $11.3 million during 2009. The relatively large balance fluctuations in our savings deposits are typical, primarily reflecting periodic deposits and withdrawals from several local municipal customers, as well as from certain municipal customers transferring funds between savings accounts and certificates of deposit. In addition, some customers have transferred their savings balances to other deposits products, particularly the executive banking product and money market deposit account.
Certificates of deposit purchased by customers located within our market areas declined $5.9 million during 2011, after declining $115.8 million during 2010 and increasing $164.1 million during 2009, thereby providing a net increase of $42.4 million during the three-year period ended December 31, 2011. During 2009, we ran a high-rate one-year certificate of deposit campaign that raised about $65.0 million, with most of the funds representing new deposit funds. As these certificates of deposit matured during the first quarter of 2010, we were able to retain a relatively large percentage of the maturing funds, a majority of which were transferred to our executive banking or money market deposit accounts. The remaining increase during 2009 primarily reflects the success of our enhanced marketing program and relatively aggressive rates, which resulted in many new individual, business and municipality deposits. The declines during 2011 and 2010 are primarily due to maturing certificates of deposit being transferred to our executive banking and money market deposit accounts.
Deposits obtained from customers located outside of our market areas declined $798.7 million during the three-year period ended December 31, 2011, including a $178.5 million decline during 2011. Out-of-area deposits primarily consist of certificates of deposit obtained from depositors located outside our market areas and placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. The owners of the out-of-area deposits include individuals, businesses and governmental units located throughout the United States. In addition, in early 2011 we established an interest-bearing checking account relationship with an out-of-area depositor engaged in managing retirement accounts. This custodial relationship totaled $26.1 million as of December 31, 2011, and is expected to remain relatively stable for the foreseeable future. We expect this to be a long-term relationship. The significant decline in out-of-area deposits since year-end 2008 primarily reflects the influx of cash resulting from the reduction in total loans and from increased local deposits.
FHLB advances declined $225.0 million during the three-year period ended December 31, 2011, including a $20.0 million decline during 2011. The decline during the past three years primarily reflects the influx of cash resulting from the reduction in total loans and from increased local deposits. FHLB advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit at December 31, 2011 totaled $97.7 million, with availability of $50.9 million.
F-19
Shareholders equity decreased $9.4 million during the three-year period ended December 31, 2011. During 2011, shareholders equity increased $39.1 million, primarily reflecting net income attributable to common shares of $36.1 million, of which $27.4 million was related to the reversal of our valuation allowance against our net deferred tax asset. The net decline in shareholders equity during 2010 and 2009 was primarily due to the net loss attributable to common shares of $67.5 million, of which $23.2 million was related to the recording of a valuation allowance against our net deferred tax asset during 2009. Positively impacting shareholders equity was the sale of preferred stock and a warrant for common stock to the United States Treasury Department for $21.0 million under the Capital Purchase Program during 2009. Cash dividends on our common stock reduced shareholders equity by $0.1 million and $0.6 million during 2010 and 2009, respectively.
RESULTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2011 and 2010
Summary
We recorded net income attributable to common shares of $36.1 million, or $4.20 per basic share and $4.07 per diluted share, for 2011, compared to a net loss attributable to common shares of $14.6 million, or $1.72 per basic and diluted share, for 2010. The fourth quarter 2011 reversal of the valuation allowance established against our net deferred tax asset in the fourth quarter of 2009 distorts 2011 and 2010 after-tax operating result comparisons. On a pre-tax basis, our net income for 2011 was $10.1 million and net loss for 2010 was $13.4 million.
The improvement in pre-tax earnings performance in 2011 compared to 2010 is primarily the result of a substantially lower provision expense. The decreased provision expense reflects lower volumes of loan rating downgrades and nonperforming loans and a higher volume of loan rating upgrades, as well as progress in the stabilization of economic and real estate market conditions and resulting collateral valuations. In addition, in many instances the reserve allocation factors for non-impaired commercial loans were lowered as the higher loan charge-off periods of 2009 were replaced with the lower 2011 loan charge-off periods in the quarterly reserve migration calculations. An increased net interest margin, which partially mitigated the negative impact of a lower level of average earning assets, and a reduction in overhead expenses also contributed to the improved earnings performance in 2011 compared to 2010.
Our earnings performance continues to be hindered by elevated provisions to the allowance and costs associated with the administration and resolution of problem assets, reflecting continuing difficulties in the loan portfolio, most notably in the CRE segment. Ongoing state, regional and national economic struggles have significantly hampered certain of our borrowers cash flows and negatively impacted real estate values, resulting in elevated levels of nonperforming assets and net loan charge-offs when compared to pre-2007 reporting periods.
The following table shows some of the key performance and equity ratios for the years ended December 31, 2011 and 2010:
2011 | 2010 | |||||||
Return on average assets |
2.36 | % | (0.80 | %) | ||||
Return on average shareholders equity |
27.28 | % | (10.62 | %) | ||||
Average shareholders equity to average assets |
8.66 | % | 7.56 | % |
Net Interest Income
Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $71.8 million and $19.8 million, respectively, during 2011, providing for net interest income of $52.0 million. During 2010, interest income and interest expense equaled $89.0 million and $31.8 million, respectively, providing for net interest income of $57.2 million. In comparing 2011 with 2010, interest income decreased 19.3%, interest expense was down 37.6%, and net interest income decreased 9.2%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types and levels of assets and liabilities, interest rate environment, interest rate risk, asset quality, liquidity, and customer behavior also impact net interest income as well as the net interest margin.
F-20
The $5.2 million decrease in net interest income in 2011 compared to 2010 resulted from a decreased level of average earning assets, which more than offset an improved net interest margin. During 2011, the net interest margin equaled 3.60%, up from 3.31% during 2010. Although our yield on earning assets declined slightly in 2011 compared to 2010 primarily due to a shift in earning asset mix (lower level of higher-yielding average total loans and higher levels of lower-yielding securities and average federal funds sold) and a decreased yield on average loans, our cost of funds declined at a far greater rate, resulting in the improved net interest margin. Average total loans equaled 79.6% of average earning assets during 2011, down from 81.8% during 2010, while average federal funds sold represented 5.4% of average earning assets during 2011 compared to 4.0% during 2010. Average securities equaled 14.3% of average earning assets during 2011, up from 13.7% during 2010. The decline in loan yield primarily resulted from a decreased yield on commercial loans, while the cost of funds primarily decreased as a result of higher-costing matured certificates of deposit and borrowings being renewed at lower rates, replaced by lower-costing funds, or allowed to runoff and the lowering of interest rates on non-certificate of deposit accounts and repurchase agreements.
The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders equity during 2011, 2010 and 2009. The subsequent table also depicts the dollar amount of change in interest income and interest expense of interest-earning assets and interest-bearing liabilities, segregated between change due to volume and change due to rate. For tax-exempt investment securities, interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 35%. As a result, securities interest income was increased by $0.7 million in 2011, $0.8 million in 2010, and $1.3 million in 2009.
F-21
(Dollars in thousands) | Years ended December 31, | |||||||||||||||||||||||||||||||||||
2011 | 2010 | 2009 | ||||||||||||||||||||||||||||||||||
Average Balance |
Interest | Average Rate |
Average Balance |
Interest | Average Rate |
Average Balance |
Interest | Average Rate |
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Taxable securities |
$ | 157,081 | $ | 6,685 | 4.26 | % | $ | 176,084 | $ | 7,846 | 4.46 | % | $ | 155,041 | $ | 7,498 | 4.84 | % | ||||||||||||||||||
Tax-exempt securities |
49,428 | 2,508 | 5.07 | 59,911 | 3,125 | 5.22 | 83,048 | 4,623 | 5.57 | |||||||||||||||||||||||||||
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Total securities |
206,509 | 9,193 | 4.45 | 235,995 | 10,971 | 4.65 | 238,089 | 12,121 | 5.09 | |||||||||||||||||||||||||||
Loans |
1,148,671 | 62,356 | 5.43 | 1,412,555 | 77,791 | 5.51 | 1,704,335 | 93,903 | 5.51 | |||||||||||||||||||||||||||
Interest-bearing deposit balances |
9,709 | 24 | 0.24 | 9,251 | 39 | 0.42 | 6,730 | 21 | 0.31 | |||||||||||||||||||||||||||
Federal funds sold |
78,596 | 199 | 0.25 | 69,319 | 176 | 0.25 | 53,825 | 136 | 0.25 | |||||||||||||||||||||||||||
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Total earning assets |
1,443,485 | 71,772 | 4.97 | 1,727,120 | 88,977 | 5.15 | 2,002,979 | 106,181 | 5.30 | |||||||||||||||||||||||||||
Allowance for loan losses |
(41,517 | ) | (48,963 | ) | (34,155 | ) | ||||||||||||||||||||||||||||||
Cash and due from banks |
15,080 | 15,414 | 16,341 | |||||||||||||||||||||||||||||||||
Other non-earning assets |
112,983 | 127,354 | 120,508 | |||||||||||||||||||||||||||||||||
|
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|
|
|
|
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Total assets |
$ | 1,530,031 | $ | 1,820,925 | $ | 2,105,673 | ||||||||||||||||||||||||||||||
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|
|
|
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Interest-bearing demand deposits |
$ | 184,140 | $ | 2,536 | 1.38 | % | $ | 140,384 | $ | 2,419 | 1.72 | % | $ | 60,155 | $ | 867 | 1.44 | % | ||||||||||||||||||
Savings deposits |
45,860 | 210 | 0.46 | 43,571 | 305 | 0.70 | 48,182 | 521 | 1.08 | |||||||||||||||||||||||||||
Money market accounts |
154,450 | 1,179 | 0.76 | 86,283 | 1,225 | 1.42 | 25,759 | 361 | 1.40 | |||||||||||||||||||||||||||
Time deposits |
697,664 | 12,459 | 1.79 | 979,584 | 19,580 | 2.00 | 1,279,188 | 39,520 | 3.09 | |||||||||||||||||||||||||||
|
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|
|
|
|
|
|
|
|
|
|
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Total interest-bearing deposits |
1,082,114 | 16,384 | 1.51 | 1,249,822 | 23,529 | 1.88 | 1,413,284 | 41,269 | 2.92 | |||||||||||||||||||||||||||
Short-term borrowings |
80,137 | 405 | 0.51 | 107,802 | 1,410 | 1.31 | 98,513 | 1,845 | 1.87 | |||||||||||||||||||||||||||
Federal Home Loan Bank advances |
54,753 | 2,033 | 3.71 | 153,575 | 5,509 | 3.59 | 239,699 | 8,808 | 3.67 | |||||||||||||||||||||||||||
Other borrowings |
37,776 | 1,010 | 2.67 | 47,315 | 1,346 | 2.84 | 50,278 | 1,654 | 3.29 | |||||||||||||||||||||||||||
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|
|
|
|
|
|
|
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Total interest-bearing liabilities |
1,254,780 | 19,832 | 1.58 | 1,558,514 | 31,794 | 2.04 | 1,801,774 | 53,576 | 2.97 | |||||||||||||||||||||||||||
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|
|
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Demand deposits |
136,980 | 118,904 | 112,821 | |||||||||||||||||||||||||||||||||
Other liabilities |
5,808 | 5,913 | 14,258 | |||||||||||||||||||||||||||||||||
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|
|
|
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Total liabilities |
1,397,568 | 1,683,331 | 1,928,853 | |||||||||||||||||||||||||||||||||
Average equity |
132,463 | 137,594 | 176,820 | |||||||||||||||||||||||||||||||||
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|
|
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Total liabilities and equity |
$ | 1,530,031 | $ | 1,820,925 | $ | 2,105,673 | ||||||||||||||||||||||||||||||
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|
|
|
|||||||||||||||||||||||||||||||
Net interest income |
$ | 51,940 | $ | 57,183 | $ | 52,605 | ||||||||||||||||||||||||||||||
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Rate spread |
3.39 | % | 3.11 | % | 2.33 | % | ||||||||||||||||||||||||||||||
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Net interest margin |
3.60 | % | 3.31 | % | 2.63 | % | ||||||||||||||||||||||||||||||
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F-22
Years ended December 31, | ||||||||||||||||||||||||
2011 over 2010 | 2010 over 2009 | |||||||||||||||||||||||
Total | Volume | Rate | Total | Volume | Rate | |||||||||||||||||||
Increase (decrease) in interest income |
||||||||||||||||||||||||
Taxable securities |
$ | (1,161,000 | ) | $ | (821,000 | ) | $ | (340,000 | ) | $ | 348,000 | $ | 967,000 | $ | (619,000 | ) | ||||||||
Tax exempt securities |
(617,000 | ) | (533,000 | ) | (84,000 | ) | (1,498,000 | ) | (1,222,000 | ) | (276,000 | ) | ||||||||||||
Loans |
(15,435,000 | ) | (14,340,000 | ) | (1,095,000 | ) | (16,112,000 | ) | (16,069,000 | ) | (43,000 | ) | ||||||||||||
Interest-bearing deposit balances |
(15,000 | ) | 2,000 | (17,000 | ) | 18,000 | 9,000 | 9,000 | ||||||||||||||||
Federal funds sold |
23,000 | 23,000 | 0 | 40,000 | 40,000 | 0 | ||||||||||||||||||
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|
|
|
|
|
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Net change in tax-equivalent interest income |
(17,205,000 | ) | (15,669,000 | ) | (1,536,000 | ) | (17,204,000 | ) | (16,275,000 | ) | (929,000 | ) | ||||||||||||
Increase (decrease) in interest expense |
||||||||||||||||||||||||
Interest-bearing demand deposits |
117,000 | 662,000 | (545,000 | ) | 1,552,000 | 1,354,000 | 198,000 | |||||||||||||||||
Savings deposits |
(95,000 | ) | 15,000 | (110,000 | ) | (216,000 | ) | (46,000 | ) | (170,000 | ) | |||||||||||||
Money market accounts |
(46,000 | ) | 686,000 | (732,000 | ) | 864,000 | 859,000 | 5,000 | ||||||||||||||||
Time deposits |
(7,121,000 | ) | (5,197,000 | ) | (1,924,000 | ) | (19,940,000 | ) | (7,953,000 | ) | (11,987,000 | ) | ||||||||||||
Short-term borrowings |
(1,005,000 | ) | (296,000 | ) | (709,000 | ) | (435,000 | ) | 162,000 | (597,000 | ) | |||||||||||||
Federal Home Loan Bank advances |
(3,476,000 | ) | (3,663,000 | ) | 187,000 | (3,299,000 | ) | (3,094,000 | ) | (205,000 | ) | |||||||||||||
Other borrowings |
(336,000 | ) | (259,000 | ) | (77,000 | ) | (308,000 | ) | (93,000 | ) | (215,000 | ) | ||||||||||||
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Net change in interest expense |
(11,962,000 | ) | (8,052,000 | ) | (3,910,000 | ) | (21,782,000 | ) | (8,811,000 | ) | (12,971,000 | ) | ||||||||||||
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Net change in tax-equivalent net interest income |
$ | (5,243,000 | ) | $ | (7,617,000 | ) | $ | 2,374,000 | $ | 4,578,000 | $ | (7,464,000 | ) | $ | 12,042,000 | |||||||||
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Interest income is primarily generated from the loan portfolio, and to a significantly lesser degree, from securities, federal funds sold, and interest-bearing deposit balances. Interest income decreased $17.2 million during 2011 from that earned in 2010, totaling $71.8 million in 2011 compared to $89.0 million in the previous year. The reduction in interest income is attributable to a decreased level of average earning assets and, to a much lesser extent, a declining yield on average earning assets. During 2011, earning assets averaged $1.44 billion, or $283.6 million lower than average earning assets of $1.73 billion during 2010. Average loans were down $263.9 million, average securities decreased $29.5 million, average federal funds sold increased $9.3 million, and average interest-bearing deposit balances increased $0.5 million.
Interest income generated from the loan portfolio decreased $15.4 million in 2011 compared to the level earned in 2010; the reduction in the loan portfolio during 2011 resulted in a $14.3 million decrease in interest income, while a decline in loan yield from 5.51% in 2010 to 5.43% in 2011 resulted in a $1.1 million decrease in interest income. The lower yield on average loans mainly resulted from a decreased yield on average commercial loans, which equaled 5.46% in 2011 compared to 5.54% in 2010. The commercial loan yield was negatively impacted by the lowering of rates on certain commercial loans throughout 2011 as a result of competitive pricing pressures and borrowers warranting decreased loan rates due to improved financial performance. In addition, the commercial loan yield in 2011 was negatively impacted by a $259,000 net decline in the present values of the purchased and sold interest rate caps; excluding the impact of this net decline, the yield on average commercial loans was 5.48% and the yield on average total loans was 5.45% in 2011.
F-23
Interest income generated from the securities portfolio decreased $1.8 million in 2011 compared to the level earned in 2010 due to portfolio contraction and a lower yield on average securities, which equaled 4.45% in 2011 compared to 4.65% in 2010. The reduced average portfolio balance resulted in a $1.4 million decrease in interest income, while the lower yield on average securities equated to a decrease in interest income of $0.4 million. Average securities equaled $206.5 million during 2011, down from $236.0 million during 2010 primarily due to decreases in the average balances of mortgage-backed securities and municipal securities. The lower yield on average securities in 2011 compared to 2010 mainly resulted from a decreased yield on U.S. Government agency bonds, reflecting a decrease in market rates, and a shift in the securities portfolio mix from higher-yielding municipal securities and mortgage-backed securities to lower-yielding U.S. Government agency bonds. The re-investment of proceeds received from called U.S. Government agency bonds into bonds of the same type during the decreased market rate environments experienced in the latter six months of 2010 and 2011, along with additional purchases of agency bonds necessary to support increased collateral requirements during the last six months of 2010, negatively impacted the yield on average securities in 2011. After analyzing our current and forecasted federal income tax position, we decided to sell certain tax-exempt municipal bonds with an aggregate book value of $20.0 million in late March 2010. A vast majority of the sales proceeds were used to purchase U.S. Government agency bonds during April and early May of 2010. Principal payments received on mortgage-backed securities totaled $12.6 million in 2011.
Interest income earned on federal funds sold increased slightly in 2011 compared to 2010 due to an increased average balance, while interest income earned on interest-bearing deposit balances decreased slightly as the negative impact of a declined average rate more than offset the positive impact of an increased average balance.
During 2011 and 2010, earning assets had an average yield (tax equivalent-adjusted basis) of 4.97% and 5.15%, respectively. The slight decline in earning asset yield in 2011 compared to 2010 resulted from a change in earning asset mix, most notably a decrease in higher-yielding average loans and increases in lower-yielding average securities and federal funds sold as a percentage of average earning assets, a decreased yield on average loans, and a decreased yield on average securities. Average loans equaled 79.6% of average earning assets during 2011, while average securities, federal funds sold, and interest-bearing deposit balances equaled 14.3%, 5.4%, and 0.7%, respectively. During 2010, average loans, securities, federal funds sold, and interest-bearing deposit balances represented 81.8%, 13.7%, 4.0%, and 0.5%, respectively, of average earning assets.
Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree, from FHLB advances, repurchase agreements, subordinated debentures, and other borrowings. Interest expense decreased $12.0 million during 2011 from that expensed in 2010, totaling $19.8 million in 2011 compared to $31.8 million in the previous year. The decline in interest expense is attributable to a decreased level of average interest-bearing liabilities and a decreased cost of funds. During 2011, interest-bearing liabilities averaged $1.25 billion, or $303.7 million lower than average interest-bearing liabilities of $1.56 billion during the prior year. This reduction resulted in decreased interest expense of $8.1 million. Average interest-bearing deposits were down $167.7 million, while average FHLB advances decreased $98.8 million, average short-term borrowings decreased $27.7 million, and average other borrowings decreased $9.5 million.
During 2011 and 2010, interest-bearing liabilities had a weighted average rate of 1.58% and 2.04%, respectively; a decline in interest expense of $3.9 million was recorded during 2011 due to the decreased cost of funds. The lower weighted average cost of interest-bearing liabilities in 2011 compared to 2010 is primarily due to the decline in market interest rates that began late in the third quarter of 2007 and continued through December of 2008 and a change in average interest-bearing liability mix, most notably decreases in higher-costing average certificates of deposit and average FHLB advances and increases in certain lower-costing average non-certificate of deposit accounts as a percentage of average interest-bearing liabilities. Market interest rates remained low during 2009, 2010, and 2011. Maturing fixed-rate certificates of deposit and borrowings were renewed at lower rates, replaced by lower-costing funds, or allowed to runoff during the 24-month period ending December 31, 2011. In addition, the lowering of interest rates on non-certificate of deposit accounts and repurchase agreements during this time frame positively impacted the weighted average cost of interest-bearing liabilities in 2011 compared to 2010.
F-24
Average certificates of deposit declined $281.9 million during 2011, which equated to a decrease in interest expense of $5.2 million. An additional $1.9 million reduction in interest expense resulted from a decrease in the average rate paid as higher-rate certificates of deposit matured and were either renewed or replaced with lower-costing certificates of deposit throughout 2011. Growth in other average interest-bearing deposit accounts, totaling $114.2 million, equated to an increase in interest expense of $1.4 million, while a decrease in the average rate paid on these deposit accounts resulted in a $1.4 million decline in interest expense.
Average short-term borrowings, comprised primarily of repurchase agreements, declined $27.7 million during 2011, resulting in decreased interest expense of $0.3 million, while a decrease in the average rate paid during 2011 resulted in a reduction in interest expense of $0.7 million. Average FHLB advances decreased $98.8 million, equating to a $3.7 million reduction in interest expense, while a higher average rate paid on the advances resulted in a $0.2 million increase in interest expense. A reduction in average other borrowings, which is comprised of subordinated debentures, structured repurchase agreements, and deferred director and officer compensation programs, equated to a decrease in interest expense of $0.3 million during 2011, while a decrease in the average rate paid on these borrowings reduced interest expense by $0.1 million.
Provision for Loan Losses
The provision for loan losses totaled $6.9 million in 2011, compared to $31.8 million in 2010. The reduced provision expense reflects lower volumes of nonperforming loans and loan rating downgrades and a higher volume of loan rating upgrades, as well as progress in the stabilization of economic and real estate market conditions and resulting collateral valuations. In addition, in many instances the reserve allocation factors for non-impaired commercial loans were lowered as the higher loan charge-off periods of 2009 were replaced with the lower 2011 loan charge-off periods in the quarterly reserve migration calculations. Nonperforming loans totaled $45.1 million, or 4.20% of total loans, as of December 31, 2011, compared to $69.4 million, or 5.50% of total loans, as of December 31, 2010. Net loan charge-offs totaled $15.7 million, or 1.37% of average total loans, during 2011 compared to $34.3 million, or 2.43% of average total loans, during 2010. Of the $19.9 million in gross loans charged-off during 2011, $5.7 million, or 28.5%, represents the elimination of specific reserves that were established through provision expense in earlier periods. The allowance, as a percentage of total loans outstanding, was 3.41% as of December 31, 2011, compared to 3.59% as of December 31, 2010.
Noninterest Income
Noninterest income totaled $7.3 million in 2011, a decrease of $2.0 million, or 21.2%, from the $9.3 million earned in 2010. Noninterest income during 2010 includes gains totaling $0.8 million from the sales of tax-exempt municipal bonds and guaranteed portions of certain Small Business Administration-guaranteed loans. Excluding these gains, noninterest income during 2011 decreased $1.2 million, or 13.8%, from the prior year. The decline in noninterest income in 2011 compared to 2010, after consideration of the above discussed gains on security and loan sales, was mainly due to lower rental income from fewer foreclosed properties and decreased mortgage banking income, commercial letter of credit fees, and service charges on accounts.
Noninterest Expense
Noninterest expense during 2011 totaled $41.5 million, a decrease of $5.7 million, or 12.0%, from the $47.2 million expensed in 2010. Overhead costs during 2011 include $0.2 million in nonrecurring fees related to the prepayment of $10.0 million in FHLB advances, while overhead costs during 2010 include $1.0 million in such fees related to the prepayment of $95.0 million in advances; excluding these prepayment fees, noninterest expense in 2011 and 2010 totaled $41.3 million and $46.2 million, respectively. The $4.9 million decline in noninterest expense in 2011 compared to 2010, excluding the impact of the prepayment fees, primarily resulted from lower costs associated with the administration and resolution of nonperforming assets, including legal expenses, property tax payments, appraisal fees, and write-downs on foreclosed properties, and decreased FDIC insurance premiums.
Nonperforming asset administration and resolution costs totaled $8.3 million during 2011, a decrease of $2.6 million, or 23.7%, from the $10.9 million in costs incurred during 2010. As a result of the significant level of nonperforming assets, these costs remain elevated; however, the costs are expected to decrease further in future periods if the level of nonperforming assets continues to decline.
F-25
FDIC insurance premiums were $2.9 million during 2011, down $1.5 million from the $4.4 million in premiums expensed during 2010; the lower premiums resulted from a decreased assessment rate. The implementation of the FDICs revised risk-based assessment system on April 1, 2011, primarily resulted in the decreased assessment rate. Given the large number of insured institution failures in recent years, the increase in per-depositor insurance coverage, the temporary unlimited insurance of noninterest-bearing deposit accounts, and other changes in federal deposit insurance made by the Dodd-Frank Act, it is difficult to predict the level of our future deposit insurance assessments.
Controllable operating expenses, including salaries and benefits, occupancy, and furniture and equipment costs, declined $0.7 million, or 3.3%, during 2011 compared to 2010. Salary and benefit costs, which declined $0.4 million in 2011 compared to 2010, were positively impacted by a reduction in full-time equivalent employees from 242 at December 31, 2010 to 232 at December 31, 2011. Occupancy and furniture and equipment costs declined by $0.3 million in 2011 compared to 2010, primarily resulting from an aggregate reduction in depreciation expense.
Federal Income Tax Expense
During 2011, we recorded income before federal income tax of $10.1 million and a federal income tax benefit of $27.4 million, compared to a loss before federal income tax of $13.4 million and a federal income tax benefit of less than $0.1 million during 2010. Tax expense on 2011 income was entirely offset by a corresponding reduction to the valuation allowance against deferred tax assets, and the $27.4 million benefit was the result of reversing the remaining valuation allowance. The tax benefit of the 2010 loss was mostly offset by the expense to record a valuation allowance against the net deferred tax asset it created; the nominal benefit resulted from adjustments between operations and other comprehensive income due to intraperiod tax allocation accounting rules.
Accounting guidance requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a more likely than not standard. We reviewed our deferred tax assets and determined that the valuation allowance necessary at year-end 2010, due to operating losses in 2010 and earlier years, was no longer necessary at year-end 2011 due to an expected return to sustainable profitability. Consequently, we reversed the valuation allowance that we had previously determined necessary to carry against our entire net deferred tax asset as of December 31, 2010 and 2009.
RESULTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2010 and 2009
Summary
We recorded a net loss attributable to common shares of $14.6 million, or $1.72 per basic and diluted share, for 2010, compared to a net loss of $52.9 million, or $6.23 per basic and diluted share, for 2009. The establishment of a valuation allowance against our net deferred tax asset in the fourth quarter of 2009 distorts 2010 after-tax operating result comparisons with earlier reporting periods. On a pre-tax basis, our net loss for 2010 was $13.4 million compared to $46.6 million for 2009.
The 71.3% improvement in pre-tax earnings performance in 2010 compared to 2009 is primarily the result of a substantially lower provision for loan losses and higher net interest income. The reduced provision reflects lower levels of loan rating downgrades, nonperforming loans, and net loan charge-offs, as well as the solidification of real estate market conditions and resulting valuations. An increase in loan rating upgrades during 2010 compared to the nominal level of 2009 upgrades also contributed to the lower provision expense. The increase in net interest income is the result of an improved net interest margin, which has been positively impacted by a substantial reduction in our cost of funds.
The net loss recorded in 2010 primarily results from a substantial provision expense and costs associated with the administration and resolution of problem assets, reflecting continuing difficulties in the loan portfolio, most notably in the CRE and construction and development segments. Continued state, regional and national economic struggles have significantly hampered certain commercial borrowers cash flows and negatively impacted real estate values, resulting in elevated levels of nonperforming assets and net loan charge-offs when compared to pre-2007 reporting periods.
F-26
The following table shows some of the key performance and equity ratios for the years ended December 31, 2010 and 2009:
2010 | 2009 | |||||||
Return on average assets |
(0.80 | %) | (2.51 | %) | ||||
Return on average shareholders equity |
(10.62 | %) | (29.91 | %) | ||||
Average shareholders equity to average assets |
7.56 | % | 8.40 | % |
Net Interest Income
Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $89.0 million and $31.8 million, respectively, during 2010, providing for net interest income of $57.2 million. During 2009, interest income and interest expense equaled $106.2 million and $53.6 million, respectively, providing for net interest income of $52.6 million. In comparing 2010 with 2009, interest income decreased 16.2%, interest expense was down 40.7%, and net interest income increased 8.7%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types and levels of assets and liabilities, interest rate environment, interest rate risk, asset quality, liquidity, and customer behavior also impact net interest income as well as the net interest margin.
The $4.6 million increase in net interest income in 2010 compared to 2009 resulted from an improved net interest margin, which more than offset a decreased level of average earning assets. Although our yield on earning assets declined slightly in 2010 compared to 2009 primarily due to a shift in earning asset mix (lower level of average total loans and a higher level of low-yielding average federal funds sold) and a decreased yield on average securities, our cost of funds declined at a far greater rate, resulting in the improved net interest margin. Average total loans equaled 81.8% of average earning assets during 2010, down from 85.1% during 2009, while average federal funds sold represented 4.0% of average earning assets during 2010 compared to 2.7% during 2009. The cost of funds primarily decreased as a result of higher-costing matured certificates of deposit and FHLB advances being replaced by lower-costing funds or being allowed to runoff. The prepayment of $95.0 million in higher-costing FHLB advances during the fourth quarter of 2010 also positively impacted the cost of funds.
Interest income is primarily generated from the loan portfolio, and to a lesser degree, from securities, federal funds sold, and short-term investments. Interest income decreased $17.2 million during 2010 from that earned in 2009, totaling $89.0 million in 2010 compared to $106.2 million in the previous year. The reduction in interest income is attributable to a decreased level of average earning assets and, to a much lesser degree, a declining yield on average earning assets, primarily resulting from a decreased yield on average securities, a decreased percentage of average total loans to total earning assets, and an increased percentage of low-yielding federal funds sold to total earning assets.
During 2010, earning assets averaged $1.73 billion, or $275.9 million lower than average earning assets of $2.00 billion during 2009. A decrease in average total loans totaling $291.8 million primarily resulted in the lower level of average earning assets during 2010. Interest income generated from the loan portfolio decreased $16.1 million in 2010 compared to the level earned in 2009; the reduction in the loan portfolio during 2010 resulted in the $16.1 million decrease in interest income. The loan portfolio yield was 5.51% in both 2010 and 2009.
F-27
Interest income generated from the securities portfolio decreased $1.2 million in 2010 compared to the level earned in 2009 due to a lower yield on average securities, which equaled 4.65% in 2010 compared to 5.09% in 2009, and portfolio contraction. The lower yield on average securities in 2010 compared to 2009 primarily resulted from a decreased yield on U.S. Government agency bonds, reflecting a decrease in market rates, and a shift in the securities portfolio mix from higher-yielding municipal securities to lower-yielding U.S. Government agency bonds. Reflective of the low market rate environment experienced during 2010, U.S. Government agency bonds totaling $78.2 million were called during the year, with a vast majority of the proceeds reinvested in the same type of securities at reduced rates. After analyzing our current and forecasted federal income tax position, we decided to sell certain tax-exempt municipal bonds with an aggregate book value of $20.0 million in late March 2010. A vast majority of the sales proceeds were used to purchase U.S. Government agency bonds during April and early May. Average securities equaled $236.0 million during 2010 compared to $238.1 million during 2009. The lower yield on average securities equated to a decrease in interest income of $0.9 million, while the reduced average portfolio balance resulted in a $0.3 million decrease in interest income. Interest income earned on federal funds sold increased slightly due to an increase in the average balance.
During 2010 and 2009, earning assets had an average yield (tax equivalent-adjusted basis) of 5.15% and 5.30%, respectively. The slight decline in earning asset yield in 2010 compared to the prior year primarily resulted from a shift in earning asset mix (lower level of average total loans and a higher level of low-yielding average federal funds sold) and a decreased yield on average securities. Average total loans equaled $1.41 billion, or 81.8% of average earning assets, during 2010, compared to $1.70 billion, or 85.1% of average earning assets, during 2009. Average federal funds sold were $69.3 million, or 4.0% of average earning assets during 2010, compared to $53.8 million, or 2.7% of average earning assets, during 2009. During 2010 and 2009, the yield on average earning assets was relatively stable due to the effectiveness of loan pricing initiatives instituted within the commercial loan function in 2008 and 2009.
Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree, from repurchase agreements, FHLB advances, and subordinated debentures. Interest expense decreased $21.8 million during 2010 from that expensed in 2009, totaling $31.8 million in 2010 compared to $53.6 million in the previous year. The decline in interest expense is attributable to a decreased cost of funds and a decreased level of average interest-bearing liabilities. The decreased cost of funds in 2010 compared to 2009 mainly resulted from fixed-rate certificates of deposit and borrowings being renewed or replaced at lower interest rates, reflecting the decreasing interest rate environment during the period of September 2007 through December 2008, or being allowed to runoff. Interest-bearing liabilities averaged $1.56 billion during 2010, or $243.3 million lower than average interest-bearing liabilities of $1.80 billion during 2009. This reduction resulted in decreased interest expense of $8.8 million. A decline in interest expense of $13.0 million was recorded during 2010 due to a decreased cost of funds, which resulted primarily from lower average rates paid on fixed rate certificates of deposit and borrowings. The cost of average interest-bearing liabilities decreased from 2.97% in 2009 to 2.04% in 2010.
Average certificates of deposit declined $299.6 million during 2010, which equated to a decrease in interest expense of $7.9 million. An additional $12.0 million reduction in interest expense resulted from a decrease in the average rate paid as higher-rate certificates of deposit matured and were either renewed or replaced with lower-costing certificates of deposit throughout 2010. Growth in other average interest-bearing deposit accounts, totaling $136.1 million, equated to an increase in interest expense of $2.2 million, while an increase in the average rate paid on these deposit accounts resulted in a nominal increase in interest expense.
Average short-term borrowings, comprised of repurchase agreements and federal funds purchased, increased $9.3 million during 2010, resulting in increased interest expense of $0.2 million, while a decrease in the average rate paid during 2010 resulted in a reduction in interest expense of $0.6 million. Average FHLB advances decreased $86.1 million, equating to a $3.1 million reduction in interest expense, while a decreased average rate paid on the advances resulted in a $0.2 million reduction in interest expense. A reduction in average other borrowings, which is comprised of subordinated debentures, structured repurchase agreements, and deferred director and officer compensation programs, combined with a lower average rate, resulted in a decrease in interest expense of $0.3 million during 2010.
F-28
Provision for Loan Losses
The provision for loan losses totaled $31.8 million in 2010, compared to $59.0 million in 2009. The significant provision expense incurred in both 2010 and 2009 is in response to the deterioration of the quality of our loan portfolio. Continued state, regional, and national economic struggles have negatively impacted some of our borrowers cash flows and underlying collateral values, leading to increased nonperforming assets, elevated net loan charge-offs, and increased overall credit risk within our loan portfolio.
The decreased provision expense in 2010 compared to 2009 reflects lower levels of loan rating downgrades, nonperforming loans, and net loan charge-offs, as well as the solidification of real estate market conditions and resulting valuations. Nonperforming loans totaled $69.4 million, or 5.50% of total loans, as of December 31, 2010, compared to $85.1 million, or 5.52% of total loans, as of December 31, 2009. Net loan charge-offs during 2010 totaled $34.3 million, or 2.43% of average total loans. Net loan charge-offs during 2009 totaled $38.2 million, or 2.24% of average total loans.
Noninterest Income
Noninterest income totaled $9.2 million in 2010, an increase of $1.6 million, or 22.3%, from the $7.6 million earned in 2009. Noninterest income during 2010 includes gains totaling $0.3 million from the sales of guaranteed portions of certain Small Business Administration-guaranteed loans and $0.5 million from the sales of tax-exempt municipal bonds. Excluding these gains, noninterest income during 2010 increased $0.9 million, or 11.7%, from the prior year. Increased rental income from foreclosed properties and earnings on bank-owned life insurance, which more than offset decreased service charges on accounts and mortgage banking income, mainly resulted in the higher level of noninterest income during 2010 compared to 2009, after consideration of the above discussed gains on loan and security sales. The decreased level of service charges on accounts during 2010 compared to the prior-year primarily resulted from a lower level of overdraft service fees.
Noninterest Expense
Noninterest expense during 2010 totaled $47.2 million, an increase of $0.7 million, or 1.4%, from the $46.5 million expensed in 2009. Overhead costs during 2010 include $1.0 million in nonrecurring fees related to the prepayment of $95.0 million in FHLB advances, while overhead costs during 2009 include $1.3 million in charges for the branch consolidations and a $0.9 million charge for the bank industry-wide FDIC special assessment. Excluding these one-time charges, noninterest expense in 2010 totaled $46.1 million, or $1.9 million higher than in 2009. The increase in overhead costs during 2010 compared to 2009 primarily resulted from higher costs associated with the administration and resolution of nonperforming assets, including legal expenses, property tax payments, appraisal fees, and write-downs on foreclosed properties, and increased normal FDIC insurance premiums.
Nonperforming asset administration and resolution costs totaled $10.9 million during 2010, an increase of $3.6 million from the $7.3 million in costs incurred during 2009. FDIC insurance premiums were $4.4 million during 2010, compared to $4.0 million, excluding the one-time special assessment, in the prior-year.
Controllable operating expenses, including salaries and benefits, occupancy, and furniture and equipment costs, declined $3.0 million, or 11.6%, during 2010 compared to 2009. Salary and benefit costs were down $2.0 million in 2010 compared to 2009, primarily resulting from a reduction in full-time equivalent employees from 257 at year-end 2009 to 242 at year-end 2010. Occupancy and furniture and equipment costs declined by $0.9 million in 2010 compared to 2009, primarily resulting from an aggregate reduction in rent and depreciation expenses. Beginning in the fourth quarter of 2009, overhead cost savings of approximately $0.2 million per month were achieved as a result of the consolidation of the mid- and eastern-Michigan regions of our banking activities that was completed in August of 2009.
Federal Income Tax Expense
During 2010, we recorded a loss before federal income tax of $13.4 million and a federal income tax benefit of less than $0.1 million, compared to a loss before federal income tax of $46.6 million and a federal income tax expense of $5.5 million during 2009. The tax benefit of the 2010 loss was mostly offset by the expense to record a valuation allowance against the net deferred tax asset it created; the nominal benefit resulted from adjustments between operations and other comprehensive income due to intraperiod tax allocation accounting rules. The tax benefit of the 2009 loss was offset by a one-time non-cash charge of $23.2 million to establish a valuation allowance against the entire balance of net deferred tax assets at year-end 2009.
F-29
Accounting guidance requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a more likely than not standard. We reviewed our deferred tax assets and determined that a valuation allowance was necessary at year-end 2009 and again at year-end 2010, in light of our then recent operating losses.
CAPITAL RESOURCES
Shareholders equity decreased $9.4 million during the three-year period ended December 31, 2011. During 2011, shareholders equity increased $39.1 million, primarily reflecting net income attributable to common shares of $36.1 million, of which $27.4 million was related to the reversal of our valuation allowance against our net deferred tax asset. The net decline in shareholders equity during 2010 and 2009 was primarily due to the net loss attributable to common shares of $67.5 million, of which $23.2 million was related to the recording of a valuation allowance against our net deferred tax assets during 2009. Positively impacting shareholders equity was the sale of preferred stock and a warrant for common stock to the United States Treasury Department for $21.0 million under the Capital Purchase Program during 2009. Cash dividends on our common stock reduced shareholders equity by $0.1 million and $0.6 million during 2010 and 2009, respectively.
Our and our banks regulatory risk-based capital ratios have increased throughout the past three years, and our bank remains well capitalized. As of December 31, 2011, our banks total risk-based capital ratio was 15.5%, compared to 12.5%, 11.1% and 10.8% at December 31, 2010, 2009 and 2008, respectively. Our banks total regulatory capital, consisting of our shareholders equity plus a portion of the allowance but less a portion of our net deferred tax asset, increased $13.3 million during 2011, primarily reflecting net income of $37.1 million, which more than offset cash dividends to Mercantile Bank Corporation of $4.9 million and a reduction of $2.4 million in eligible allowance due to a decline in risk-weighted assets. In addition, $16.5 million of our net deferred tax asset were not eligible for inclusion in our regulatory capital as of December 31, 2011. Risk-weighted assets declined $189.9 million during 2011. As of December 31, 2011, our banks total regulatory capital equaled $188.4 million, or $66.9 million in excess of the amount necessary to attain the 10.0% minimum total risk-based capital ratio, which is among the requirements to be categorized as well capitalized.
Our banks regulatory capital declined an aggregate $50.9 million during 2010 and 2009, primarily reflecting a net loss of $57.8 million and a reduction of $8.3 million in eligible allowance due to a decline in total risk-weighted assets, which was partially offset by a $19.0 million capital injection from Mercantile Bank Corporation from the proceeds of the preferred stock and warrant sale. Despite the reduction in total regulatory capital, our banks total risk-based capital ratio increased during 2010 and 2009 due to a decline of $688.5 million in total risk-weighted assets. As of December 31, 2010, our banks total regulatory capital equaled $175.1 million, or $34.6 million in excess of the 10.0% minimum which is among the requirements to be categorized as well capitalized. Our and our banks capital ratios as of December 31, 2011 and 2010 are disclosed in Note 18 of the Notes to Consolidated Financial Statements.
On July 9, 2010, we announced via a Form 8-K filed with the Securities and Exchange Commission that we were deferring regularly scheduled quarterly interest payments on our subordinated debentures beginning with the quarterly interest payment scheduled to have been paid on July 18, 2010. The deferral of interest payments on the subordinated debentures resulted in the deferral of distributions on our trust preferred securities. We also announced that we were deferring regularly scheduled quarterly dividend payments on our preferred stock beginning with the quarterly dividend payment scheduled to have been paid on August 15, 2010. On October 18, 2011, we announced via a Form 8-K filed with the Securities and Exchange Commission that we were bringing all of the accrued and unpaid interest (approximately $1.28 million) current on the subordinated debentures on that date, thereby providing for the distributions on our trust preferred securities to also be brought current on that date. We also announced that on October 19, 2011, we intended to bring current all accrued and unpaid dividends (approximately $1.36 million) on our preferred stock through October 18, 2011, which in fact we did consummate as planned. We had been accruing during the deferral period for the unpaid interest under the subordinated debentures and undeclared dividends under the preferred stock. We have made all scheduled payments on our subordinated debentures and preferred stock since, and we expect to make the scheduled payments in future periods.
F-30
We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Our banks ability to pay cash and stock dividends is subject to limitations under various laws and regulations, to prudent and sound banking practices, and to contractual provisions relating to our subordinated debentures and participation in the Capital Purchase Program. During 2009, we paid a cash dividend on our common stock each calendar quarter. However, reflecting our financial results and the poor and weakening economy, we lowered the dollar amount of the cash dividends paid during the year. During the first quarter of 2009, our cash dividend was $0.04 per share, but was lowered to $0.01 per share for the second, third and fourth quarters. Our cash dividend on our common stock was also $0.01 per common share during the first quarter of 2010. In April 2010, we suspended future payments of cash dividends on our common stock until economic conditions and our financial condition improve. In addition, from July 2010 through October 2011, we were precluded from paying cash dividends on our common stock and preferred stock because, under the terms of our subordinated debentures, we could not pay cash dividends during periods when we had deferred the payment of interest on our subordinated debentures. Also, pursuant to our Articles of Incorporation, we were precluded from paying dividends on our common stock while any dividends accrued on our preferred stock had not been declared and paid. As discussed above, those restrictions were removed on October 18 and 19, 2011, when we terminated the deferral of interest on our subordinated debentures and brought current the dividends on our preferred stock, respectively.
LIQUIDITY
Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-bearing deposit balances. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.
To assist in providing needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, primarily comprised of deposits from customers outside of our market areas and advances from the FHLB, totaled $375.5 million, or 30.5% of combined deposits and borrowed funds as of December 31, 2011, compared to $584.1 million, or 39.8% of combined deposits and borrowed funds, as of December 31, 2010, and $1.41 billion, or 71.5% of combined deposits and borrowed funds, as of December 31, 2008. The significant decline in wholesale funds since year-end 2008 primarily reflects the influx of cash resulting from the reduction in total loans and from increased local deposits.
Although local deposits have generally increased as new business, municipal governmental unit and individual deposit relationships are established and as existing customers increase the balances in their accounts, and we witnessed significant local deposit growth during the past three years, the relatively high reliance on wholesale funds will likely remain, although at a much lower level than historical levels. As part of our interest rate risk management strategy, a majority of our wholesale funds have a fixed rate and mature within one year, reflecting the fact that a majority of our loans have a floating interest rate. While this strategy increases inherent liquidity risk, we believe the increased liquidity risk is sufficiently mitigated by the benefits derived from an interest rate risk management standpoint. In addition, we have developed a comprehensive contingency funding plan which we believe further mitigates the increased liquidity risk.
Wholesale funds are generally a lower all-in cost source of funds when compared to the interest rates that would have to be offered in the local markets to generate a commensurate level of funds. Interest rates paid on new out-of-area deposits and FHLB advances have historically been similar to interest rates paid on new certificates of deposit issued to local customers. In addition, the overhead costs associated with wholesale funds are considerably less than the overhead costs that would be incurred to attract and administer a similar level of local deposits, especially if the estimated costs of a needed expanded branching network were taken into account.
F-31
As part of our sweep program, collected funds from certain business noninterest-bearing checking accounts are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. Repurchase agreements decreased $44.4 million during 2011, totaling $72.6 million as of December 31, 2011. A large portion of the decline represents transfers to noninterest-bearing checking accounts, reflecting a reduction in rates offered on the repurchase agreement product whereby for certain lower-balance customers, maintaining their relationship with us in a noninterest-bearing checking account was less expensive for them than keeping their funds in the repurchase agreement product when taking into account the rate paid and fees assessed. Information regarding our repurchase agreements as of December 31, 2011 and during 2011 is as follows:
Outstanding balance at December 31, 2011 |
$ | 72,569,000 | ||
Weighted average interest rate at December 31, 2011 |
0.31 | % | ||
Maximum daily balance twelve months ended December 31, 2011 |
$ | 116,397,000 | ||
Average daily balance for twelve months ended December 31, 2011 |
$ | 80,137,000 | ||
Weighted average interest rate for twelve months ended December 31, 2011 |
0.51 | % |
As a member of the FHLB, we have access to the FHLB advance borrowing programs. Advances totaled $45.0 million as of December 31, 2011, compared to $65.0 million, $205.0 million, and $270.0 million as of December 31, 2010, 2009 and 2008, respectively. Based on available collateral as of December 31, 2011, we could borrow an additional $50.9 million.
We also have the ability to borrow up to $38.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We did not access these lines of credit during 2011; in fact, we have not accessed the lines of credit since January of 2010. In contrast, federal funds sold averaged $78.6 million and $69.3 million during 2011 and 2010, respectively. In addition, interest-bearing deposit balances averaged $9.7 million and $9.3 million during the respective time periods. Given the volatile market and stressed economic conditions, we have been operating with a higher than normal balance of federal funds sold and interest-bearing deposit balances. It is expected that we will maintain the higher balance of liquid funds, likely to average 3.0% to 4.0% of average earning assets, until market and economic conditions return to more normalized levels. As a result, we expect the use of our federal funds purchased lines of credit, in at least the near future, will be rare, if at all.
We have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using a substantial majority of our tax-exempt municipal securities as collateral, we could have borrowed up to $27.1 million for terms of 1 to 28 days at December 31, 2011. We did not utilize this line of credit during the past three years, and do not plan to access this line of credit in future periods.
The following table reflects, as of December 31, 2011, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:
One Year or Less |
One to Three Years |
Three to Five Years |
Over Five Years |
Total | ||||||||||||||||
Deposits without a stated maturity |
$ | 530,813,000 | $ | 0 | $ | 0 | $ | 0 | $ | 530,813,000 | ||||||||||
Certificates of deposit |
369,362,000 | 144,753,000 | 67,147,000 | 0 | 581,262,000 | |||||||||||||||
Short-term borrowings |
72,569,000 | 0 | 0 | 0 | 72,569,000 | |||||||||||||||
Federal Home Loan Bank advances |
30,000,000 | 15,000,000 | 0 | 0 | 45,000,000 | |||||||||||||||
Subordinated debentures |
0 | 0 | 0 | 32,990,000 | 32,990,000 | |||||||||||||||
Other borrowed money |
0 | 0 | 0 | 1,434,000 | 1,434,000 |
F-32
In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. At December 31, 2011, we had a total of $238.2 million in unfunded loan commitments and $15.9 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $207.3 million were commitments available as lines of credit to be drawn at any time as customers cash needs vary, and $30.9 million were for loan commitments scheduled to close and become funded within the next twelve months. The level of commitments to make loans has declined significantly when compared to historical levels, primarily reflecting relatively stressed economic conditions; however, the $30.9 million level at December 31, 2011 is relatively high when compared to the levels over the past few years. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management.
The following table depicts our loan commitments at the end of the past three years:
12/31/11 | 12/31/10 | 12/31/09 | ||||||||||
Commercial unused lines of credit |
$ | 171,683,000 | $ | 158,945,000 | $ | 205,018,000 | ||||||
Unused lines of credit secured by 1-4 family residential properties |
24,663,000 | 26,870,000 | 24,916,000 | |||||||||
Credit card unused lines of credit |
7,565,000 | 7,768,000 | 8,565,000 | |||||||||
Other consumer unused lines of credit |
3,367,000 | 4,052,000 | 4,526,000 | |||||||||
Commitments to make loans |
30,929,000 | 9,840,000 | 7,701,000 | |||||||||
Standby letters of credit |
15,923,000 | 19,343,000 | 36,512,000 | |||||||||
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Total |
$ | 254,130,000 | $ | 226,818,000 | $ | 287,238,000 | ||||||
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We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, economic or market conditions, reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.
MARKET RISK ANALYSIS
Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on interest-earning assets over the interest paid on interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.
Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality.
F-33
We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest-sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to the net interest margin during periods of changing market interest rates.
The following table depicts our GAP position as of December 31, 2011:
Within Three Months |
Three to Twelve Months |
One to Five Years |
After Five Years |
Total | ||||||||||||||||
Assets: |
||||||||||||||||||||
Commercial loans (1) |
$ | 255,638,000 | $ | 205,052,000 | $ | 495,276,000 | $ | 18,166,000 | $ | 974,132,000 | ||||||||||
Residential real estate loans |
33,142,000 | 11,250,000 | 39,638,000 | 10,167,000 | 94,197,000 | |||||||||||||||
Consumer loans |
1,962,000 | 116,000 | 1,902,000 | 113,000 | 4,093,000 | |||||||||||||||
Securities (2) |
30,015,000 | 205,000 | 41,472,000 | 113,261,000 | 184,953,000 | |||||||||||||||
Federal funds sold |
54,329,000 | 0 | 0 | 0 | 54,329,000 | |||||||||||||||
Interest-bearing deposits |
9,641,000 | 0 | 0 | 0 | 9,641,000 | |||||||||||||||
Allowance for loan losses |
0 | 0 | 0 | 0 | (36,532,000 | ) | ||||||||||||||
Other assets |
0 | 0 | 0 | 0 | 148,416,000 | |||||||||||||||
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Total assets |
384,727,000 | 216,623,000 | 578,288,000 | 141,707,000 | $ | 1,433,229,000 | ||||||||||||||
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Liabilities: |
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Interest-bearing checking |
205,912,000 | 0 | 0 | 0 | 205,912,000 | |||||||||||||||
Savings deposits |
32,468,000 | 0 | 0 | 0 | 32,468,000 | |||||||||||||||
Money market accounts |
145,402,000 | 0 | 0 | 0 | 145,402,000 | |||||||||||||||
Time deposits under $100,000 |
18,399,000 | 31,590,000 | 31,798,000 | 0 | 81,787,000 | |||||||||||||||
Time deposits $100,000 & over |
163,617,000 | 155,756,000 | 180,102,000 | 0 | 499,475,000 | |||||||||||||||
Short-term borrowings |
72,569,000 | 0 | 0 | 0 | 72,569,000 | |||||||||||||||
Federal Home Loan Bank advances |
10,000,000 | 20,000,000 | 15,000,000 | 0 | 45,000,000 | |||||||||||||||
Other borrowed money |
34,424,000 | 0 | 0 | 0 | 34,424,000 | |||||||||||||||
Noninterest-bearing checking |
0 | 0 | 0 | 0 | 147,031,000 | |||||||||||||||
Other liabilities |
0 | 0 | 0 | 0 | 4,162,000 | |||||||||||||||
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Total liabilities |
682,791,000 | 207,346,000 | 226,900,000 | 0 | 1,268,230,000 | |||||||||||||||
Shareholders equity |
0 | 0 | 0 | 0 | 164,999,000 | |||||||||||||||
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Total liabilities & shareholders equity |
682,791,000 | 207,346,000 | 226,900,000 | 0 | $ | 1,433,229,000 | ||||||||||||||
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Net asset (liability) GAP |
$ | (298,064,000 | ) | $ | 9,277,000 | $ | 351,388,000 | $ | 141,707,000 | |||||||||||
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Cumulative GAP |
$ | (298,064,000 | ) | $ | (288,787,000 | ) | $ | 62,601,000 | $ | 204,308,000 | ||||||||||
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Percent of cumulative GAP to total assets |
(20.8 | %) | (20.1 | %) | 4.4 | % | 14.3 | % | ||||||||||||
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(1) | Floating rate loans that are currently at interest rate floors are treated as fixed rate loans and are reflected using maturity date and not repricing frequency. |
(2) | Mortgage-backed securities are categorized by expected maturities based upon prepayment trends as of December 31, 2011. |
F-34
The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.
We conducted multiple simulations as of December 31, 2011, in which it was assumed that changes in market interest rates occurred ranging from up 400 basis points to down 400 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested impact on net interest income over the next twelve months in comparison to estimated net interest income based on our balance sheet structure, including the balances and interest rates associated with our specific loans, securities, deposits and borrowed funds, as of December 31, 2011. The resulting estimates are well within our policy parameters established to manage and monitor interest rate risk.
Interest Rate Scenario |
Dollar Change In Net Interest Income |
Percent Change In Net Interest Income |
||||||
Interest rates down 400 basis points |
$ | (1,630,000 | ) | (3.4 | %) | |||
Interest rates down 300 basis points |
(1,200,000 | ) | (2.5 | ) | ||||
Interest rates down 200 basis points |
(640,000 | ) | (1.3 | ) | ||||
Interest rates down 100 basis points |
40,000 | 0.1 | ||||||
No change in interest rates |
1,120,000 | 2.4 | ||||||
Interest rates up 100 basis points |
700,000 | 1.5 | ||||||
Interest rates up 200 basis points |
450,000 | 0.9 | ||||||
Interest rates up 300 basis points |
590,000 | 1.2 | ||||||
Interest rates up 400 basis points |
40,000 | 0.1 |
The resulting estimates have been significantly impacted by the current interest rate and economic environment, as adjustments have been made to critical model inputs with regards to traditional interest rate relationships. This is especially important as it relates to floating rate commercial loans and brokered certificates of deposit, which comprise a substantial portion of our balance sheet. As of December 31, 2011, the Mercantile Bank Prime Rate is 4.50% as compared to the Wall Street Journal Prime Rate of 3.25%. Historically, the two indices have been equal; however, we elected not to reduce the Mercantile Bank Prime Rate in late October and mid-December of 2008 when the Wall Street Journal Prime Rate declined by 50 and 75 basis points, respectively. In conducting our simulations since year-end 2008, we have made the assumption that the Mercantile Bank Prime Rate will remain unchanged until the Wall Street Journal Prime Rate equals the Mercantile Bank Prime Rate, at which time the two indices will remain equal in the increasing interest rate scenarios. Also, brokered certificate of deposit rates have substantially decreased since year-end 2008, with part of the decline attributable to a significant imbalance whereby the supply of available funds far outweighs the demand from banks looking to raise funds. As a result, we have substantially limited further reductions in brokered certificate of deposit rates in the declining interest rate scenarios. The resulting estimates also take into account the cap corridor that is addressed in Note 13, which provides for a net increase in net interest income of $0.6 million, $1.0 million, $1.1 million and $1.2 million in the increasing interest rate environments of 100 basis points, 200 basis points, 300 basis points and 400 basis points, respectively.
In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.
F-35
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Mercantile Bank Corporation
Grand Rapids, Michigan
We have audited the accompanying consolidated balance sheets of Mercantile Bank Corporation as of December 31, 2011 and 2010, and the related consolidated statements of operations, changes in shareholders equity and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. 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 Mercantile Bank Corporation as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercantile Bank Corporations internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 14, 2012 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP |
BDO USA, LLP |
Grand Rapids, Michigan
March 14, 2012
F-36
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Mercantile Bank Corporation
Grand Rapids, Michigan
We have audited Mercantile Bank Corporations internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Mercantile Bank Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report by Mercantile Bank Corporations Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Mercantile Bank Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercantile Bank Corporation as of December 31, 2011 and 2010, and the related consolidated statements of operations, changes in shareholders equity and cash flows for each of the three years in the period ended December 31, 2011, and our report dated March 14, 2012 expressed an unqualified opinion thereon.
/s/ BDO USA, LLP |
BDO USA, LLP |
Grand Rapids, Michigan
March 14, 2012
F-37
March 14, 2012
REPORT BY MERCANTILE BANK CORPORATIONS MANAGEMENT
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining an effective system of internal control over financial reporting that is designed to produce reliable financial statements presented in conformity with generally accepted accounting principles. There are inherent limitations in the effectiveness of any system of internal control. Accordingly, even an effective system of internal control can provide only reasonable assurance with respect to financial statement preparation.
Management assessed the Companys system of internal control over financial reporting that is designed to produce reliable financial statements presented in conformity with generally accepted accounting principles as of December 31, 2011. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2011, Mercantile Bank Corporation maintained an effective system of internal control over financial reporting that is designed to produce reliable financial statements presented in conformity with generally accepted accounting principles based on those criteria.
The Companys independent auditors have issued an audit report on the effectiveness of the Companys internal control over financial reporting.
Mercantile Bank Corporation
/s/ MICHAEL H. PRICE |
Michael H. Price |
Chairman of the Board, President and Chief Executive Officer |
/s/ CHARLES E. CHRISTMAS |
Charles E. Christmas |
Senior Vice President, Chief Financial Officer and Treasurer |
F-38
MERCANTILE BANK CORPORATION
December 31, 2011 and 2010
2011 | 2010 | |||||||
ASSETS |
||||||||
Cash and due from banks |
$ | 12,402,000 | $ | 6,674,000 | ||||
Interest-bearing deposit balances |
9,641,000 | 9,600,000 | ||||||
Federal funds sold |
54,329,000 | 47,924,000 | ||||||
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|
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Total cash and cash equivalents |
76,372,000 | 64,198,000 | ||||||
Securities available for sale |
172,992,000 | 220,830,000 | ||||||
Federal Home Loan Bank stock |
11,961,000 | 14,345,000 | ||||||
Loans |
1,072,422,000 | 1,262,630,000 | ||||||
Allowance for loan losses |
(36,532,000 | ) | (45,368,000 | ) | ||||
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Loans, net |
1,035,890,000 | 1,217,262,000 | ||||||
Premises and equipment, net |
26,802,000 | 27,873,000 | ||||||
Bank owned life insurance |
48,520,000 | 46,743,000 | ||||||
Accrued interest receivable |
4,403,000 | 5,942,000 | ||||||
Other real estate owned and repossessed assets |
15,282,000 | 16,675,000 | ||||||
Net deferred tax asset |
26,013,000 | 0 | ||||||
Other assets |
14,994,000 | 18,553,000 | ||||||
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|
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Total assets |
$ | 1,433,229,000 | $ | 1,632,421,000 | ||||
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LIABILITIES AND SHAREHOLDERS EQUITY |
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Deposits |
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Noninterest-bearing |
$ | 147,031,000 | $ | 112,944,000 | ||||
Interest-bearing |
965,044,000 | 1,160,888,000 | ||||||
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|
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Total |
1,112,075,000 | 1,273,832,000 | ||||||
Securities sold under agreements to repurchase |
72,569,000 | 116,979,000 | ||||||
Federal Home Loan Bank advances |
45,000,000 | 65,000,000 | ||||||
Subordinated debentures |
32,990,000 | 32,990,000 | ||||||
Other borrowed money |
1,434,000 | 11,804,000 | ||||||
Accrued interest and other liabilities |
4,162,000 | 5,880,000 | ||||||
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Total liabilities |
1,268,230,000 | 1,506,485,000 | ||||||
Shareholders equity |
||||||||
Preferred stock, no par value; 1,000,000 shares authorized; 21,000 shares outstanding |
20,331,000 | 20,077,000 | ||||||
Common stock, no par value; 20,000,000 shares authorized; 8,605,391 shares outstanding at December 31, 2011 and 8,597,993 shares outstanding at December 31, 2010 |
172,841,000 | 172,677,000 | ||||||
Common stock warrant |
1,138,000 | 1,138,000 | ||||||
Retained earnings (deficit) |
(32,639,000 | ) | (68,781,000 | ) | ||||
Accumulated other comprehensive income |
3,328,000 | 825,000 | ||||||
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|
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Total shareholders equity |
164,999,000 | 125,936,000 | ||||||
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Total liabilities and shareholders equity |
$ | 1,433,229,000 | $ | 1,632,421,000 | ||||
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See accompanying notes to consolidated financial statements.
F-39
MERCANTILE BANK CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 2011, 2010 and 2009
2011 | 2010 | 2009 | ||||||||||
Interest income |
||||||||||||
Loans, including fees |
$ | 62,356,000 | $ | 77,791,000 | $ | 93,903,000 | ||||||
Securities, taxable |
6,685,000 | 7,846,000 | 7,498,000 | |||||||||
Securities, tax-exempt |
1,805,000 | 2,291,000 | 3,351,000 | |||||||||
Federal funds sold |
199,000 | 176,000 | 136,000 | |||||||||
Interest-bearing deposit balances |
24,000 | 39,000 | 21,000 | |||||||||
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Total interest income |
71,069,000 | 88,143,000 | 104,909,000 | |||||||||
Interest expense |
||||||||||||
Deposits |
16,384,000 | 23,529,000 | 41,269,000 | |||||||||
Short-term borrowings |
405,000 | 1,410,000 | 1,845,000 | |||||||||
Federal Home Loan Bank advances |
2,033,000 | 5,509,000 | 8,808,000 | |||||||||
Other borrowings |
1,010,000 | 1,346,000 | 1,654,000 | |||||||||
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Total interest expense |
19,832,000 | 31,794,000 | 53,576,000 | |||||||||
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Net interest income |
51,237,000 | 56,349,000 | 51,333,000 | |||||||||
Provision for loan losses |
6,900,000 | 31,800,000 | 59,000,000 | |||||||||
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Net interest income (deficiency) after provision for loan losses |
44,337,000 | 24,549,000 | (7,667,000 | ) | ||||||||
Noninterest income |
||||||||||||
Service charges on accounts |
1,640,000 | 1,797,000 | 2,023,000 | |||||||||
Earnings on bank owned life insurance |
1,777,000 | 1,718,000 | 1,444,000 | |||||||||
Mortgage banking activities |
846,000 | 1,092,000 | 1,202,000 | |||||||||
Rental income from other real estate owned |
825,000 | 1,488,000 | 438,000 | |||||||||
Credit and debit card fees |
825,000 | 727,000 | 670,000 | |||||||||
Payroll processing |
515,000 | 494,000 | 504,000 | |||||||||
Letter of credit fees |
300,000 | 460,000 | 541,000 | |||||||||
Net gain on sale of securities |
0 | 476,000 | 0 | |||||||||
Gain on sale of commercial loans |
0 | 324,000 | 0 | |||||||||
Other income |
554,000 | 668,000 | 736,000 | |||||||||
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Total noninterest income |
7,282,000 | 9,244,000 | 7,558,000 | |||||||||
Noninterest expense |
||||||||||||
Salaries and benefits |
17,891,000 | 18,297,000 | 20,331,000 | |||||||||
Occupancy |
2,780,000 | 2,838,000 | 3,377,000 | |||||||||
Furniture and equipment rent, depreciation and maintenance |
1,206,000 | 1,481,000 | 1,871,000 | |||||||||
Nonperforming asset costs |
8,290,000 | 10,858,000 | 7,294,000 | |||||||||
FDIC insurance costs |
2,843,000 | 4,370,000 | 4,852,000 | |||||||||
Data processing |
2,719,000 | 2,598,000 | 2,526,000 | |||||||||