ENTERPRISE FINANCIAL SERVICES CORP – 10-K – : MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Introduction
The objective of this section is to provide an overview of the results of operations and financial condition of the Company for the three years endedDecember 31, 2011 . It should be read in conjunction with the Consolidated Financial Statements, Notes and other financial data presented elsewhere in this report, particularly the information regarding the Company's business operations described in Item 1. Executive Summary This overview of management's discussion and analysis highlights selected information in this document and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire document. 2011 Operating Results For 2011, we reported net income of$25.4 million compared to net income of$5.6 million in 2010. After deducting preferred stock dividends, net income available to common shareholders was$22.9 million , or$1.34 per diluted share, compared to net income available to common shareholders of$3.1 million , or$0.21 per diluted share in 2010.
Acquisitions
OnJanuary 7, 2011 , the Bank acquired certain assets and assumed certain liabilities of Legacy, a full service community bank that was headquartered inScottsdale, Arizona . The acquisition consisted of tangible assets with fair values of approximately$128.0 million and liabilities of approximately$130.4 million . In addition, the Bank also acquired approximately$55.6 million of discretionary and$13.6 million of non-discretionary trust assets. Thewill reimburse the Bank for 80% of all losses on Covered Assets. In conjunction with the Legacy acquisition, the Company provided the FDIC with a Value Appreciation Instrument ("VAI") whereby 372,500 units were awarded to theFDIC at an exercise price of$10.63 per unit. The units were exercisable at any time fromJanuary 14, 2011 untilJanuary 6, 2012 . TheFDIC exercised the units onJanuary 20, 2011 at a settlement price of$11.8444 . A cash payment of$452,364 was made to theFDIC onJanuary 21, 2011 . OnAugust 12, 2011 , the Bank acquired certain assets and assumed certain liabilities of FNBO, a full service community bank that was headquartered inOlathe, Kansas . The acquisition consisted of tangible assets at fair value of approximately$481.6 million and liabilities with a fair value of approximately$516.2 million . TheFDIC will reimburse the Bank for 80% of losses up to$112.6 million , 0% of losses between$112.6 million and $148.9 million and 80% of losses in excess of$148.9 million with respect to the Covered Assets. In conjunction with the FNBO acquisition, the Company provided theFDIC with a VAI whereby 1.0 million units were awarded to theFDIC at an exercise price of$13.59 per unit. The units were exercisable any time fromAugust 19, 2011 untilAugust 10, 2012 . The units were exercised onOctober 31, 2011 at a settlement price of$15.8393 . A cash payment of approximately$2.2 million was made to theFDIC onNovember 1, 2011 . The acquisition of FNBO added approximately$1.4 million of pre-tax earnings, or$0.05 of diluted earnings per share in 2011, including$900,000 of acquisition and conversion related costs. OnOctober 21, 2011 , the Bank purchased certain assets and assumed certain deposit liabilities from BankLiberty ofLiberty, Missouri . The Bank assumed$43.0 million in deposits associated with the BankLiberty branch located at11401 Olive Boulevard , in theSt. Louis suburb ofCreve Coeur, Missouri . The deposits consisted of$2.6 million in demand deposits,$21.9 million in money market and other interest bearing deposits, and$18.6 million in certificates of deposit. The Bank also paid a deposit premium of$323,000 on these deposits and purchased$150,000 of personal property in the branch. The Bank executed a full-service sublease on approximately 6,556 square feet at the above address. Enterprise will operate the location as a full-service branch of the Bank.
See Note 2 - Acquisitions and Note 6 - Portfolio Loans for more information.
22 -------------------------------------------------------------------------------- Below are highlights of our Banking and Wealth Management segments. For more information on our segments, see Item 8, Note 20 - Segment Reporting. Unless otherwise noted, this discussion excludes discontinued operations.
Banking
For 2011, the Banking segment recorded net income of$29.1 million compared to net income of$10.4 million for 2010. Excluding the non-tax deductible goodwill impairment of$45.4 million , the Banking segment recorded net income of$2.2 million for 2009. Below is a summary of 2011: • Loan demand - Portfolio loans were$2.2 billion atDecember 31, 2011 ,
including
("Covered loans"). Portfolio loans, excluding the Covered loans ("Non-covered
loans"), increased
similar Non-covered loan growth in 2012 as business activity continues to improve and additional capacity from new hires takes effect. Excluding Covered loans, Commercial and industrial loans increased$169.3 million , or 29%, sinceDecember 31, 2010 , while Construction and residential real estate loans decreased$68.6 million , or, 18%, over the same time frame. December 31, (in thousands) 2011 2010 Commercial and industrial 763,202 35 % 593,938 31 % Commercial real estate - Investor Owned 477,154 22 % 444,724 24 % Commercial real estate - Owner Occupied 334,416 15 % 331,544 18 % Construction and land development 140,147 6 % 190,285 10 % Residential real estate 171,034 8 % 189,484 10 % Consumer & other 11,121 1 % 16,376 1 % Portfolio loans covered under FDIC loss share 300,610 13 % 121,570 6 % Total loan portfolio 2,197,684 100 % 1,887,921 100 %
• Deposit growth - Total deposits at
increase of
brokered certificates of deposit, "core" deposits increased
or 24%, to
deposits increased
total deposits at
Management believes a portion of the growth in noninterest-bearing demand
deposits is the result of the
on non-guaranteed accounts. The Company has maintained a favorable deposit
mix, with core deposits representing 96% of total deposits at December 31,
2011, compared to 93% in the prior year.
The FNB acquisition added$423.1 million in deposits in the third quarter of 2011. These deposits included$66.9 million in noninterest-bearing demand deposits,$123.6 million in money market and other interest-bearing transaction accounts, and$232.6 million in certificates of deposit. • Asset quality - Nonperforming loans were$41.6 million , or 1.89%, of
portfolio loans at
million, or 1.80%, of portfolio loans versus
portfolio loans, at the end of 2010. In 2011, net charge-offs were $19.2
million, or 0.94% of average loans compared to
charge-offs, or 1.83% of average loans in 2010.
Provision for loan losses not covered underFDIC loss share was$13.3 million for 2011 compared to$33.7 million for 2010. The decrease in provision was primarily due to fewer loan risk rating downgrades. Excluding the Covered loans, the Company's watch list credits as a percentage of total loans declined almost a full percentage point in 2011. The Company continues to monitor loan portfolio risk closely. See Provision for Loan Losses and Nonperforming Assets below for more information. The Company recorded$2.8 million in provision for loan losses covered underFDIC loss share agreements in 2011. This impact was partially offset through noninterest income by an increase in theFDIC loss share receivable. 23 --------------------------------------------------------------------------------
• Net Interest Rate Margin - Our fully tax-equivalent net interest rate margin
was 4.12% for 2011 versus 3.76% for 2010. The net interest margin was
favorably impacted by lower deposit costs, and the net interest income
generated by the loans acquired in the
2011. For 2011, the net interest rate margin, less the
related nonearning assets and acquired deposits, was 3.42% compared to 3.53%
for 2010. We expect our 2012 net interest margin will be 4% or more based on a better earning asset mix, the full year impact of the FNBO acquisition and continued discipline on funding costs. We expect continued volatility in the yield on Covered loans, especially due to unanticipated prepayment activity. In 2011, there was approximately$14.3 million of accelerated discount recognized in interest income on Covered loans due primarily to prepayments. After recognizing any related offsets to the indemnification asset through noninterest income, pre-tax earnings were positively impacted by$6.8 million in 2011. In addition, the quarterly re-measurement of cash flows from Covered loans can impact the prospective yield on Covered loans and adjustments to the indemnification asset.
• Noninterest expenses and efficiency ratio - Noninterest expense increased
primarily due to increases in salaries and benefits, occupancy, data
processing and other operating expenses related to the 2011 acquisitions. The
Company's efficiency ratio, which measures noninterest expense as a
percentage of total revenue, for 2011 was 59.2% compared to 60.8% for 2010.
Wealth Management The Wealth Management segment is comprised ofEnterprise Trust and our state tax credit brokerage activities. Wealth Management is a strategic line of business consistent with our Company mission of "guiding our clients to a lifetime of financial success." It is a driver of fee income and is intended to help us diversify our dependency on bank spread income.
For 2011, the Wealth Management segment recorded net income of
• Trust revenues - Revenues from the Trust division increased
over 2010. The increase in Trust revenue was primarily attributable to the
impact of the additional Legacy and FNBO trust business. Trust assets under
administration were$1.6 billion atDecember 31, 2011 compared to$1.5 billion atDecember 31, 2010 , a 7% increase over one year ago.
• State tax credit brokerage activities - In 2011, revenue from state tax
credit brokerage activities were
increase over 2010. The increase is primarily due to a
from the sale of state tax credits.
RESULTS OF CONTINUING OPERATIONS ANALYSIS
Net Interest Income Comparison of 2011 vs. 2010 Net interest income is the primary source of the Company's revenue. Net interest income is the difference between interest income on earning assets, such as loans and securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest earning and other assets. The amount of net interest income is affected by changes in interest rates and by the amount and composition of interest-earning assets and interest-bearing liabilities, such as the mix of fixed vs. variable rate loans. When and how often loans and deposits mature and re-price also impacts net interest income. Net interest spread and net interest rate margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest rate margin is expressed as the percentage of net interest income to average interest-earning assets. The net interest rate margin exceeds the interest rate spread because noninterest-bearing sources of funds (net free funds), principally demand deposits and shareholders' equity, also support earning 24 --------------------------------------------------------------------------------
assets.
Net interest income (on a tax-equivalent basis) increased$29.0 million , or 34%, from$85.0 million for 2010 to$114.0 million for 2011. Total interest income increased$26.7 million while total interest expense decreased$2.3 million . Average interest-earning assets were$2.8 billion in 2011, an increase of$505.4 million , or 22%, from 2010. Loans accounted for the majority of the growth, increasing by$198.7 million , or 11%, to$2.1 billion . Securities and short-term investments increased$306.7 million , or 75% to$714.3 million from 2010. Interest income increased$30.9 million due to volume and decreased by$4.2 million due to the impact of rates, for a net increase of$26.7 million versus 2010. Average interest-bearing liabilities increased$419.7 million , or 21%, to$2.4 billion compared to$2.0 billion for 2010. The increase in interest-bearing liabilities primarily resulted from a$397.8 million increase in interest-bearing deposits. For 2011, interest expense on interest-bearing liabilities increased$4.3 million due to volume while the impact of declining rates decreased interest expense on interest-bearing liabilities by$6.5 million , for a net decrease of$2.3 million versus 2010. See "Liquidity and Capital Resources" for more information. For the year endedDecember 31, 2011 , the tax-equivalent net interest rate margin was 4.12% compared to 3.76% for 2010. The net interest margin was favorably impacted by lower deposit costs and the net interest income generated by the loans acquired in the Legacy and FNBO acquisitions. For 2011, the net interest rate margin, less theFDIC loss share loans, related nonearning assets and acquired deposits, was 3.42% compared to 3.53% for 2010. Comparison of 2010 vs. 2009 Net interest income (on a tax-equivalent basis) increased$13.6 million , or 19%, from$71.4 million for 2009 to$85.0 million for 2010. Total interest income decreased$2.8 million while total interest expense decreased$16.4 million . Average interest-earning assets were$2.3 billion in 2010, a decrease of$73.8 million , or 3%, from 2009. Loans accounted for the majority of the reduction, decreasing by$245.1 million , or 12%, to$1.9 billion . The decrease in loans was partially offset by an increase in securities and short-term investments of$171.3 million , or 72% to$407.7 million . Interest income decreased$4.4 million due to volume declines and increased by$1.6 million due to the impact of rates, for a net decrease of$2.8 million versus 2009. Average interest-bearing liabilities decreased$67.9 million , or 3%, to$2.0 billion compared to$2.0 billion for 2009. The decrease in interest-bearing liabilities resulted from a$199.3 million decrease in borrowed funds. The decrease in borrowed funds was partially offset by a$131.3 million increase in interest-bearing deposits. For 2010, interest expense on interest-bearing liabilities decreased$4.8 million due to volume while the impact of declining rates decreased interest expense on interest-bearing liabilities by$11.6 million , for a net decrease of$16.4 million versus 2009. See "Liquidity and Capital Resources" for more information.
For the year ended
25 -------------------------------------------------------------------------------- Average Balance Sheet The following table presents, for the periods indicated, certain information related to our average interest-earning assets and interest-bearing liabilities, as well as, the corresponding interest rates earned and paid, all on a tax equivalent basis. For the years ended December 31, 2011 2010 2009 Average Average Average Interest Yield/ Interest Yield/ Interest Yield/ (in thousands) Average Balance Income/Expense Rate Average Balance Income/Expense Rate Average Balance Income/Expense Rate Assets Interest-earning assets: Taxable loans (1) $ 1,786,601 $ 95,520 5.35 % $ 1,751,459 $ 95,798 5.47 % $ 2,043,202 $ 109,413 5.35 % Tax-exempt loans (2) 32,935 2,542 7.72 30,564 2,621 8.58 53,826 4,868 9.04 Covered loans (3) 232,363 32,926 14.17 71,152 10,924 15.35 1,244 38 3.05 Total loans 2,051,899 130,988 6.38 1,853,175 109,343 5.90 2,098,272 114,319 5.45 Taxable investments in debt and equity securities 473,620 11,510 2.43 276,493 7,458 2.70 172,815 5,778 3.34 Non-taxable investments in debt and equity securities (2) 22,434 1,086 4.84 5,132 245 4.77 634 37 5.84 Short-term investments 218,287 562 0.26 126,058 380 0.30 62,976 136 0.22
Total securities and short-term
investments 714,341 13,158 1.84 407,683 8,083 1.98 236,425 5,951 2.52 Total interest-earning assets 2,766,240 144,146 5.21 2,260,858 117,426 5.19 2,334,697 120,270 5.15 Noninterest-earning assets: Cash and due from banks 15,801 11,800 23,959 Other assets 357,993 227,038 146,674 Allowance for loan losses (43,887 ) (45,673 ) (43,093 ) Total assets $ 3,096,147 $ 2,454,023 $ 2,462,237 Liabilities and Shareholders' Equity Interest-bearing liabilities: Interest-bearing transaction accounts $ 212,257 $ 811 0.38 % $ 190,275 $ 847 0.45 % $ 122,563 $ 662 0.54 % Money market accounts 997,415 7,987 0.80 701,360 6,245 0.89 636,350 6,079 0.96 Savings 27,106 112 0.41 10,022 35 0.35 9,147 35 0.38 Certificates of deposit 847,057 12,748 1.50 784,369 15,740 2.01 786,631 23,427 2.98 Total interest-bearing deposits 2,083,835 21,658 1.04 1,686,026 22,867 1.36 1,554,691 30,203 1.94 Subordinated debentures 85,081 4,515 5.31 85,081 4,954 5.82 85,081 5,171 6.08 Borrowed funds 208,128 3,982 1.91 186,283 4,590 2.46 385,567 13,471 3.49
Total interest-bearing
liabilities 2,377,044 30,155 1.27 1,957,390 32,411 1.66 2,025,339 48,845 2.41 Noninterest bearing liabilities: Demand deposits 494,609 305,887 250,435 Other liabilities 10,844 12,115 9,089 Total liabilities 2,882,497 2,275,392 2,284,863 Shareholders' equity 213,650 178,631 177,374 Total liabilities & shareholders' equity $ 3,096,147 $ 2,454,023 $
2,462,237
Net interest income $ 113,991 $ 85,015 $ 71,425 Net interest spread 3.94 % 3.53 % 2.74 % Net interest rate margin (4) 4.12 3.76 3.06
(1) Average balances include non-accrual loans. The income on such loans is
included in interest but is recognized only upon receipt. Loan fees, net of
amortization of deferred loan origination fees and costs, included in
interest income are approximately
the years endedDecember 31, 2011 , 2010, and 2009, respectively. 26
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(2) Non-taxable income is presented on a fully tax-equivalent basis using a 36%
tax rate. The tax-equivalent adjustments were
respectively.
(3) Covered loans are loans covered under
recorded at fair value.
(4) Net interest income divided by average total interest-earning assets.
Rate/Volume
The following table sets forth, on a tax-equivalent basis for the periods indicated, a summary of the changes in interest income and interest expense resulting from changes in yield/rates and volume.
2011 compared to 2010
2010 compared to 2009
Increase (decrease) due to Increase (decrease) due to (in thousands) Volume(1) Rate(2) Net Volume(1) Rate(2) Net Interest earned on: Taxable loans $ 1,902 $ (2,180 ) $ (278 ) $ (15,915 ) $ 2,300 $ (13,615 ) Nontaxable loans (3) 194 (273 ) (79 ) (2,007 ) (240 ) (2,247 ) Covered loans 22,907 (905 ) 22,002 10,149 737 10,886 Taxable investments in debt and equity securities 4,855 (803 ) 4,052 2,960 (1,280 ) 1,680 Nontaxable investments in debt and equity securities (3) 838 3 841 216 (8 ) 208 Short-term investments 244 (62 ) 182 175 69 244 Total interest-earning assets $ 30,940 $ (4,220 ) $ 26,720 $ (4,422 ) $ 1,578 $ (2,844 ) Interest paid on: Interest-bearing transaction accounts $ 92 $ (128 ) $ (36 ) $ 317 $ (132 ) $ 185 Money market accounts 2,422 (680 ) 1,742 596 (430 ) 166 Savings 70 7 77 3 (3 ) - Certificates of deposit 1,182 (4,174 ) (2,992 ) (67 ) (7,620 ) (7,687 ) Subordinated debentures - (439 ) (439 ) - (217 ) (217 ) Borrowed funds 497 (1,105 ) (608 ) (5,656 ) (3,225 ) (8,881 ) Total interest-bearing liabilities 4,263 (6,519 ) (2,256 ) (4,807 ) (11,627 ) (16,434 ) Net interest income $ 26,677 $ 2,299 $ 28,976 $ 385 $ 13,205 $ 13,590
(1) Change in volume multiplied by yield/rate of prior period.
(2) Change in yield/rate multiplied by volume of prior period.
(3) Nontaxable income is presented on a fully-tax equivalent basis using a 36%
tax rate.
NOTE: The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each. Provision for loan losses. The provision for loan losses not covered underFDIC loss share was$13.3 million for 2011 compared to$33.7 million for 2010 and$40.4 million for 2009. The decline in the provision for loan losses since 2011 is due to lower levels of adverse risk rating changes and trends in nonperforming loans. For Covered loans, the Company re-measures contractual and expected cashflows on a quarterly basis. When the re-measurement process results in a decrease in expected cash flows due to an increase in expected credit losses, impairment is recorded. As a result of this impairment, theFDIC loss share receivable is increased to reflect anticipated future cash to be received from theFDIC . The amount of the increase is determined based on the specific loss share agreement, but is generally 80% of the losses. In the third quarter of 2011, an impairment of$2.7 million was recorded in the provision for loan losses covered underFDIC loss share for certain loan pools covered under loss share which was partially offset through noninterest income by an increase in theFDIC loss share receivable. In the fourth quarter of 27 --------------------------------------------------------------------------------
2011, this impairment reversed, but was offset by impairment on other loan pools covered under loss share. The
See the sections below captioned "Loans" And "Allowance for Loan Losses" for more information on our loan portfolio and asset quality.
Noninterest Income The following table presents a comparative summary of the major components of noninterest income. Years ended December 31, Change 2010 over (in thousands) 2011 2010 2009 Change 2011 over 2010 2009 Wealth Management revenue $ 6,841 $ 6,414 $ 4,524 $ 427 $ 1,890 Service charges on deposit accounts 5,091 4,739 5,012 352 (273 ) Other service charges and fee income 1,679 1,128 963 551 165 Sale of other real estate 862 79 (436 ) 783 515 State tax credit activity, net 3,645 2,250 1,035 1,395 1,215 Sale of securities 1,450 1,987 955 (537 ) 1,032 Change in FDIC loss share receivable (3,494 ) 99 - (3,593 ) 99 Extinguishment of debt - - 7,388 - (7,388 ) Miscellaneous income 2,434 1,664 436 770 1,228 Total noninterest income $ 18,508 $ 18,360 $ 19,877 $ 148 $ (1,517 ) Comparison 2011 vs. 2010 Noninterest income increased$148,000 , or 1% in 2011 compared to 2010. Our ratio of noninterest income to total revenue for 2011 was 14%, compared to 18% in 2010. Wealth Management revenue from the Trust division increased$427,000 , or 7%. The increase in Trust revenue was primarily attributable to the impact of the additional Legacy and FNBO trust business. Assets under administration were$1.6 billion atDecember 31, 2011 , a$104.0 million , or 7% increase from one year ago.
In 2011, we sold
Gains from state tax credit brokerage activities were$3.6 million in 2011, compared to$2.3 million in 2010, an increase of$1.4 million . The increase is due to a$1.7 million increase from the sale of state tax credits to clients, and a$905,000 increase in the fair value adjustment on the related interest rate caps used to economically hedge the tax credits partially offset by a$1.2 million negative fair value adjustment on the tax credit assets.
In 2011, the Company purchased approximately
The decrease in income related to theFDIC loss share receivable was primarily due to loan pay offs in which the losses on the loans were less than expected along with lower loss expectations on certain loan pools. To correlate with the new projected loss amounts, theFDIC loss share receivable must be reduced. In 2012, absent any changes based on the results of the quarterly re-measurement process, the Company anticipates continued lower losses in certain loan pools. These lower loss expectations will reduce the accretion on theFDIC loss share receivable and may result in negative accretion. 28 -------------------------------------------------------------------------------- The increase in Miscellaneous income was primarily due to$313,000 in fee income earned related to the allocation of New Market Tax Credits to developers and projects along with distributions from private equity fund investments. Comparison 2010 vs. 2009 The 2009 results include a$7.4 million pre-tax gain from the extinguishment of debt. Excluding the gain on extinguishment of debt, noninterest income increased$5.9 million , or 47%, during 2010. Wealth Management revenue from the Trust division increased$1.9 million , or 42%. The increase in revenue was attributable to higher account asset values, several estate planning-related insurance sales and generally improving sales momentum in the Trust organization. In 2010, we elected to record Wealth Management revenue on a gross basis resulting in a$971,000 increase in Wealth Management revenue which was offset by a related$971,000 increase in Other expenses. Assets under administration were$1.499 billion atDecember 31, 2010 , a$219 million , or 17% increase from one year ago primarily due to higher asset values from stronger financial markets.
In 2010, we sold
Gains from state tax credit brokerage activities were$2.3 million in 2010, compared to$1.0 million in 2009. The increase is due to a$142,000 increase from the sale of state tax credits to clients, and a$3.0 million positive fair value adjustment on the tax credit assets offset by a$1.9 million decrease in the fair value adjustment on the related interest rate caps used to economically hedge the tax credits. In 2010, the Company elected to reposition a portion of the investment portfolio and sold approximately$127.0 million of securities realizing a gain of$2.0 million on these sales. With the proceeds from securities sales and maturities and excess cash, we purchased approximately$323.8 million in mortgage backed securities, including collateralized mortgage obligations, government sponsored agency debentures, and federally tax free municipal securities. The increase in Miscellaneous income was primarily due to$776,000 of income on bank-owned life insurance policies, and$524,000 related to two interest rate swaps terminated by the Company in 2009. 29 -------------------------------------------------------------------------------- Noninterest Expense The following table presents a comparative summary of the major components of noninterest expense. Years ended December 31, Change 2011 over Change 2010 (in thousands) 2011 2010 2009 2010 over 2009 Employee compensation and benefits 36,839 28,316 25,969 8,523 2,347 Occupancy 5,001 4,297 4,709 704 (412 )
Furniture and equipment 1,601 1,393 1,425
208 (32 ) Data processing 3,159 2,234 2,147 925 87 Communications 636 554 556 82 (2 ) Director related expense 599 607 459 (8 ) 148
Meals and entertainment 1,747 1,258 1,037
489 221 Marketing and public relations 1,063 902 504 161 398
(283 ) 198 Amortization of intangibles 999 420 482 579 (62 ) Goodwill impairment charges - - 45,377 - (45,377 ) Postage, courier, and armored car 909 769 772 140 (3 ) Professional, legal, and consulting 3,138 1,736 2,278 1,402 (542 ) Loan, legal and other real estate expense 10,703 9,941 4,788 762 5,153 Other taxes 675 635 566 40 69 Other 6,530 4,748 3,154 1,782 1,594
Total noninterest expense
15,506 $ (36,215 )
Comparison 2011 vs. 2010 Noninterest expense increased$15.5 million , or 25%, in 2011. The Company's efficiency ratio, which measures noninterest expense as a percentage of total revenue, for 2011 was 59.2% compared to 60.8% for 2010. Employee compensation and benefits. Employee compensation and benefits increased$8.5 million , or 30%, over 2010. Employee compensation and benefits increased primarily due to staff additions to support ourKansas andArizona acquisition activity and higher variable compensation accruals.
<p>All other expense categories. All other expense categories increased
Occupancy expense and data processing increases were due to the addition of new branches as part of our acquisition activity in 2011.
Professional, legal and consulting increased$1.4 million due to litigation defense costs, fees related to the FNBO acquisition, and various consulting expenses related to new business activities and regulatory compliance. Loan, legal and other real estate expenses increased$762,000 due to increased levels of other real estate properties. Other real estate expenses for items such as utilities, legal fees and insurance increased$1.8 million over 2010. These expenses were partially offset by a$930,000 decrease in expenses related to writedowns on other real estate. In 2012, the Company expects noninterest expenses to average$20 to $22 million per quarter as loan collection expenses on Covered assets remain elevated and the full year impact of compensation expense for the FNBO acquisition and expenses for other new initiatives are realized. Comparison 2010 vs. 2009 Noninterest expense decreased$36.2 million , or 37%, in 2010. The decrease was primarily due to a$45.4 million 30 --------------------------------------------------------------------------------
goodwill impairment charge associated with the banking segment in 2009. Excluding the goodwill impairment charge, noninterest expenses increased
Employee compensation and benefits. Employee compensation and benefits increased$2.3 million , or 9%, over 2009. Employee compensation and benefits increased primarily due to the recruitment of several prominentSt. Louis bankers, higher variable compensation accruals, and staff additions to support ourArizona acquisition activity.
All other expense categories. Excluding the goodwill impairment charge, all other expense categories increased
Occupancy expense decreases were due to lower amortization of leasehold improvements in 2010.
Loan, legal and other real estate expenses increased$5.2 million due to increased levels of nonperforming loans and other real estate properties. Approximately,$3.2 million of the increase represents fair value writedowns on other real estate. Other real estate expenses for items such as utilities, legal fees and insurance increased$1.1 million over 2009. Approximately$278,000 of the increase was related to estimated losses attributable to the unadvanced commitments on impaired loans. In 2010, we elected to record Wealth Management revenue on a gross basis resulting in a$971,000 increase in Other expenses offset by a related$971,000 increase in Wealth Management revenue. Other expenses also include a$250,000 accrual for a potential loss on a depository account. Discontinued Operations OnJanuary 20, 2010 , we soldMillennium Brokerage Group, LLC , a wholly owned life insurance subsidiary, to an investor group led mostly by former managers of Millennium for$4.0 million in cash, resulting in a$1.6 million pre-tax loss recognized in 2009. As a result of the sale, we have reclassified the results of Millennium for 2009 and prior periods to discontinued operations. The amount of the loss on the sale is primarily due to the write-off of the remaining goodwill associated with the Millennium reporting unit. For 2009, net loss from discontinued operations was$1.3 million , compared to a net loss of$6.2 million from discontinued operations in 2008. The 2008 loss includes$9.2 million of pre-tax goodwill impairment charges and lower levels of paid premium sales and lower sales margins which significantly reduced Millennium's operating results. Income Taxes In 2011, the Company recorded income tax expense of$11.9 million on pre-tax income of$37.4 million , resulting in an effective tax rate of 32.0%. The following items were included in Income tax expense (benefit) and impacted the 2011 effective tax rate: • the expiration of the statute of limitations for the 2007 tax year
warranted the release of
positions;
• recognition of federal tax benefits of
housing tax credits from limited partnership interests.
In 2010, the Company recorded income tax expense of$0.8 million on pre-tax income of$6.4 million , resulting in an effective tax rate of 12.9%. The following items were included in Income tax expense (benefit) and impacted the 2010 effective tax rate: • the expiration of the statute of limitations for the 2006 tax year
warranted the release of
positions;
• recognition of federal tax benefits of
housing tax credits from limited partnership interests. 31
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FINANCIAL CONDITION
Comparison forDecember 31, 2011 and 2010 Total assets atDecember 31, 2011 were$3.4 billion compared to$2.8 billion atDecember 31, 2010 , an increase of$577.6 million , or 21%. Acquisitions and organic growth drove the increase which included a$309.8 million increase in portfolio loans, a$231.6 million increase in securities available for sale, and a$96.8 million increase in theFDIC loss share receivable. AtDecember 31, 2011 , portfolio loans totaled$2.2 billion , an increase of$309.8 million , or 16% fromDecember 31, 2010 . For the year, the Covered loans increased$179.0 million to$300.6 million , while Non-covered loans increased by$130.7 million , or 7% . Strong core deposit growth in 2011, led to significant increases in cash. A portion of the cash was used to increase the available for sale securities portfolio. Securities available for sale were$593.2 million atDecember 31, 2011 compared to$361.5 million atDecember 31, 2010 . In 2011, securities purchases included government sponsored agency debentures, mortgage backed securities, including collateralized mortgage obligations, and federally tax free municipal securities. AtDecember 31, 2011 , theFDIC loss share receivable included$12.5 million due from theFDIC pursuant to the First Amendment to Purchase and Assumption Agreement with theFDIC as Receiver for FNBO. For more information, see the Form 8-K filed with theSEC onMarch 22, 2012 .
At
AtDecember 31, 2011 , deposits were$2.8 billion , an increase of$493.6 million , or 21%, from$2.3 billion atDecember 31, 2010 . The FNB acquisition added$423.1 million in deposits in the third quarter of 2011. These deposits included$66.9 million in noninterest-bearing demand deposits,$123.6 million in money market and other interest-bearing transaction accounts, and$232.6 million in certificates of deposit.
Other borrowings at
On
On
Loans
Non-covered portfolio loans less unearned loan fees, increased$130.7 million , or 7%, during 2011. Non-covered Commercial & Industrial loans increased$169.3 million , or 28%, during the year and represent 40% of the loan portfolio atDecember 31, 2011 . The Company's lending strategy emphasizes commercial, residential real estate, and commercial real estate loans to small and medium sized businesses and their owners in theSt. Louis ,Kansas City andPhoenix metropolitan markets. Consumer lending, including residential real estate, is minimal. Payoffs and paydowns, along with net charge-offs contributed to the decline in loan balances. A common underwriting policy is employed throughout the Company. Lending to small and medium sized businesses is riskier from a credit perspective than lending to larger companies, but the risk is appropriately considered with higher loan pricing and ancillary income from cash management activities. As additional risk mitigation, the Company will generally hold only$12.0 million or less of aggregate credit exposure (both direct and indirect) with one borrower, in 32 -------------------------------------------------------------------------------- spite of a legal lending limit of over$68 million . There are seven borrowing relationships where we have committed more than$10.0 million with the largest being a$15.0 million line of credit with minimal usage. For the$1.9 billion loan portfolio, the Company's average loan relationship size was just under$1.0 million , and the average note size is approximately$500,000 . The Company also buys and sells loan participations with other banks to help manage its credit concentration risk. AtDecember 31, 2011 , the Company had purchased loan participations of$305.8 million ($166.5 million outstanding) and had sold loan participations of$398.7 million ($310.5 million outstanding). Approximately 71 borrowers make up the participations purchased, with an average outstanding loan balance of$1.6 million . Seventeen relationships, or$62.0 million of the$166.5 million in participations purchased, met the definition of a "Shared National Credit"; however, only two of the relationships, or$12.0 million , were considered out of our market. The following table sets forth the composition of the Company's loan portfolio by type of loans as reported in the quarterly Federal Financial Institutions Examination Council Report of Condition and Income ("Call report") at the dates indicated. December 31, (in thousands) 2011 2010 2009 2008 2007 Commercial and industrial $ 763,202 $ 593,938 $ 553,988 $ 675,216 $ 549,479 Real Estate: Commercial 811,570 776,268 817,332 887,963 720,072 Construction and land development 140,147 190,285 221,397 378,092 301,710 Residential 171,034 189,484 209,743 235,019 175,258 Consumer and other 11,121 16,376 16,021 25,167 37,759 Total Portfolio loans not covered under FDIC loss share 1,897,074 1,766,351 1,818,481 2,201,457 1,784,278 Portfolio loans covered under FDIC loss share 300,610 121,570 13,644 - - Total Loans $ 2,197,684 $ 1,887,921 $ 1,832,125 $ 2,201,457 $ 1,784,278 December 31, (in thousands) 2011 2010 2009 2008 2007 Commercial and industrial 40.2 % 33.6 % 30.5 % 30.7 % 30.8 % Real Estate: Commercial 42.8 % 43.9 % 44.9 % 40.3 % 40.4 % Construction and land development 7.4 % 10.8 % 12.2 % 17.2 % 16.9 % Residential 9.0 % 10.7 % 11.5 % 10.7 % 9.8 % Consumer and other 0.6 % 1.0 % 0.9 % 1.1 % 2.1 % Total Portfolio loans not covered under FDIC loss share 100.0 % 100.0 % 100.0 %
100.0 % 100.0 %
Commercial and industrial loans are made based on the borrower's character, experience, general credit strength, and ability to generate cash flows for repayment from income sources, even though such loans may also be secured by real estate or other assets. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower's operations. Commercial and industrial loans are primarily made to borrowers operating within the manufacturing industry.
Real estate loans are also based on the borrower's character, but more emphasis is placed on the estimated collateral values.
Approximately
33 -------------------------------------------------------------------------------- underlying collateral. Multifamily properties and other commercial properties on which income from the property is the primary source of repayment represent the balance of this category. The majority of this category of loans is secured by commercial and multi-family properties located within ourSt. Louis andKansas City markets. These loans are underwritten based on the cash flow coverage of the property, typically meet the Company's loan to value guidelines, and generally require either the limited or full guaranty of principal sponsors of the credit. Real estate construction loans, relating to residential and commercial properties, represent financing secured by raw ground or real estate under development for eventual sale. Approximately$42.5 million of these loans include the use of interest reserves and follow standard underwriting guidelines. Construction projects are monitored by the officer and a centralized independent loan disbursement function is employed. Given the weak demand and stress in both the residential and commercial real estate markets, the Company reduced the level of these loan types in 2011. Residential real estate loans include residential mortgages, which are loans that, due to size, do not qualify for conventional home mortgages that the Company sells into the secondary market, second mortgages and home equity lines. Residential mortgage loans are usually limited to a maximum of 80% of collateral value.
Consumer and other loans represent loans to individuals on both a secured and unsecured basis. Credit risk is mitigated by thoroughly reviewing the creditworthiness of the borrowers prior to origination.
34 --------------------------------------------------------------------------------
Following is a further breakdown of our loan categories using Call report codes at
% of portfolio 2011 2010 Portfolio Loans not Portfolio Covered under Loans Covered FDIC loss under FDIC share loss share Total Total Real Estate: Construction & Land Development 7 % 22 % 9 % 12 % Commercial Owner Occupied Commercial & Industrial 16 % 18 % 16 % 17 % Other 2 % 3 % 2 % 2 % Total 18 % 21 % 18 % 19 % Commercial Investor Owned Retail 8 % 13 % 9 % 8 % Commercial Office 7 % 7 % 7 % 7 % Multi-Family Housing 3 % 2 % 3 % 3 % Churches/ Schools/ Nursing Homes/ Other 3 % - % 3 % 3 % Industrial/ Warehouse 4 % 3 % 4 % 4 % Total 25 % 25 % 26 % 25 % Residential: Owner Occupied 6 % 15 % 7 % 7 % Investor Owned 3 % 4 % 3 % 4 % Total 9 % 19 % 10 % 11 % Total Real Estate 59 % 87 % 63 % 67 % Non Real Estate Commercial & Industrial 40 % 12 % 36 % 32 % Consumer & Other 1 % 1 % 1 % 1 % Total Non Real Estate 41 % 13 % 37 % 33 % Total 100 % 100 % 100 % 100 %
The following descriptions focus on the Non-covered portion of the loan portfolio.
The Non-covered Construction andLand Development category represents$140.1 million , or 7%, of the total loan portfolio. Within that category, there was$10.0 million of loans secured by raw ground,$66.6 million of commercial construction, and$63.5 million of residential construction. Of the$140.1 million in loans in theNon-covered Construction andLand Development category, approximately$49 million was included on the Watch List. The Non-covered Commercial construction component of the portfolio consisted of approximately 49 loan relationships with an average outstanding loan balance of$1.1 million . The largest loans were a$9.1 million line of credit secured by commercially zoned land inSt. Louis , and a$4.5 million fixed line secured by commercially zoned land inKansas City .
The Non-covered Residential construction component of the portfolio consists of single family housing development properties primarily in our
35 --------------------------------------------------------------------------------
category with an average outstanding loan balance of
The largest segments of the non-owner occupied components of the commercial real estate portfolio are retail and commercial office permanent loans. AtDecember 31, 2011 , the Company had$147.0 million of Non-covered non-owner occupied permanent loans secured by retail properties. There were approximately 62 loan relationships in this category with an average outstanding loan balance of$1.5 million . The largest loans outstanding at year end were an$7.8 million loan secured by various retail properties inKansas City , a$6.8 million loan secured by a hotel inArizona , and a$6.4 million loan secured by a retail shopping center inKansas City . AtDecember 31, 2011 , the Company$134.7 million of Non-covered non-owner occupied permanent loans secured by commercial office properties. There were approximately 71 loan relationships with an average outstanding loan balance of$1.5 million . The largest loans outstanding at year end were an$8.6 million loan secured by a single tenant office building inKansas City , a$7.9 million loan secured by a medical office building in theSt. Louis region and a$5.9 million loan secured by a multi-tenant office property inKansas City .
Vacancy rates for commercial office space in the
Factors that are critical to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, early identification of potential problems, an adequate allowance for loan losses, and sound non-accrual and charge-off policies. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. AtDecember 31, 2011 , no significant concentrations exceeding 10% of total loans existed in the Company's loan portfolio, except as described above. 36
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Loans at
Loans Maturing or Repricing After One In One Through Five After (in thousands) Year or Less Years Five Years Total Fixed Rate Loans (1) (2) Commercial and industrial $ 94,696 $ 156,331 $ 31,980 $ 283,007 Real estate: Commercial 187,761 396,882 46,390 631,033 Construction and land development 57,882 19,530 2,498 79,910 Residential 42,587 70,243 1,657 114,487 Consumer and other 3,362 2,136 - 5,498 Portfolio loans covered under FDIC loss share 68,076 80,767 11,587 160,430 Total $ 454,364 $ 725,889 $ 94,112 $ 1,274,365 Variable Rate Loans (1) Commercial and industrial $ 310,157 $ 142,079 $ 27,959 $ 480,195 Real estate: Commercial 66,414 98,938 15,185 180,537 Construction and land development 48,142 9,888 2,207 60,237 Residential 20,255 11,085 25,207 56,547 Consumer and other 5,397 226 - 5,623 Portfolio loans covered under FDIC loss share 53,508 39,965 46,707 140,180 Total $ 503,873 $ 302,181 $ 117,265 $ 923,319 Loans (1) (2) Commercial and industrial $ 404,853 $ 298,410 $ 59,939 $ 763,202 Real estate: Commercial 254,175 495,820 61,575 811,570 Construction and land development 106,024 29,418 4,705 140,147 Residential 62,842 81,328 26,864 171,034 Consumer and other 8,759 2,362 - 11,121 Portfolio loans covered under FDIC loss share 121,584 120,732 58,294 300,610 Total $ 958,237 $ 1,028,070 $ 211,377 $ 2,197,684
(1) Loan balances include unearned loan (fees) costs, net. (2) Not adjusted for impact of interest rate swap agreements.
Fixed rate loans comprise approximately 58% of the loan portfolio atDecember 31, 2011 and 61% atDecember 31, 2010 . Variable rate loans are based on the prime rate or the London Interbank Offered Rate ("LIBOR"). The Bank's "prime rate" has been 4.00% since late 2008 when the Federal Reserve lowered the targeted Fed Funds rate to 0.25%. Some of the variable rate loans also use the "Wall Street Journal Prime Rate" which has been 3.25% since late 2008. Most loan originations have one to three year maturities. While the loan relationship has a much longer life, the shorter maturities allow the Company to revisit the underwriting and pricing on each relationship periodically. Management monitors this mix as part of its interest rate risk management. See "Interest Rate Risk" section. Of the$254.2 million of commercial real estate loans maturing in one year or less,$154.6 million , or 61%, represents loans secured by non-owner occupied commercial properties. 37
-------------------------------------------------------------------------------- Allowance for Loan Losses The loan portfolio is the primary asset subject to credit risk. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and ongoing review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, further ensures appropriate management of credit risk. Credit risk management for each loan type is discussed briefly in the section entitled "Loans." The allowance for loan losses represents management's estimate of an amount adequate to provide for probable credit losses in the loan portfolio at the balance sheet date. Various quantitative and qualitative factors are analyzed and provisions are made to the allowance for loan losses. Such provisions are reflected in our consolidated statements of income. The evaluation of the adequacy of the allowance for loan losses is based on management's ongoing review and grading of the loan portfolio, consideration of past loss experience, trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, and other factors that could affect probable credit losses. Assessing these numerous factors involves significant judgment and could be significantly impacted by changes in economic conditions. Management considers the allowance for loan losses a critical accounting policy. See "Critical Accounting Policies" for more information. In determining the allowance and the related provision for loan losses, three principal elements are considered: 1) specific allocations based upon probable losses identified during a
quarterly review of the loan portfolio,
2) allocations based principally on the Company's risk rating formulas, and
3) a qualitative adjustment based on subjective factors.
The first element reflects management's estimate of probable losses based upon a systematic review of specific loans considered to be impaired. These estimates are based upon collateral exposure, if they are collateral dependent for collection. Otherwise, discounted cash flows are estimated and used to assign loss. AtDecember 31, 2011 the allocated allowance for loan losses on individually impaired loans was$10.7 million , or 26% of the total impaired loans. AtDecember 31, 2010 , the allocated allowance for loan losses on individually impaired loans was$9.1 million , or 20% of the total impaired loans. The second element reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Loans are rated and assigned a loss allocation factor for each category that is based on a loss migration analysis using the Company's loss experience and heavily weighting the most recent 12 months. The higher the rating assigned to a loan, the greater the loss allocation percentage that is applied. The qualitative adjustment is based on management's evaluation of conditions that are not directly reflected in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they may not be identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the qualitative adjustment include the following: • general economic and business conditions affecting our markets;
• asset quality trends (including trends in nonperforming loans expected to
result from existing conditions); and
• loan review findings. Executive management reviews these conditions quarterly in discussion with our entire lending staff. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's estimate of the effect of such conditions may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's evaluation of the probable loss related to such condition is reflected in the qualitative adjustment. The allocation of the allowance for loan losses by loan category is a result of the analysis above. The allocation methodology applied by the Company, designed to assess the adequacy of the allowance for loan losses, focuses on changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, and historical losses on each portfolio category. Because each of the criteria used is subject to change, the 38 -------------------------------------------------------------------------------- allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. Management continues to target and maintain the allowance for loan losses equal to the allocation methodology plus a qualitative adjustment, as determined by economic conditions and other qualitative and quantitative factors affecting the Company's borrowers, as described above. For Covered loans, the Company re-measures contractual and expected cash flows on a quarterly basis. When the re-measurement process results in a decrease in expected cash flows, impairment is recorded as a provision for loan losses covered underFDIC loss share. As a result of impairment, theFDIC loss share receivable is increased to reflect future cash to be received from theFDIC . The amount of the increase is recorded in noninterest income and is determined based on the specific loss share agreement, but is generally 80% of the losses. AtDecember 31, 2011 , the allowance for loan losses includes$1.6 million for Covered loans.
Management believes that the allowance for loan losses is adequate at
In 2012, the Company expects similar levels of net chargeoffs, (excluding Covered loans), given the continued softness in real estate values and activities in our markets.
39 -------------------------------------------------------------------------------- The following table summarizes changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off, by loan category, and additions to the allowance charged to expense. At December 31, (in thousands) 2011 2010 2009 2008 2007 Allowance at beginning of year, for loans not covered underFDIC loss share $ 42,759 $ 42,995 $ 33,808 $ 22,585 $ 17,475 (Disposed) acquired allowance for loan losses - - - (50 ) 2,010 Release of allowance related to loan participations sold - - (1,383 ) - - Loans charged off: Commercial and industrial 5,488 3,865 3,663 3,783 238 Real estate: Commercial 2,429 15,482 5,710 1,384 43 Construction and land development 10,627 12,148 15,086 8,044 705 Residential 1,613 4,391 5,931 2,367 1,418 Consumer and other 5 274 42 31 125 Total loans charged off 20,162 36,160 30,432 15,609 2,529 Recoveries of loans previously charged off: Commercial and industrial 583 157 62 64 347 Real estate: Commercial 729 1,001 66 - 15 Construction and land development 415 314 28 241 25 Residential 303 536 422 56 17 Consumer and other 62 181 12 11 105 Total recoveries of loans 2,092 2,189 590 372 509 Net loan chargeoffs for loans not covered under FDIC loss share 18,070 33,971 29,842 15,237 2,020 Provision for loan losses not covered under FDIC loss share 13,300 33,735 40,412 26,510 5,120
Allowance at end of year, for loans not covered under
Allowance at beginning of year, for loans covered under FDIC loss share $ - $ - $
- $ - $ -
Loans charged off covered under FDIC loss share 1,168 - - - - Recoveries of loans covered under FDIC loss share - - - - - Net loan chargeoffs for loans covered under FDIC loss share 1,168 - - - - Provision for loan losses covered under FDIC loss share 2,803 - - - - Allowance at end of year, for loans covered under FDIC loss share $ 1,635 $ - $
- $ - $ -
Total Allowance at end of year
Excludes loans covered underFDIC loss share Average loans $ 1,819,536 $ 1,782,023 $ 2,097,028 $ 2,001,073 $ 1,599,596 Total portfolio loans 1,897,074 1,766,351 1,818,481 2,201,457 1,784,278 Net chargeoffs to average loans 0.99 % 1.91 % 1.42 % 0.76 % 0.13 % Allowance for loan losses to loans 2.00 2.42 2.36 1.54 1.27 Includes loans covered underFDIC loss share Average loans $ 2,051,899 $ 1,853,175 $ 2,098,272 $ 2,001,073 $ 1,599,596 Total portfolio loans 2,197,684 1,887,921 1,832,125 2,201,457 1,784,278 Net chargeoffs to average loans 0.94 % 1.83 % 1.42 % 0.76 % 0.13 % Allowance for loan losses to loans 1.80 2.26 2.35 1.54 1.27 40
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The following table is a summary of the allocation of the allowance for loan losses for the five years ended
December 31, 2011 2010 2009 2008 2007 Percent by Percent by Percent by Percent by Percent by Category to Category to Category to Category to Category to (in thousands) Allowance Total Loans Allowance Total Loans Allowance Total Loans Allowance Total Loans Allowance Total Loans Commercial and industrial $ 11,945 34.7 % $ 12,727 31.5 % $ 9,715 30.2 % $ 6,431 30.7 % $ 4,582 30.8 % Real estate: Commercial 13,048 36.9 % 10,689 41.1 % 19,600 44.7 % 11,085 40.3 % 7,229 40.4 % Construction and land development 5,847 6.4 % 8,407 10.1 % 4,289 12.1 % 7,886 17.2 % 5,418 16.9 % Residential 3,931 7.8 % 5,485 10.0 % 3,859 11.4 % 2,762 10.7 % 2,632 9.8 % Consumer and other 14 0.5 % 93 0.9 % 45 0.9 % 188 1.1 % 438 2.1 % Portfolio loans covered under FDIC loss share 1,635 13.7 % - 6.4 % - 0.7 % - - % - - % Qualitative adjustment 3,204 5,358 5,487 5,456 2,286 Total allowance $ 39,624 100.0 % $ 42,759 100.0 % $ 42,995 100.0 % $ 33,808 100.0 % $ 22,585 100.0 % Nonperforming assets Nonperforming loans are defined as loans on non-accrual status, loans 90 days or more past due but still accruing, and restructured loans that are still accruing interest or in a non-accrual status. Restructured loans involve the granting of a concession to a borrower experiencing financial difficulty involving the modification of terms of the loan, such as changes in payment schedule or interest rate. Nonperforming assets include nonperforming loans plus foreclosed real estate.
Nonperforming loans exclude credit-impaired loans acquired in
Loans are placed on non-accrual status when contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectibility of principal or interest on loans, it is management's practice to place such loans on non-accrual status immediately, rather than delaying such action until the loans become 90 days past due. Previously accrued and uncollected interest on such loans is reversed. Income is recorded only to the extent that a determination has been made that the principal balance of the loan is collectable and the interest payments are subsequently received in cash, or for a restructured loan, the borrower has made six consecutive contractual payments. If collectability of the principal is in doubt, payments received are applied to loan principal. Loans past due 90 days or more but still accruing interest are also included in nonperforming loans. Loans past due 90 days or more but still accruing are classified as such where the underlying loans are both well secured (the collateral value is sufficient to cover principal and accrued interest) and are in the process of collection. The Company's nonperforming loans meet the definition of "impaired loans" in accordance with U.S. generally accepted accounting principles ("U.S. GAAP"). As ofDecember 31, 2011 , 2010, and 2009, the Company had 41, 43, and 39 impaired loan relationships, respectively. 41 --------------------------------------------------------------------------------
The following table presents the categories of nonperforming assets and certain ratios as of the dates indicated:
December 31, (in thousands) 2011 2010 2009 2008 2007 Non-accrual loans $ 30,885 $ 38,477 $ 37,441 $ 35,487 $ 12,720 Loans past due 90 days or more and still accruing interest 755 - - - - Restructured loans 9,982 7,880 1,099 - - Total nonperforming loans 41,622 46,357 38,540 35,487 12,720 Foreclosed property (1) 17,217 25,373 22,918 13,868 2,963 Other bank owned assets - 850 - - -
Total nonperforming assets (1)
Excludes assets covered underFDIC loss share Total assets $ 3,377,779 $ 2,800,199 $ 2,365,655 $ 2,493,767 $ 2,141,329 Total portfolio loans 1,897,074 1,766,351 1,818,481 2,201,457 1,784,278 Total loans plus foreclosed property 1,914,291 1,792,574 1,841,399 2,215,325 1,787,241 Nonperforming loans to total loans 2.19 % 2.62 % 2.12 % 1.61 % 0.71 % Nonperforming assets to total loans plus foreclosed property 3.07 4.05 3.34 2.23 0.88 Nonperforming assets to total assets (1) 1.74 2.59 2.60 1.98 0.73 Includes assets covered underFDIC loss share Total assets $ 3,377,779 $ 2,800,199 $ 2,365,655 $ 2,493,767 $ 2,141,329 Total portfolio loans 2,197,684 1,887,921 1,832,125 2,201,457 1,784,278 Total loans plus foreclosed property 2,251,372 1,924,979 1,857,209 2,215,325 1,787,241 Nonperforming loans to total loans 1.89 % 2.46 % 2.10 % 1.61 % 0.71 % Nonperforming assets to total loans plus foreclosed property 4.23 4.33 3.43 2.23 0.88 Nonperforming assets to total assets 2.82 2.98 2.69 1.98 0.73 Allowance for loan losses to nonperforming loans 95.00 % 92.00 %
112.00 % 95.00 % 178.00 %
(1) Excludes assets covered under
inclusion in total assets Nonperforming loans Nonperforming loans atDecember 31, 2011 and 2010 based on Call Report codes were as follows: (in thousands) 2011 2010
Construction, Real Estate/Land Acquisition and Development
11,127
10,935
Commercial Real Estate - Owner Occupied 4,572 2,024 Residential Real Estate 5,522 12,188 Commercial & Industrial 5,634 11,276 Consumer & Other - - Total $ 41,622 $ 46,357 42
-------------------------------------------------------------------------------- The following table summarizes the changes in nonperforming loans by quarter for 2011 and 2010. 2011 (in thousands) 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr Total year Nonperforming loans beginning of period $ 48,038 $ 43,118 $ 43,487 $ 46,357 $ 46,357 Additions to nonaccrual loans 7,276 14,618 6,204 18,187 46,285 Additions to restructured loans 3,803 2,314 2,508 297 8,922 Chargeoffs (5,558 ) (4,959 ) (5,679 ) (3,966 ) (20,162 ) Other principal reductions (7,545 ) (3,372 ) (3,992 ) (6,445 ) (21,354 ) Moved to Other real estate (1,203 ) (2,932 ) (159 ) (7,014 ) (11,308 ) Moved to performing (3,944 ) - - (3,929 ) (7,873 ) Loans past due 90 days or more and still accruing interest 755 (749 ) 749 - 755 Nonperforming loans end of period $ 41,622 $ 48,038 $ 43,118 $ 43,487 $ 41,622 2010 (in thousands) 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr Total Year Nonperforming loans beginning of period $ 51,955 $ 46,550 $ 55,785 $ 38,540 $ 38,540 Additions to nonaccrual loans 15,877 19,373 15,440 39,663 90,353 Additions to restructured loans 3,430 2,286 454 611 6,781 Chargeoffs (7,860 ) (7,023 ) (8,314 ) (12,963 ) (36,160 ) Other principal reductions (7,288 ) (1,881 ) (4,580 ) (2,739 ) (16,488 ) Moved to Other real estate (8,743 ) (7,122 ) (11,350 ) (5,564 ) (32,779 ) Moved to Other bank owned assets - - - (955 ) (955 ) Moved to performing (1,014 ) (228 ) - (1,693 ) (2,935 ) Loans past due 90 days or more and still accruing interest - - (885 ) 885 -
Nonperforming loans end of period
AtDecember 31, 2011 , the nonperforming loans represent 41 relationships. The largest of these is a$4.5 million commercial real estate loan. Five relationships comprise 44% of the nonperforming loans. Approximately 52% of the nonperforming loans were in theSt. Louis market, 47% were in theKansas City market and 1% in thePhoenix market. AtDecember 31, 2010 , the nonperforming loans represent 43 relationships. The largest of these is a$4.1 million commercial real estate loan. Five relationships comprise 45% of the nonperforming loans. Approximately 57% of the nonperforming loans were in theSt. Louis market and 43% were in theKansas City market. AtDecember 31, 2009 , the nonperforming loans represent 39 relationships. The largest of these is a$4.0 million commercial real estate loan. Five relationships comprise 41% of the nonperforming loans. Approximately 52% of the nonperforming loans were in theKansas City market, 47% were in theSt. Louis market and less than 1% were in thePhoenix market. AtDecember 31, 2008 , of the total nonperforming loans,$23.6 million , or 67%, related to five relationships:$10.6 million secured by a partially completed retail center;$3.5 million secured by commercial ground;$4.7 million secured by a medical office building;$2.8 million secured by a single family residence; and$1.9 million secured by a residential development. The remaining nonperforming loans consisted of 20 relationships. Eighty-four percent of the total nonperforming loans are located in theKansas City market. AtDecember 31, 2007 , of the total nonperforming loans,$7.3 million , or 57%, were related to eight residential homebuilders inSt. Louis andKansas City . The two largest related to a residential builder inKansas City totaling$2.2 million and a single-family rehab builder inKansas City totaling$1.6 million . The remaining nonperforming loans consisted of 11 relationships, nearly all of which were related to the soft residential housing markets inSt. Louis andKansas City . 43 --------------------------------------------------------------------------------
In 2012, the Company expects similar or lower levels of new Non-covered, nonperforming loans compared to 2011, thereby continuing a trend from 2010.
Other real estate Other real estate atDecember 31, 2011 was$53.7 million , an increase of$17.5 million over 2010. Approximately$36.5 million , or 68% of total Other real estate, is covered by anFDIC shared-loss agreement. AtDecember 31, 2011 , Other real estate represented 100 properties. The largest single component of Other real estate is commercial ground with a book value of$3.6 million that is covered underFDIC loss share. Thirteen properties comprise 50% of the Other real estate. AtDecember 31, 2011 , Other real estate was comprised of 14% residential lots, 6% completed homes, and 80% commercial real estate. Of the total Other real estate, approximately 44%, or 42 properties, are located in theKansas City region, 26%, or 17 properties, are located in theSt. Louis region and 30%, or 39 properties, are located in theArizona region. All Arizona Other real estate and 31 properties or$20.2 million , of the Kansas City Other real estate are covered underFDIC loss share. The following table summarizes the changes in Other real estate by quarter for 2011 and 2010. 2011 (in thousands) 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr Total Year Other real estate beginning of period $ 72,563 $ 42,790 $ 51,305 $ 36,208 $ 36,208 Additions and expenses capitalized to prepare property for sale 1,203 2,932 159 7,014 11,308 Additions fromFDIC assisted transactions 1,250 41,793 3,298 12,826 59,167 Writedowns in fair value (1,998 ) (2,714 ) (2,944 ) (703 ) (8,359 ) Sales (19,330 ) (12,238 ) (9,028 ) (4,040 ) (44,636 ) Other real estate end of period $ 53,688 $ 72,563 $ 42,790 $ 51,305 $ 53,688 2010 (in thousands) 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr Total Year Other real estate beginning of period $ 34,685 $ 25,884 $ 20,947 $ 25,084 $ 25,084 Additions and expenses capitalized to prepare property for sale 8,743 7,122 11,350 5,564 32,779 Additions fromFDIC assisted transactions 4,871 5,469 - 113 10,453 Writedowns in fair value (2,406 ) (1,750 ) (1,364 ) (574 ) (6,094 ) Sales (9,685 ) (2,040 ) (5,049 ) (9,240 ) (26,014 ) Other real estate end of period $ 36,208 $ 34,685 $ 25,884
The writedowns in fair value were recorded in Loan legal and other real estate expense based on current market activity shown in the appraisals. In 2011, the Company realized a net gain of$862,000 on the sale of other real estate and recorded these gains as part of Noninterest income. Management believes it is prudent to sell these properties, rather than wait for an improved real estate market. Potential problem loans Potential problem loans, which are not included in nonperforming loans, amounted to approximately$60.6 million , or 3.19% of total Non-covered loans outstanding atDecember 31, 2011 , compared to$85.4 million , or 4.83% of total Non-covered loans outstanding atDecember 31, 2010 . Potential problem loans represent those loans where payment of principal and interest is up-to-date and the loans are therefore, fully performing, but where some doubts exist as to the borrower's ability to continue to comply with present repayment terms. Given this level of potential problem loans and continued softness in the local real estate markets, combined with the Company's demonstrated ability to work through this adverse credit cycle to-date, we believe the dollar levels of the nonperforming assets, excluding Covered loans, will be flat in 2012 compared to 2011. 44 --------------------------------------------------------------------------------
Investments
AtDecember 31, 2011 , our portfolio of Securities available for sale was$593.2 million , or 18%, of total assets. This portfolio is primarily comprised of residential mortgage-based securities and obligations of U.S. government sponsored enterprises. The size of the investment portfolio is generally 5 to 20% of total assets and will vary within that range based on liquidity. Typically, management classifies securities as available for sale to maximize management flexibility, although securities may be purchased with the intention of holding to maturity. Securities available-for-sale are carried at fair value, with related unrealized gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. Our Other investments, at cost primarily consist of the FHLB capital stock, common stock investments related to our trust preferred securities and other private equity investments. AtDecember 31, 2011 , of the$ 9.6 million in FHLB capital stock,$3.4 million is required for FHLB membership and$4.6 million is required to support our outstanding advances. Historically, it has been the FHLB's practice to automatically repurchase activity-based stock that became excess because of a member's reduction in advances. The FHLB has the discretion, but is not required, to repurchase any shares that a member is not required to hold.
The table below sets forth the carrying value of investment securities held by the Company at the dates indicated:
December 31, 2011 2010 2009 (in thousands) Amount % Amount % Amount % Obligations ofU.S. Government agencies $ - - % $ 453 0.1 % 27,189 9.2 % Obligations ofU.S. Government sponsored enterprises 126,917 20.9 % 32,119 8.6 % 75,814 25.6 % Obligations of states and political subdivisions 39,837 6.6 % 17,676 4.7 % 3,408 1.2 % Residential mortgage-backed securities 426,428 70.1 % 311,298 83.4 % 176,050 59.5 % FHLB capital stock 9,588 1.6 % 7,633 2.0 % 8,476 2.9 % Other investments 4,938 0.8 % 4,645 1.2 % 4,713 1.6 % Total $ 607,708 100.0 % $ 373,824 100.0 % $ 295,650 100.0 %
In 2011, the portfolio grew with additions to the mortgage backed securities, including collateralized mortgage obligations, government sponsored agency debentures, and federally tax free municipal securities. All residential mortgage-backed securities were issued by government sponsored enterprises.
The Company had no securities classified as trading at
The following table summarizes expected maturity and tax equivalent yield information on the investment portfolio at
Within 1 year 1 to 5 years 5 to 10 years Over 10 years No Stated Maturity
Total
(in thousands) Amount Yield Amount Yield
Amount Yield Amount Yield Amount Yield
Amount Yield Obligations of U.S. Government sponsored enterprises 2,007 0.46 % 69,197 1.38 % 55,713 1.58 % - - % - - % 126,917 1.45 % Obligations of states and political subdivisions 1,026 4.59 % 10,644 4.07 % 23,979 4.59 % 4,188 1.84 % - - % 39,837 4.16 % Residential mortgage-backed securities 20,547 0.59 % 334,745 2.04 % 37,777 2.08 % 33,359 1.35 % - - % 426,428 1.92 % FHLB capital stock - - % - - % - - % - - % 9,588 2.30 % 9,588 2.30 % Other investments - - % - - % - - % - - % 4,938 2.98 % 4,938 2.98 % Total $ 23,580 0.75 % $ 414,586 1.98 % $
117,469 2.35 %
Yields on tax-exempt securities are computed on a taxable equivalent basis using a tax rate of 36%. Expected maturities
45 --------------------------------------------------------------------------------
will differ from contractual maturities, as borrowers may have the right to call or repay obligations with or without prepayment penalties.
Deposits
The following table shows, for the periods indicated, the average annual amount and the average rate paid by type of deposit:
For the year ended December 31, 2011 2010 2009 Weighted Weighted Weighted (in thousands) Average balance average rate Average
balance average rate Average balance average rate Interest-bearing transaction accounts $ 212,257 0.38 % $ 190,275 0.45 % $ 122,563 0.54 % Money market accounts 997,415 0.80 % 701,360 0.89 % 636,350 0.96 % Savings accounts 27,106 0.41 % 10,022 0.35 % 9,147 0.38 % Certificates of deposit 847,057 1.50 % 784,369 2.01 % 786,631 2.98 % 2,083,835 1.04 % 1,686,026 1.36 % 1,554,691 1.94 % Noninterest-bearing demand deposits 494,609 - % 305,887 - % 250,435 - % $ 2,578,444 0.84 % $ 1,991,913 1.15 % $ 1,805,126 1.67 % The Bank achieved several deposit related goals in 2011 including strong growth in core relationships, an improvement in the overall mix and a reduction in broker related funds. The year over year increase in deposits was largely comprised of noninterest-bearing demand deposits and money market and savings accounts with higher cost certificates of deposit declining during the year. Strong direct selling efforts, primarily by the commercial banking group coupled with the FNBO acquisition, drove the deposit growth. As deposit rates continued to decline, the Bank positioned its pricing strategy to favor adjustable rate transaction accounts over longer term time deposits. The result was to lower the percentage of time deposits and better position the bank for a prolonged low rate cycle. The Company also undertook an initiative to significantly reduce its reliance on broker funds. The Company offers a broad range of Treasury Management products and services that benefit businesses ranging from large national clients to the smallest local merchants. Customized solutions and special product bundles are available to clients of all sizes. Responding to ever increasing needs for tightened security and improved functional efficiency, the Company successfully migrated to a new on-line banking platform in 2011. Other recent Treasury enhancements include new mobile technology to improve on-line security and mobile applications for remote deposit and merchant credit card processing. The FNB acquisition added$423.1 million in deposits in the third quarter of 2011. These deposits included$66.9 million in noninterest-bearing demand deposits,$123.6 million in money market and other interest-bearing transaction accounts, and$232.6 million in certificates of deposit. Brokered certificates of deposits were$126.6 million atDecember 31, 2011 , a decrease of$30.1 million , or 19% compared toDecember 31, 2010 . For the year endedDecember 31, 2011 , brokered certificates of deposits represented 5% of total deposits compared to 7% for the year endedDecember 31, 2010 . Noninterest-bearing demand deposits represented 21% of total deposits atDecember 31, 2011 compared to 16% atDecember 31, 2010 . 46 -------------------------------------------------------------------------------- Maturities of certificates of deposit of$100,000 or more were as follows as ofDecember 31, 2011 : (in thousands) Total Three months or less $ 95,405 Over three through six months 62,362 Over six through twelve months 120,559 Over twelve months 272,209 Total $ 550,535
Liquidity and Capital Resources
Liquidity
The objective of liquidity management is to ensure we have the ability to generate sufficient cash or cash equivalents in a timely and cost-effective manner to meet our commitments as they become due. Typical demands on liquidity are run-off from demand deposits, maturing time deposits which are not renewed, and fundings under credit commitments to customers. Funds are available from a number of sources, such as from the core deposit base and from loans and securities repayments and maturities. Additionally, liquidity is provided from sales of the securities portfolio, fed fund lines with correspondent banks, the Federal Reserve and the FHLB, the ability to acquire large and brokered deposits and the ability to sell loan participations to other banks. These alternatives are an important part of our liquidity plan and provide flexibility and efficient execution of the asset-liability management strategy. Our Asset-Liability Management Committee oversees our liquidity position, the parameters of which are approved by the Board of Directors. Our liquidity position is monitored monthly by producing a liquidity report, which measures the amount of liquid versus non-liquid assets and liabilities. Our liquidity management framework includes measurement of several key elements, such as the loan to deposit ratio, a liquidity ratio, and a dependency ratio. The Company's liquidity framework also incorporates contingency planning to assess the nature and volatility of funding sources and to determine alternatives to these sources. While core deposits and loan and investment repayments are principal sources of liquidity, funding diversification is another key element of liquidity management and is achieved by strategically varying depositor types, terms, funding markets, and instruments. For the year endedDecember 31, 2011 , net cash provided by operating activities was$22.1 million less than for 2010. Net cash used in investing activities was$0.4 million for 2011 versus$287.9 million in 2010. The higher net cash used in investing activities in 2010 was primarily due to the asset acquisition of Home National. Net cash used in financing activities was$133.1 million in 2011 versus net cash provided by financing activities of$425.4 million in 2010. The change in cash provided by financing activities was primarily due to a decrease in certificates of deposit (net of acquired balances). Strong capital ratios, credit quality and core earnings are essential to retaining cost-effective access to the wholesale funding markets. Deterioration in any of these factors could have a negative impact on the Company's ability to access these funding sources and, as a result, these factors are monitored on an ongoing basis as part of the liquidity management process. The Bank is subject to regulations and, among other things, may be limited in its ability to pay dividends or transfer funds to the parent company. Accordingly, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available for the payment of cash dividends to the Company's shareholders or for other cash needs. Parent Company liquidity The parent company's liquidity is managed to provide the funds necessary to pay dividends to shareholders, service debt, invest in subsidiaries as necessary, and satisfy other operating requirements. The parent company had cash and cash equivalents of$21.2 million and$15.4 million , respectively, atDecember 31, 2011 and 2010. The parent company's primary funding sources to meet its liquidity requirements are dividends and payments from the Bank and proceeds from the issuance of equity. We believe our current level of cash at the parent company will be sufficient to meet all projected ongoing cash needs in 2012. 47 -------------------------------------------------------------------------------- Another source of funding for the parent company includes the issuance of subordinated debentures. As ofDecember 31, 2011 , the parent company had$82.6 million of outstanding subordinated debentures as part of nine Trust Preferred Securities Pools. These securities are classified as debt but are included in regulatory capital and the related interest expense is tax-deductible, which makes them a very attractive source of funding. See Item 8, Note 11 - Subordinated Debentures for more information. Bank liquidity The Bank has a variety of funding sources available to increase financial flexibility. In addition to amounts currently borrowed atDecember 31, 2011 , the Bank could borrow an additional$139.4 million from the FHLB ofDes Moines under blanket loan pledges and has an additional$379.6 million available from theFederal Reserve Bank under a pledged loan agreement. The Bank has unsecured federal funds lines with three correspondent banks totaling$35.0 million . Investment securities are another important tool to the Bank's liquidity objectives. As ofDecember 31, 2011 , the entire investment portfolio was available for sale. Of the$593.2 million investment portfolio available for sale,$287.8 million was pledged as collateral for depository client repurchase agreements, public deposits, treasury, tax and loan notes, and other requirements. The remaining$305.4 million could be pledged or sold to enhance liquidity, if necessary. The Bank participates in the Certificate of Deposit Account Registry Service, or CDARS, which allows us to provide our customers with access to additional levels ofFDIC insurance coverage. The CDARS program is designed to provide fullFDIC insurance on deposit amounts larger than the stated maximum by exchanging or reciprocating larger depository relationships with other member banks. Our depositors' funds are broken into smaller amounts and placed with other banks that are members of the network. Each member bank issues CDs in amounts that are eligible forFDIC insurance. CDARS are considered brokered deposits according to banking regulations; however, the Company considers the reciprocal deposits placed through the CDARS program as core funding and does not report the balances as brokered sources in its external financial reports. The Bank must remain "well-capitalized" in order to utilize the CDARS program. AtDecember 31, 2011 , the Bank had$14.5 million of reciprocal CDARS deposits outstanding compared to$160.5 million outstanding atDecember 31, 2010 . AtDecember 31, 2011 , the Bank also had$53.2 million of reciprocal money market accounts through CDARS. In addition to the reciprocal deposits available through CDARS, we also have access to the "one-way buy" program, which allows us to bid on the excess deposits of other CDARS member banks. The Company will report any outstanding "one-way buy" funds as brokered funds in its internal and external financial reports. AtDecember 31, 2011 , we had no outstanding "one-way buy" deposits.
As long as the Bank remains "well-capitalized", we have the ability to sell certificates of deposit through various national or regional brokerage firms, if needed. At
Over the normal course of business, the Bank enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Bank's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Bank has$591.6 million in unused commitments as ofDecember 31, 2011 , including$43.2 million that are covered underFDIC loss share. While this commitment level would be very difficult to fund given the Bank's current liquidity resources, the nature of these commitments is such that the likelihood of funding them is very low.
At
Capital Resources On
48 -------------------------------------------------------------------------------- offering. In the first quarter of 2010, the proceeds of the offering were injected into the Bank to further strengthen the Bank's capital position. OnMay 24, 2011 , we issued 2,743,900 shares, or$35.0 million in common stock through a public offering. The shares in the offering were issued pursuant to a prospectus supplement filed with theSecurities and Exchange Commission as part of the Company's effective registration statement. The net proceeds to the Company, after deducting underwriting discounts and commissions and offering expenses, was approximately$32.6 million . AtJune 30, 2011 , approximately$20.0 million of the offering proceeds were injected into the Bank to support expected growth. As a financial holding company, the Company is subject to "risk-based" capital adequacy guidelines established by the Federal Reserve. Risk-based capital guidelines were designed to relate regulatory capital requirements to the risk profile of the specific institution and to provide for uniform requirements among the various regulators. Currently, the risk-based capital guidelines require the Company to meet a minimum total capital ratio of 8.0% of which at least 4.0% must consist of Tier 1 capital. Tier 1 capital consists of (a) common shareholders' equity (excluding the unrealized market value adjustments on the available-for-sale securities and cash flow hedges), (b) qualifying perpetual preferred stock and related additional paid in capital subject to certain limitations specified by theFDIC , (c) qualifying trust preferred securities, subject to certain limitations specified by theFDIC , and (d) minority interests in the equity accounts of consolidated subsidiaries less (e) goodwill, (f) mortgage servicing rights within certain limits, and (g) certain other intangible assets and investments in subsidiaries. TheFDIC also requires a minimum leverage ratio of 3.0%, defined as the ratio of Tier 1 capital to average total assets for banking organizations deemed the strongest and most highly rated by banking regulators. A higher minimum leverage ratio is required of less highly rated banking organizations. Total capital, a measure of capital adequacy, includes Tier 1 capital, allowance for loan losses, and portions of subordinated debentures not eligible for Tier 1 treatment.
The Bank met the definition of "well-capitalized" (the highest category) at
The following table summarizes the Company's risk-based capital, tangible common and leverage ratios at the dates indicated:
At December
31,
(Dollars in thousands) 2011 2010
2009
Average common equity to average assets 5.84 % 5.97 % 5.93 % Tier 1 capital to risk weighted assets 12.40 % 11.73 % 10.67 % Total capital to risk weighted assets 13.78 % 14.11 % 13.32 % Tier 1 common equity to risk weighted assets 7.32 % 7.16 % 6.33 % Leverage ratio (Tier 1 capital to average assets) 8.26 % 8.99 % 8.96 % Tangible common equity to tangible assets 4.99 % 5.15 % 5.44 % Tier 1 capital $ 276,275 $ 237,099 $ 215,099 Total risk-based capital $ 306,996 $ 285,226 $ 268,458 49
-------------------------------------------------------------------------------- Below are reconciliation's of Tier 1 common equity to risk weighted assets and shareholders' equity to tangible common equity and total assets to tangible assets. These ratios are widely followed by analysts of bank and financial holding companies and management believes they are an important financial measure of capital strength even though they are considered to be non-GAAP measures. For the years ended December 31, (In thousands) 2011 2010 2009 Shareholders' equity $ 239,565 $ 179,801 $ 163,912 Less: Goodwill (30,334 ) (2,064 ) (2,064 ) Less: Intangible assets (9,285 ) (1,223 ) (1,643 ) Less: Unrealized gains; Plus: Unrealized losses (3,602 ) 573 (933 ) Plus: Qualifying trust preferred securities 79,874 59,953 55,768 Other 57 59 59 Tier 1 capital $ 276,275 $ 237,099 $ 215,099 Less: Preferred stock (33,293 ) (32,519 ) (31,802 ) Less: Qualifying trust preferred securities (79,874 ) (59,953 ) (55,768 ) Tier 1 common equity $ 163,108 $ 144,627 $ 127,529 Total risk weighted assets determined in accordance with prescribed regulatory requirements $ 2,227,958 $ 2,021,136 $ 2,015,390 Tier 1 common equity to risk weighted assets 7.32 % 7.16 % 6.33 % For the years ended December 31, (In thousands) 2011 2010 2009 Total shareholders' equity $ 239,565 $ 179,801 $ 163,912 Less: Preferred stock (33,293 ) (32,519 ) (31,802 ) Less: Goodwill (30,334 ) (2,064 ) (2,064 ) Less: Intangible assets (9,285 ) (1,223 ) (1,643 ) Tangible common equity $ 166,653 $ 143,995 $ 128,404 Total assets $ 3,377,779 $ 2,800,199 $ 2,365,655 Less: Goodwill (30,334 ) (2,064 ) (2,064 ) Less: Intangible assets (9,285 ) (1,223 ) (1,643 ) Tangible assets $ 3,338,160 $ 2,796,912 $ 2,361,948
Tangible common equity to tangible assets 4.99 % 5.15 %
5.44 % Risk Management Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. The Company faces market risk in the form of interest rate risk through transactions other than trading activities. Market risk from these activities, in the form of interest rate risk, is measured and managed through a number of methods. The Company uses financial modeling techniques to measure interest rate risk. These techniques measure the sensitivity of future earnings due to changing interest rate environments. Guidelines established by the Bank's Asset/Liability Management Committee and approved by the Bank's Board of Directors are used to monitor exposure of earnings at risk. General interest rate movements are used to develop sensitivity as the Company feels it has no primary exposure to a specific point on the yield curve. These limits are based on the Company's exposure to a 100 basis points and 200 basis points immediate and sustained parallel rate move, either upward or downward. In today's low interest rate environment, the Company also monitors its exposure to immediate and sustained parallel rate increases of 300 basis points and 400 basis points. 50 -------------------------------------------------------------------------------- Interest Rate Risk Our interest rate sensitivity management seeks to avoid fluctuating interest margins to provide for consistent growth of net interest income through periods of changing interest rates. Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. We attempt to maintain interest-earning assets, comprised primarily of both loans and investments, and interest-bearing liabilities, comprised primarily of deposits, maturing or repricing in similar time horizons in order to minimize or eliminate any impact from market interest rate changes. In order to measure earnings sensitivity to changing rates, the Company uses a static GAP analysis and earnings simulation model.
The static GAP analysis starts with contractual repricing information for assets, liabilities, and off-balance sheet instruments. These items are then combined with repricing estimations for administered rate (interest-bearing demand deposits, savings, and money market accounts) and non-rate related products (demand deposit accounts, other assets, and other liabilities) to create a baseline repricing balance sheet. In addition, mortgage-backed securities are adjusted based on industry estimates of prepayment speeds.
The following table represents the estimated interest rate sensitivity and periodic and cumulative GAP positions calculated as ofDecember 31, 2011 . Significant assumptions used for this table include: loans will repay their contractual repayment schedule; interest-bearing demand accounts and savings accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table. Beyond 5 years or no stated (in thousands) Year 1 Year 2 Year 3 Year 4 Year 5 maturity Total Interest-Earning Assets Securities available for sale $ 196,023 $ 74,568 $ 58,823 $
35,722
- - - - - 14,527 14,527 Interest-bearing deposits 168,711 - - - - - 168,711 Federal funds sold 143 - - - - - 143 Portfolio loans (1) 1,474,205 410,770 164,660 72,723 48,288 27,038 2,197,684 Loans held for sale 6,494 - - - - - 6,494 Total interest-earning assets $ 1,845,576 $ 485,338 $ 223,483 $ 108,445 $ 142,519 $ 175,380 $ 2,980,741 Interest-Bearing Liabilities Savings, NOW and Money market deposits $ 1,388,953 $ - $ - $ - $ - $ - $ 1,388,953 Certificates of deposit 430,223 173,680 46,563 97,748 68,647 60 816,921 Subordinated debentures 56,807 28,274 - - - - 85,081 Other borrowings 176,545 - - 10,000 - 70,000 256,545 Total interest-bearing liabilities $ 2,052,528 $ 201,954 $ 46,563 $
107,748
Interest-sensitivity GAP GAP by period $ (206,952 ) $ 283,384 $ 176,920 $ 697 $ 73,872 $ 105,320 $ 433,241 Cumulative GAP $ (206,952 ) $ 76,432 $ 253,352 $ 254,049 $ 327,921 $ 433,241 $ 433,241 Ratio of interest-earning assets to interest-bearing liabilities Periodic 0.90 2.40 4.80 1.01 2.08 2.50 1.17 Cumulative GAP as of December 31, 2011 0.90 1.03 1.11 1.11 1.13 1.17 1.17
(1) Adjusted for the impact of the interest rate swaps.
51 -------------------------------------------------------------------------------- AtDecember 31, 2011 , the Company was asset sensitive for all periods, except Year 1, based on repricing characteristics. Asset sensitive means that assets will reprice faster than liabilities. Along with the static GAP analysis, the Company determines the sensitivity of its short-term future earnings to a hypothetical plus or minus 100 and 200 basis point parallel rate shock through the use of simulation modeling. In addition to the assumptions used to create the static GAP, simulation of earnings includes the modeling of the balance sheet as an ongoing entity. Future business assumptions involving administered rate products, prepayments for future rate-sensitive balances, and the reinvestment of maturing assets and liabilities are included. These items are then modeled to project net interest income based on a hypothetical change in interest rates. The resulting net interest income for the next 12-month period is compared to the net interest income amount calculated using flat rates. This difference represents the Company's earnings sensitivity to a plus or minus 100 basis points parallel rate shock. The resulting simulations forDecember 31, 2011 demonstrated that the Company's balance sheet was relatively neutral to interest rate changes. The simulations projected that the annual net interest income of the Bank would increase by approximately 0.01% if rates increased by 100 basis points under a parallel rate shock and 1.3% if rates increased 300 basis points. The increase in interest income from short term assets would be offset by higher rates on deposits and re-issuance of maturing debt. The simulations also indicate that net interest income would increase during the second year by 1.3% under a 100 basis point parallel rate shock and 6.6% under a 300 basis point rate shock. The Company also performs rate shock simulations for declining interest rates, however, given the very low level of short term interest rates, the falling interest rate shock simulations are considered irrelevant. The Company occasionally uses interest rate derivative financial instruments as an asset/liability management tool to hedge mismatches in interest rate exposure indicated by the net interest income simulation described above. They are used to modify the Company's exposures to interest rate fluctuations and provide more stable spreads between loan yields and the rate on their funding sources. AtDecember 31, 2011 , the Company had$65.1 million and$80.1 million in notional amount of outstanding interest rate swaps and caps, respectively, to help manage interest rate risk. Derivative financial instruments are also discussed in Item 8, Note 7 - Derivative Financial Instruments. Contractual Obligations, Off-Balance Sheet Risk, and Contingent Liabilities Through the normal course of operations, the Company has entered into certain contractual obligations and other commitments. Such obligations relate to funding of operations through deposits or debt issuances, as well as leases for premises and equipment. As a financial services provider, the Company routinely enters into commitments to extend credit. While contractual obligations represent future cash requirements of the Company, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans made by the Company.
The required contractual obligations and other commitments, excluding any contractual interest(1), at
Over 1 Year Less Less Than than (in thousands) Total 1 Year 5 Years Over 5 Years Operating leases $ 20,705 $ 2,419 $ 8,436 $ 9,850 Certificates of deposit 816,921 431,361 385,500 60 Subordinated debentures 85,081 - - 85,081 Federal Home Loan Bank advances 102,000 22,000 10,000 70,000 Commitments to extend credit 547,657 413,063 112,989 21,605 Standby letters of credit 43,973 43,973 - - Private equity funds 1,823 - 1,823 -
(1) In the banking industry, interest-bearing obligations are principally utilized to fund interest-earning assets. As such, interest charges on related contractual obligations were excluded from reported amounts as the potential
52 --------------------------------------------------------------------------------
cash outflows would have corresponding cash inflows from interest-earning assets.
As ofDecember 31, 2011 , we had liabilities associated with uncertain tax positions of$1.1 million . The table above does not include these liabilities due to the high degree of uncertainty regarding the future cash flows associated with these amounts. The Company also enters into derivative contracts under which the Company either receives cash from or pays cash to counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of these contracts changes daily as market interest rates change. Derivative liabilities are not included as contractual cash obligations as their fair value does not represent the amounts that may ultimately be paid under these contracts.
As discussed in Item 8, Note 14 - Litigation and Other Claims and Item 3 - Legal Proceedings, the Company faces risks of litigation. See Note 14 for a description of such litigation and the possible effects on our business.
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered most critical to the understanding of the Company's financial condition and results of operations. These critical accounting policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to our critical accounting policies on our business operations are discussed throughout "Management's Discussion and Analysis of Financial Condition and Results of Operations," where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Item 8, Note 1 - Significant Accounting Policies. The Company has prepared all of the consolidated financial information in this report in accordance with U.S. GAAP. The Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Such estimates include the valuation of loans, goodwill, intangible assets, and other long-lived assets, along with assumptions used in the calculation of income taxes, among others. These estimates and assumptions are based on management's best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Decreased real estate values, volatile credit markets, and persistent high unemployment have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statement in future periods. There can be no assurances that actual results will not differ from those estimates. Allowance for Loan Losses The Company maintains an allowance for loan losses ("the allowance"), which is intended to be management's best estimate of probable inherent losses in the outstanding loan portfolio. The allowance is based on management's continuing review and evaluation of the loan portfolio. The review and evaluation combines several factors including: consideration of past loan loss experience; trends in past due and nonperforming loans; risk characteristics of the various classifications of loans; existing economic conditions; the fair value of underlying collateral; and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. These agencies may require that certain loan 53 -------------------------------------------------------------------------------- balances be charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. The Company believes the allowance for loan losses is adequate and properly recorded in the consolidated financial statements. See Provision for Loan Losses above for more information. Acquisitions and Divestitures Acquired assets and liabilities are recorded at their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets. The purchase price allocation process requires an analysis of the fair values of the assets acquired and the liabilities assumed. When a business combination agreement provides for an adjustment to the cost of the combination contingent on future events, the Company includes that adjustment in the cost of the combination when the contingent consideration is determinable beyond a reasonable doubt and can be reliably estimated. The results of operations of the acquired business are included in the Company's consolidated financial statements from the respective date of acquisition. As a general rule, goodwill established in connection with a stock purchase is nondeductible for tax purposes. Assets classified as held for sale are reported at the lower of its carrying value at the date the assets are initially classified as held for sale or their fair value less costs to sell. The results of operations of a component that either has been disposed of or held for sale is reported as discontinued operation if: • the operations and cash flows of the disposal group will be eliminated from the ongoing operations as a result of the disposal transaction; and • the Company will not have any significant continuing involvement in the
operations of the entity after the disposal transaction.
Any incremental direct costs incurred to transact the sale are allocated against the gain or loss on the sale. These costs would include items like legal fees, title transfer fees, broker fees, etc. Any goodwill associated with the portion of the reporting unit that constitutes a business to be disposed of is included in the carrying amount of the business in determining the gain or loss on the sale. Also, any intangible assets or write down to fair value associated with the entity to be disposed of is also included in the carrying amount of the business in determining the gain or loss on the sale. The gain or loss on the sale is classified in the consolidated statements of income as noninterest income. Loans Acquired Through Transfer Loans acquired through the completion of a transfer, including loans acquired in a business combination that have evidence of deterioration of credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments receivable are initially recorded at fair value (as determined by the present value of expected future cash flows) with no valuation allowance. The difference between the undiscounted cash flows expected at acquisition and the investment in the loans, or the "accretable yield," is recognized as interest income on a level-yield method over the life of the loans. Contractually required payments for interest and principal that exceed the undiscounted cash flows expected at acquisition, or the "nonaccretable difference," are not recognized as a yield adjustment or as a loss accrual or a valuation allowance. The Company aggregates individual loans with common risk characteristics into pools of loans. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through adjustment of the yield on the loans over their remaining lives. Decreases in expected cash flows due to an inability to collect contractual cash flows are recognized as impairment through the provision for loan losses account. Any allowance for loan loss on these pools reflect only losses incurred after the acquisition (meaning the present value of all cash flows expected at acquisition that ultimately are not to be received). Any disposals of loans, including sales of loans, payments in full or foreclosures result in the removal of the loan from the loan pool at the carrying amount with differences in actual results reflected in interest income. Acquired impaired loans are generally considered accruing and performing as the loans accrete income over the estimated life of the loan when cash flows are reasonably estimable. Accordingly, acquired impaired loans that are contractually past due are still considered to be accruing and performing. If the timing and amount of future cash flows is not reasonably estimable, the loans may be classified as nonaccrual loans and the purchase price discount on those loans is not recorded as interest income until the timing and amount of future cash flows can be reasonably 54 --------------------------------------------------------------------------------
estimable.
Allowance for Loan Losses on Credit-Impaired Acquired LoansThe Company updates its cash flow projections for credit-impaired acquired loans, including loans acquired from theFDIC , on a quarterly basis. Assumptions utilized in this process include projections related to probability of default, loss severity, prepayment and recovery lag. Projections related to probability of default and prepayment are calculated utilizing a loan migration analysis. The loan migration analysis is a matrix of probability that specifies the probability of a loan pool transitioning into a particular delinquency state given its delinquency state at the re-measurement date. Loss severity factors are based upon industry data along with actual charge-off data within the loan pools and recovery lags are based upon the collateral within the loan pools. Any decreases in expected cash flows after the acquisition date and subsequent measurement periods are recognized by recording an impairment in the provision for loan losses. As a result of impairment, theFDIC loss share receivable is increased to reflect future cash to be received from theFDIC . The amount of the increase is recorded in noninterest income and is determined based on the specific loss share agreement, but is generally 80% of the losses. See Loans Acquired Through Transfer above for further discussion. Any increase in expected future cash flows due to a decrease in expected credit losses will decrease the accretion of theFDIC loss share receivable, prospectively over the remaining life. Increases and decreases to theFDIC loss share receivable are recorded as adjustments to noninterest income. Goodwill and Other Intangible Assets Our goodwill impairment test is completed as ofDecember 31 each year or whenever events or changes in circumstances indicate that the Company may not be able to recover the goodwill, or intangible assets, respective carrying amount. Such tests involve the use of various estimates and assumptions. Management believes that the estimates and assumptions utilized are reasonable. However, the Company may incur impairment charges related to goodwill or intangible assets in the future due to changes in business prospects or other matters that could affect our estimates and assumptions. Goodwill is tested for impairment at the reporting unit level. Reporting units are defined as the same level as, or one level below, an operating segment. An operating segment is a component of a business for which separate financial information is available that management regularly evaluates in deciding how to allocate resources and assess performance. The Company's reporting units are Wealth Management and the Banking operations ofEnterprise Bank & Trust . AtDecember 31, 2011 and 2010, the Wealth Management reporting unit had no goodwill. Businesses must identify potential impairments by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Goodwill impairment does not occur as long as the fair value of the unit is greater than its carrying value. The second step of the impairment test is only required if a goodwill impairment is identified in step one. The second step of the test compares the implied fair market value of goodwill to its carrying amount. If the carrying amount of goodwill exceeds its implied fair market value, an impairment loss is recognized. That loss is equal to the carrying amount of goodwill that is in excess of its implied fair market value. Intangible assets other than goodwill, such as core deposit intangibles, that are determined to have finite lives are amortized over their estimated remaining useful lives. These assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. There are three general approaches commonly used in business valuation: income approach, asset-based approach, and market approach. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Professional judgment is required to determine which valuation methods are the most appropriate. The valuation may utilize one or more of the approaches. Generally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business (discounted cash flow); the asset-based approaches determine value by adding the sum of the parts of 55 -------------------------------------------------------------------------------- the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region. Banking reporting unit Based on the process described above, the Company recorded a$45.4 million , pre-tax goodwill impairment charge as ofMarch 31, 2009 thus eliminating all goodwill in the Banking segment at that time. In conjunction with the 2009 and 2011FDIC -assisted transaction, we recorded$2.1 million and$28.3 million of goodwill, respectively, based on the fair value of the assets purchased and liabilities assumed. The 2011 annual impairment evaluation of the goodwill and intangible balances did not identify any impairment for the Banking reporting unit. State Tax Credits Held for SaleThe Company purchases the rights to receive 10-year streams of state tax credits at agreed upon discount rates and sells such tax credits to Wealth Management clients and others. All state tax credits purchased prior to 2009 are accounted for at fair value. All state tax credits purchased since 2009 are accounted for at cost. The Company elected not to account for the state tax credits since 2009 at fair value in order to limit the volatility of the fair value changes in our consolidated statements of operations. The Company is not aware of an active financial market for the 10-year streams of state tax credit financial instruments. However, the Company's principal market for these tax credits consists ofMissouri state residents who buy them to reduce their state tax exposure and local and regional accounting firms who broker them. The state tax credits purchased by the Company are held until they are "usable" and then are sold to our clients for a profit. The Company utilizes a discounted cash flow analysis (income approach) to determine the fair value of the state tax credits purchased prior to 2009. The fair value measurement is calculated using an internal valuation model. The inputs to the fair value calculation include: the amount of tax credits generated each year, the anticipated sale price of the tax credit, the timing of the sale and a discount rate. The discount rate is defined as theLIBOR swap curve at a point equal to the remaining life in years of credits plus a risk premium spread. With the exception of the discount rate, the other inputs to the fair value calculation are observable and readily available. The discount rate is an "unobservable input" and is based on the Company's assumptions. As a result, fair value measurement for these instruments falls within Level 3 of the fair value hierarchy. AtDecember 31, 2011 , the discount rates utilized in our state tax credits fair value calculation ranged from 2.63% to 4.08%. Changes in the fair value of the state tax credits held for sale decreased the State tax credit activity, net in the consolidated statement of operations for the year endedDecember 31, 2011 by$1.2 million . A rate simulation with a 100 basis point parallel rate shock to the discount rate was run forDecember 31, 2011 . The resulting simulation indicates that if theLIBOR swap curve were to increase by 100 basis points, the fair value of the state tax credits held at fair value would be lower by approximately$699,000 . We would expect a portion of this decline would be offset by a change in the value of derivative financial instruments used to economically hedge the state tax credits. These Level 3 fair value measurements are based primarily upon our own estimates and are calculated based on the current economic and regulatory environment, interest rate risks and other factors. Therefore, the results cannot be determined with precision, cannot be substantiated by comparison to quoted prices in active markets, and may not be realized in a current sale or immediate settlement of the asset or liability. Additionally, there are inherent uncertainties in any fair value measurement technique, and changes in the underlying assumptions used, including the discount rate and estimate of future cash flows, could significantly affect the fair value measurement amounts. Derivative Financial Instruments The Company uses derivative financial instruments to assist in managing interest rate sensitivity. The derivative financial instruments used are interest rate swaps and caps. Derivative financial instruments are required to be measured at fair value and recognized as either assets or liabilities in the consolidated financial statements. Fair value represents the payment the Company would receive or pay if the item were sold or bought in a current transaction. As ofDecember 31, 2011 , the Company used nondesignated derivative financial instruments to economically hedge changes 56 -------------------------------------------------------------------------------- in the fair value of state tax credits held for sale and changes in the fair value of certain loans accounted for as trading instruments. In addition, the Company also offers an interest-rate hedge program that includes interest rate swaps to assist its customers in managing their interest-rate risk profile. In order to eliminate the interest-rate risk associated with offering these products, the Company enters into derivative contracts with third parties to offset the customer contracts. These customer accommodation interest rate swap contracts are not designated as hedging instruments.
•
fair value. The effective portion of the change in fair value is recorded
(net of taxes) as a component of other comprehensive income ("OCI") in
shareholders' equity. Amounts recorded in OCI are subsequently reclassified
into interest income or expense (depending on whether the hedged item is an
asset or liability) when the underlying transaction affects earnings. The
ineffective portion of the change in fair value is recorded in noninterest
income. Upon dedesignation of a derivative financial instrument from a cash
flow hedge relationship, any remaining amounts in OCI are recorded in
noninterest income over the expected remaining life of the underlying
forecasted hedge transaction. The net interest differential between the
hedged item and the hedging derivative financial instrument are recorded as
an adjustment to interest income or interest expense of the related asset or
liability.
• Fair Value Hedges - For derivatives designated as fair value hedges, the
change in fair value of the derivative instrument and related hedged item are
recorded in the related interest income or expense, as applicable, except for
the ineffective portion, which is recorded in noninterest income in the
consolidated statements of income. The swap agreement is accounted for on an
accrual basis with the net interest differential being recognized as an
adjustment to interest income or interest expense of the related asset or
liability.
• Non-Designated Hedges - Certain derivative financial instruments are not
designated as cash flow or as fair value hedges for accounting purposes.
These non-designated derivatives are entered into to provide interest rate
protection on net interest income or noninterest income but do not meet hedge
accounting treatment. Changes in the fair value of these instruments are
recorded in interest income or noninterest income in the consolidated statements of operations depending on the underlying hedged item. The judgments and assumptions most critical to the application of this accounting policy are those affecting the estimation of fair value and hedge effectiveness. Changes in assumptions and conditions could result in greater than expected inefficiencies that, if large enough, could reduce or eliminate the economic benefits anticipated when the hedges were established and/or invalidate continuation of hedge accounting. Greater inefficiency and discontinuation of hedge accounting can result in increased volatility in reported earnings. For cash flow hedges, this would result in more or all of the change in the fair value of the related derivative financial instruments being reported in income. InDecember 2008 , the Company discontinued hedge accounting on two prime based loan hedge relationships as a result of the significant decrease in the prime rate. As a result of the dedesignation, the changes in the fair value of the related derivative financial instruments are being reported in income without a corresponding and offsetting change in the fair value for the loans previously hedged. Deferred Tax Assets and Liabilities The Company accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are reduced if necessary, by a deferred tax asset valuation allowance. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, we would adjust the recorded value of our deferred tax assets, which would result in a direct charge to income tax expense in the period that the determination is made. Likewise, we would reverse the valuation allowance when realization of the deferred tax asset is expected. Effects of New Accounting Pronouncements See Item 8, Note 23 - New Authoritative Accounting Guidance for information on recent accounting pronouncements and their impact, if any, on our consolidated financial statements. 57
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