UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2009

 

Commission file number 0-13203

LNB Bancorp, Inc.

(Exact name of the registrant as specified in its charter)

 

 

(440) 244-6000

(Registrant’s telephone number, including area code)

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

 

Securities Registered Pursuant to Section 12(g) of the Act:

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the common shares held by non-affiliates of the registrant at June 30, 2009 was approximately $39,668,482.

 

The number of common shares of the registrant outstanding on March 1, 2010 was 7,363,161.

 

TABLE OF CONTENTS

 

 

 

Overview

 

LNB Bancorp, Inc. (the “Corporation”) is a diversified banking services company headquartered in Lorain, Ohio. It is organized as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). Its predecessor, The Lorain Banking Company was a state chartered bank founded in 1905. It merged with the National Bank of Lorain in 1961, and in 1984 became a wholly-owned subsidiary of LNB Bancorp, Inc.

 

The Corporation engages in lending and depository services, investment and brokerage services, and other traditional banking services. These services are generally offered through the Corporation’s wholly-owned subsidiary, The Lorain National Bank (the “Bank”). The Bank, through an agreement with a registered third-party broker-dealer, Investment Centers of America, Inc., offers mutual funds, variable annuity investments, variable annuity and life insurance products, along with investments in stocks and bonds. Investment Centers of America, Inc. is a member of the Financial Industry Regulatory Authority and the Securities Investor Protection Corporation.

 

The primary business of the Bank is providing personal, mortgage and commercial banking products, along with investment management and trust services. The Lorain National Bank operates through 20 retail-banking locations and 27 automated teller machines (“ATM’s”) in Lorain, Erie, Cuyahoga and Summit counties in the Ohio communities of Lorain, Elyria, Amherst, Avon, Avon Lake, LaGrange, North Ridgeville, Oberlin, Olmsted Township, Vermilion, Westlake and Hudson, as well as a business development office in Cuyahoga County.

 

Services

 

Commercial Lending.  The Bank’s commercial lending activities consist of commercial and industrial loans, commercial real estate loans, construction and equipment loans, letters of credit, revolving lines of credit, Small Business Administration loans and government guaranteed loans. The Bank’s wholly-owned subsidiary, North Coast Community Development Corporation, offers commercial loans with preferred interest rates on projects that meet the standards for the federal government’s New Markets Tax Credit Program.

 

Residential, Installment and Personal Lending.  The Bank’s residential mortgage lending activities consist of loans originated for portfolio or to be sold in the secondary markets, for the purchase of personal residences. The Bank’s installment lending activities consist of traditional forms of financing for automobile and personal loans, indirect automobile loans, second mortgages, and home equity lines of credit. The Bank provides indirect lending services to new and used automobile dealerships throughout Ohio, Kentucky, Indiana, Tennessee and Georgia. This program allows the Bank to generate high quality short term assets to place in its own portfolio or to sell to several investor banks

 

Deposit Services.  The Bank’s deposit services include traditional transaction and time deposit accounts as well as cash management services for corporate and municipal customers. The Bank may supplement local deposit generation with time deposits generated through a broker relationship. Deposits of the Bank are insured by the Bank Insurance Fund administered by the Federal Deposit Insurance Corporation (the “FDIC”).

 

Other Services.  Other bank services offered include safe deposit boxes, night depository, U.S. savings bonds, travelers’ checks, money orders, cashiers checks, ATM’s, debit cards, wire transfer, electronic funds transfers, foreign drafts, foreign currency, electronic banking by phone or through the internet, lockbox and other services tailored for both individuals and businesses.

 

Competition and Market Information

 

The Corporation competes primarily with 17 other financial institutions with operations in Lorain County, Ohio, which have Lorain County-based deposits ranging in size from approximately $454,000 to over $793 million. These competitors, as well as credit unions and financial intermediaries, compete for Lorain County deposits of approximately of $3.8 billion.

The Bank’s market share of total deposits in Lorain County was 23.64% in 2009 and 21.22% in 2008, and the Bank ranked number one in market share in Lorain County in 2009 and number two in 2008.

 

The Corporation’s Morgan Bank division operates from one location in Hudson, Ohio. The Morgan Bank division competes primarily with nine other financial institutions for $566 million in deposits in the City of Hudson, and holds a market share of 22.12%.

 

The Bank has a limited presence in Cuyahoga County, competing primarily with 26 other financial institutions. Cuyahoga County deposits as of June 30, 2009 totaled $53.7 billion. The Bank’s market share of deposits in Cuyahoga County was 0.4% in 2009 and 0.04% in 2008 based on the FDIC Summary of Deposits for specific market areas dated June 30, 2009.

 

Business Strategy

 

The Bank competes with larger financial institutions by providing exceptional local service that emphasizes direct customer access to the Bank’s officers. It competes against smaller local banks by providing more convenient distribution channels and a wider array of products. The Bank endeavors to provide informed and courteous personal services. The Corporation’s management team (“Management”) believes that the Bank is well positioned to compete successfully in its market area. Competition among financial institutions is based largely upon interest rates offered on deposit accounts, interest rates charged on loans, the relative level of service charges, the quality and scope of the services rendered, the convenience of the banking centers and, in the case of loans to commercial borrowers, relative lending limits. Management believes that the commitment of the Bank to provide quality personal service and its local community involvement give the Bank a competitive advantage over other financial institutions operating in its markets.

 

Supervision and Regulation

 

The Corporation is subject to the supervision and examination of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The BHC Act requires prior approval of the Federal Reserve Board before acquiring or holding more than a 5% voting interest in any bank. It also restricts interstate banking activities.

 

The Bank is subject to extensive regulation, supervision and examination by applicable federal banking agencies, including the Office of the Comptroller of the Currency (the “OCC”) and the Federal Reserve Board. Because domestic deposits in the Bank are insured (up to applicable limits) and certain deposits of the Bank and debt obligations of the Bank are temporarily guaranteed (up to applicable limits) by the FDIC, the FDIC also has certain regulatory and supervisory authority over the Bank under the Federal Deposit Insurance Act (the “FDIA”).

 

Regulatory Capital Standards and Related Matters

 

Bank holding companies are required to comply with the Federal Reserve Board’s risk-based capital guidelines. The FDIC and the OCC have adopted risk-based capital ratio guidelines to which depository institutions under their respective supervision, such as the Bank, are subject. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk-weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. The Corporation and the Bank met all risk-based capital requirements of the Federal Reserve Board, FDIC and OCC as of December 31, 2009.

 

Both federal and state law extensively regulate various aspects of the banking business, such as reserve requirements, truth-in-lending and truth-in-savings disclosures, equal credit opportunity, fair credit reporting, trading in securities and other aspects of banking operations.

 

The Corporation and the Bank are subject to the Federal Reserve Act, which restricts financial transactions between banks and affiliated companies. The statute limits credit transactions between banks, affiliated companies and its executive officers and its affiliates. The statute prescribes terms and conditions for bank affiliate transactions deemed to be consistent with safe and sound banking practices, and restricts the types of collateral security permitted in connection with a bank’s extension of credit to an affiliate. Additionally, all transactions with an

affiliate must be on terms substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated parties.

 

EESA and ARRA

 

In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. EESA authorized the U.S. Department of the Treasury (the “U.S. Treasury”) to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The U.S. Treasury allocated $350 billion towards the TARP Capital Purchase Program (the “CPP”). Under the CPP, the U.S. Treasury purchased equity securities from participating institutions. Participants in the CPP, such as the Corporation, are subject to employee compensation limitations and are encouraged to expand their lending and mortgage loan modifications. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. Among other things, ARRA, and the related interim final rule promulgated by the U.S. Treasury, imposed certain new employee compensation and corporate expenditure limits on all CPP participants, including the Corporation, until the institution has repaid the U.S. Treasury. For details regarding the Corporation’s participation in the CPP, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Federal Deposit Insurance Act

 

Deposit Insurance Coverage Limits.  Prior to enactment of EESA, the FDIC standard maximum depositor insurance coverage limit was $100,000, excluding certain retirement accounts qualifying for a maximum coverage limit of $250,000. Pursuant to EESA, the FDIC standard maximum coverage limit was temporarily increased to $250,000. This temporary standard maximum coverage limit increase will expire on December 31, 2013.

 

Deposit Insurance Assessments.  Substantially all of the Bank’s domestic deposits are insured up to applicable limits by the FDIC. Accordingly, the Bank is subject to deposit insurance premium assessments by the FDIC.

 

FICO Assessments.  Since 1997, all FDIC-insured depository institutions have been required through assessments collected by the FDIC to service the annual interest on 30-year noncallable bonds issued by the Financing Corporation (“FICO”) in the late 1980s to fund losses incurred by the former Federal Savings and Loan Insurance Corporation. FICO assessments are separate from and in addition to deposit insurance assessments, are adjusted quarterly and, unlike deposit insurance assessments, are assessed uniformly without regard to an institution’s risk category.

 

Conservatorship and Receivership of Institutions.  If any insured depository institution becomes insolvent and the FDIC is appointed its conservator or receiver, the FDIC may, under federal law, disaffirm or repudiate any contract to which such institution is a party, if the FDIC determines that performance of the contract would be burdensome, and that disaffirmance or repudiation of the contract would promote the orderly administration of the institution’s affairs. Such disaffirmance or repudiation would result in a claim by its holder against the receivership or conservatorship. The amount paid upon such claim would depend upon, among other factors, the amount of receivership assets available for the payment of such claim and its priority relative to the priority of others. In addition, the FDIC as conservator or receiver may enforce most contracts entered into by the institution notwithstanding any provision providing for termination, default, acceleration, or exercise of rights upon or solely by reason of insolvency of the institution, appointment of a conservator or receiver for the institution, or exercise of rights or powers by a conservator or receiver for the institution. The FDIC as conservator or receiver also may transfer any asset or liability of the institution without obtaining any approval or consent of the institution’s shareholders or creditors.

 

Depositor Preference.  The FDIA provides that, in the event of the liquidation or other resolution of an insured depository institution, the claims of its depositors (including claims by the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC as receiver would be afforded a priority over other general unsecured claims against such an institution. If an insured depository institution fails, insured and uninsured depositors along with the FDIC will be placed ahead of unsecured, nondeposit creditors, including a parent holding company and subordinated creditors, in order of priority of payment.

Prompt Corrective Action.  The “prompt corrective action” provisions of the FDIA create a statutory framework that applies a system of both discretionary and mandatory supervisory actions indexed to the capital level of FDIC-insured depository institutions. These provisions impose progressively more restrictive constraints on operations, management, and capital distributions of the institution as its regulatory capital decreases, or in some cases, based on supervisory information other than the institution’s capital level. This framework and the authority it confers on the federal banking agencies supplement other existing authority vested in such agencies to initiate supervisory actions to address capital deficiencies. Moreover, other provisions of law and regulation employ regulatory capital level designations the same as or similar to those established by the prompt corrective action provisions both in imposing certain restrictions and limitations and in conferring certain economic and other benefits upon institutions. These include restrictions on brokered deposits, limits on exposure to interbank liabilities, determination of risk-based FDIC deposit insurance premium assessments, and action upon regulatory applications.

 

USA PATRIOT Act

 

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”) and the federal regulations issued pursuant to it substantially broaden previously existing anti-money laundering law and regulation, increase compliance, due diligence and reporting obligations for financial institutions, create new crimes and penalties, and require the federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties in combating money laundering activities.

 

Employees

 

As of December 31, 2009, the Corporation employed 272 full-time equivalent employees. The Corporation is not a party to any collective bargaining agreement. Management considers its relationship with its employees to be good. Employee benefits programs are considered by the Corporation to be competitive with benefits programs provided by other financial institutions and major employers within the current market area.

 

Industry Segments

 

The Corporation and the Bank are engaged in one line of business, which is banking services.

 

Available Information

 

LNB Bancorp, Inc.’s internet website is www.4LNB.com. Copies of the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are made available through this website or directly through the Securities and Exchange Commission (the “SEC”) website which is www.sec.gov.

 

Forward-Looking Statements

 

This Form 10-K contains forward-looking statements within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Terms such as “will,” “should,” “plan,” “intend,” “expect,” “continue,” “believe,” “anticipate” and “seek,” as well as similar comments, are forward-looking in nature. Actual results and events may differ materially from those expressed or anticipated as a result of risks and uncertainties which include but are not limited to:

 

 

 

 

As a competitor in the banking and financial services industries, the Corporation and its business, operations and financial condition are subject to various risks and uncertainties. You should carefully consider the risks and uncertainties described below, together with all of the other information in this annual report on Form 10-K and in the Corporation’s other filings with the SEC, before making any investment decision with respect to the Corporation’s securities. In particular, you should consider the discussion contained in Item 7 of this annual report on Form 10-K, which contains Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The risks and uncertainties described below may not be the only ones the Corporation faces. Additional risks and uncertainties not presently known by the Corporation or that the Corporation currently deems immaterial may also affect the Corporation’s business. If any of these known or unknown risks or uncertainties actually occur or develop, the Corporation’s business, financial condition, results of operations and future growth prospects could change. Under those circumstances, the trading prices of the Corporation’s securities could decline, and you could lose all or part of your investment.

 

Current market developments may adversely affect the Corporation’s industry, business and results of operations.

 

Dramatic declines in the housing market during prior years, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers including other financial institutions. The resulting lack of available credit, lack of confidence in the financial sector, increased volatility in the financial markets and reduced business activity could materially and adversely affect the Corporation’s business, financial condition and results of operations.

 

Recent developments in the financial services industry and the U.S. and global capital markets may adversely impact the Corporation’s operations and results.

 

Developments in the last two years in the capital markets have resulted in uncertainty in the financial markets in general, with the expectation of the general economic downturn continuing in the first quarter of 2010 and beyond. Loan portfolio performance has deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of collateral. The competition for the Corporation’s deposits has increased significantly due to liquidity concerns at many of these same institutions. Stock prices of bank holding companies, like the Corporation’s, have been negatively affected by the current conditions of the financial markets, as has the Corporation’s ability, if needed, to raise capital or borrow in the debt markets, compared to prior years. As a result, there is a potential for new federal or state laws and regulations regarding lending and funding practices and capital and liquidity standards, and financial institution regulatory agencies are expected to be very aggressive in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement actions. Developments in the financial services industry and the impact of any new legislations in response to those developments could negatively impact the Corporation by restricting the Corporation’s business operations, including the Corporation’s ability to originate or sell loans, and adversely impact the Corporation’s financial performance.

 

It is unclear what impact EESA, ARRA, and other initiatives undertaken by the United States government to restore liquidity and stability to the U.S. financial system have had and there can be no assurance that they will continue to help stabilize the U.S. financial system.

 

EESA was enacted in response to the ongoing financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. It is unclear at this time what impact that EESA or ARRA, or programs and other initiatives undertaken by the U.S. government have had on the financial markets and there can be no assurance that these measures will continue to help stabilize the U.S. financial system; the high levels of volatility and limited credit availability currently being experienced may persist. The failure of EESA or other government programs to continue to help stabilize the financial markets and a continuation or worsening of current financial market conditions could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

Current levels of market volatility may have a material adverse effect on the Corporation.

 

The capital and credit markets have been experiencing volatility and disruption for more than 24 months. If current levels of market disruption and volatility continue or worsen, there can be no assurance that the Corporation will not experience an adverse effect, which may be material, on the Corporation’s ability to access capital and on the Corporation’s business, financial condition and results of operations.

 

The soundness of other financial institutions could adversely affect the Corporation.

 

The Corporation’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Corporation has exposure to many different industries and counterparties, and it routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Corporation or by other institutions. Many of these transactions expose the Corporation to credit risk in the event of default of the Corporation’s counterparty or client. In addition, the Corporation’s credit risk may be exacerbated when the collateral held by it cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due the Corporation. There is no assurance that any such losses would not materially and adversely affect the Corporation’s results of operations.

 

Certain industries, including the financial services industry, are disproportionately affected by certain economic indicators such as unemployment and real estate asset values. Should the improvement of these economic indicators lag the improvement of the overall economy, the Corporation could be adversely affected.

 

Should the stabilization of the U.S. economy lead to a general economic recovery, the improvement of certain economic indicators, such as unemployment and real estate asset values and rents, may nevertheless continue to lag behind the overall economy. These economic indicators typically affect certain industries, such as real estate and financial services, more significantly. Furthermore, financial services companies with a substantial lending business are dependent upon the ability of their borrowers to make debt service payments on loans. Should unemployment or real estate asset values fail to recover for an extended period of time, the Corporation’s results of operations could be negatively affected.

 

Strong competition may reduce the Corporation’s ability to generate loans and deposits in its market.

 

The Corporation competes in a consolidating industry. Increasingly, the Corporation’s competition is large regional companies which have the capital resources to substantially impact such things as loan and deposit pricing, delivery channels and products. This may allow those companies to offer what may be perceived in the market as better products and better convenience relative to smaller competitors like the Corporation, which could impact the Corporation’s ability to grow its assets and earnings.

 

Changes in interest rates could adversely affect the Corporation’s earnings and financial condition.

 

The Corporation derives the majority of its revenue from net interest income. Net interest income may be reduced if more rate sensitive assets than interest-bearing liabilities reprice or mature during a time when rates are declining, or if more interest-bearing liabilities than rate sensitive assets reprice or mature during a time when rates are rising. However, the Corporation has historically experienced improved net interest income during periods of rising interest rates, so if interest rates fall, the Corporation’s revenue may be adversely impacted. Interest rate changes also impact customer preferences for the Corporation’s products. Changing interest rates can lead to unpredictable cash flow with respect to both assets and liabilities, which can negatively impact net interest income.

The Corporation’s business may be adversely affected by changes in government policies. The Corporation competes in a highly regulated environment.

 

Changes in regulation are continually being proposed which can substantially impact the Corporation’s products and cost of delivery. Regulatory burdens imposed by legislation such as The Sarbanes-Oxley Act of 2002, The USA PATRIOT Act, The International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001, The Equal Credit Opportunity Act, The Fair Housing Act, The Community Reinvestment Act and the Home Mortgage Disclosure Act can materially impact the ability of the Corporation to grow should the Corporation fail to develop the systems to adequately comply with these regulations. Failure to comply with these regulations can lead to loss of customer confidence, substantial fines and regulatory constraints on the Corporation’s operations. These burdens can also materially impact the earnings of the Corporation as additional resources are expended to comply with these requirements. The government, through the open market activities of the Federal Reserve Board, can also adversely impact the Corporation’s business. The Federal Reserve Board can change the discount rate, which impacts the composition of the Corporation’s balance sheet by influencing the rates that the Corporation earns on its assets and pays on its liabilities.

 

The Corporation is subject to additional uncertainties, and potential additional regulatory or compliance burdens, as a result of the Corporation’s participation in the CPP.

 

The Corporation accepted an investment by the U.S. Treasury under the CPP. The Stock Purchase Agreement the Corporation entered into with the U.S. Treasury provides that the U.S. Treasury may unilaterally amend the agreement to the extent required to comply with any changes after the execution in applicable federal statutes. As a result of this provision, the U.S. Treasury and the Congress may impose additional requirements or restrictions on the Corporation and the Bank in respect of reporting, compliance, corporate governance, executive or employee compensation, dividend payments, stock repurchases, lending or other business practices, capital requirements or other matters. The Corporation may be required to expend additional resources in order to comply with these requirements. Such additional requirements could impair the Corporation’s ability to compete with institutions that are not subject to the restrictions because they did not accept an investment from the U.S. Treasury. To the extent that additional restrictions or limitations on employee compensation are imposed, such as those contained in ARRA and the regulations issued thereunder in June 2009, the Corporation may be less competitive in attracting and retaining successful incentive compensation based lenders and customer relations personnel, or senior executive officers.

 

Additionally, the ability of Congress to utilize the amendment provisions to effect political or public relations goals could result in the Corporation being subjected to additional burdens as a result of public perceptions of issues relating to the largest banks, and which are not applicable to community oriented institutions such as the Corporation. The Corporation may be disadvantaged as a result of these uncertainties.

 

The Corporation may be adversely impacted by weakness in the local economies it serves.

 

The Corporation’s business activities are geographically concentrated in Northeast Ohio and, in particular, Lorain County, Ohio, where commercial activity has deteriorated at a greater rate than in other parts of Ohio and in the national economy. This has led to and may lead to further unexpected deterioration in loan quality, slower asset and deposit growth, which may adversely affect the Corporation’s operating results.

 

The Corporation’s earnings and reputation may be adversely affected if credit risk is not properly managed. Originating and underwriting loans is critical to the success of the Corporation.

 

This activity exposes the Corporation to credit risk, which is the risk of losing principal and interest income because the borrower cannot repay the loan in full. The Corporation depends on collateral in underwriting loans, and the value of this collateral is impacted by interest rates and economic conditions.

 

The Corporation’s earnings may be adversely affected if management does not understand and properly manage loan concentrations. The Corporation’s commercial loan portfolio is concentrated in commercial real estate. This includes significant commercial and residential development customers. This means that the Corporation’s credit risk profile is dependent upon, not only the general economic conditions in the market,

but also the health of the local real estate market. Certain of these loans are not fully amortized over the loan period, but have a balloon payment due at maturity. The borrower’s ability to make a balloon payment typically will depend on being able to refinance the loan or to sell the underlying collateral. This factor, combined with others, including the Corporation’s geographic concentration, can lead to unexpected credit deterioration and higher provisions for loan losses.

 

The Corporation is subject to liquidity risk.

 

Market conditions or other events could negatively affect the level or cost of funding, affecting the Corporation’s ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner and without adverse consequences. Although management has implemented strategies to maintain sufficient sources of funding to accommodate planned as well as unanticipated changes in assets and liabilities under both normal and adverse conditions, any substantial, unexpected and/or prolonged change in the level or cost of liquidity could adversely affect the Corporation’s business, financial condition and results of operations.

 

If the Corporation’s technology and systems are damaged, its ability to service customers, comply with regulation and grow assets and liabilities may be adversely impacted.

 

The Corporation is dependent on the proper functioning of its hardware, software and communications. Security breaches, terrorist events, and natural disasters can all have a material impact on the Corporation’s ability to maintain accurate records which is critical to the Corporation’s operations.

 

The Corporation is subject to risk from the failure of third party vendors.

 

The Corporation relies on other companies to provide components of the Corporation’s business infrastructure. Third party vendors provide certain components of the Corporation’s business infrastructure, such the Bank’s processing and electronic banking systems, item processing and Internet connections. While the Corporation has selected these third party vendors carefully, it does not control their actions. Any problems caused by these third parities not providing the Corporation their services for any reason or their performing their services poorly, could adversely affect the Corporation’s ability to deliver products and services to the Corporation’s operations directly through interference with communications, including the interruption or loss of the Corporation’s websites, which could adversely affect the Corporation’s business, financial condition and results of operations.

 

Changes in accounting standards could materially impact the Corporation’s financial statements.

 

The Financial Accounting Standards Board (FASB) may change the financial accounting and reporting standards that govern the preparation of the Corporation’s financial statements. These changes can be difficult to predict and can materially impact how the Corporation records and reports it financial condition and results of operations.

 

The Corporation may not be able to attract and retain skilled people.

 

The Corporation’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities in which the Corporation is engaged can be intense, and the Corporation may not be able to retain or hire the people it wants and/or needs. In order to attract and retain qualified employees, the Corporation must compensate its employees at market levels. If the Corporation is unable to continue to attract and retain qualified employees, or do so at rates necessary to maintain its competitive position, the Corporation’s performance, including its competitive position, could suffer, and, in turn, adversely affect the Corporation’s business, financial condition and results of operations.

TARP and ARRA impose certain executive compensation and corporate governance requirements that may adversely affect the Corporation, including the Corporation’s ability to recruit and retain qualified employees.

 

The purchase agreement the Corporation entered into in connection with the Corporation’s participation in the CPP required the Corporation to adopt the U.S. Treasury’s standards for executive compensation and corporate governance while the U.S. Treasury holds the equity issued by the Corporation pursuant to the CPP. These standards generally apply to the Corporation’s Chief Executive Officer, Chief Financial Officer and the next three most highly compensated senior executive officers. The standards include:

 

 

ARRA imposed further limitations on compensation while the U.S. Treasury holds equity issued by the Corporation pursuant to TARP:

 

 

The U.S. Treasury released an interim final rule on TARP standards for compensation and corporate governance on June 10, 2009, which implemented and further expanded the limitations and restrictions imposed on executive compensation and corporate governance by the CPP and ARRA. The rules clarify prohibitions on bonus payments, provide guidance on the use of restricted stock units, expand restrictions on golden parachute payments, mandate enforcement of clawback provisions unless unreasonable to do so, outline the steps compensation committees must take when evaluating risks posed by compensations arrangements, and require the adoption and disclosure of a luxury expenditure policy, among other things. New requirements under the rules include enhanced disclosure of perquisites and the use of compensation consultants, and prohibitions on tax gross-up payments.

 

These provisions and any future rules issued by the U.S. Treasury could adversely affect the Corporation’s ability to attract and retain management capable and motivated sufficiently to manage and operate the Corporation’s business through difficult economic and market conditions. If the Corporation is unable to attract and retain qualified employees to manage and operate the Corporation’s business, it could negatively affect the Corporation’s business, financial conditions and results of operations.

 

The Corporation’s issuance of securities to the U.S. Treasury may limit the Corporation’s ability to return capital to its shareholders and is dilutive to the Corporation’s common shares. If the Corporation is unable to redeem such preferred shares, the dividend rate increases substantially after five years.

 

In connection with the Corporation’s sale of $25.2 million of its Series B Preferred Stock to the U.S. Treasury in conjunction with the CPP, the Corporation also issued a warrant to purchase 561,343 of its common shares at an exercise price of $6.74. The number of shares was determined based upon the requirements of the CPP, and was calculated based on the average market price of the Corporation’s common shares for the 20 trading days preceding approval of the Corporation’s issuance (which was also the basis for the exercise price of $6.74). The terms of the

transaction with the U.S. Treasury include limitations on the Corporation’s ability to pay dividends and repurchase its common shares. For three years after the issuance or until the U.S. Treasury no longer holds any Series B Preferred Stock, the Corporation will not be able to increase its dividends above the level of its quarterly dividend declared during the third quarter of 2008 ($0.09 per common share on a quarterly basis) nor repurchase any of its common shares or preferred stock without, among other things, U.S. Treasury approval or the availability of certain limited exceptions, e.g., purchases in connection with the Corporation’s benefit plans. Furthermore, as long as the Series B Preferred Stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Corporation’s common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. These restrictions combined with the dilutive impact of the warrant may have an adverse effect on the market price of the Corporation’s Common Shares, and, as a result, they could adversely affect the Corporation’s business, financial condition and results of operations.

 

Unless the Corporation is able to redeem the Series B Preferred Stock during the first five years, the dividend payments on this capital will increase substantially at that point, from 5% ($1.26 million annually) to 9% ($2.27 million annually). Depending on market conditions at the time, this increase in dividends could significantly impact the Corporation’s liquidity, and as a result, adversely affect the Corporation’s business, financial condition and results of operations.

 

The Corporation’s ability to pay dividends is subject to limitations.

 

Holders of the Corporation’s common shares are only entitled to receive such dividends as the Board of Directors may declare out of funds legally available for such payments. Furthermore, the Corporation’s common shareholders are subject to the prior dividend rights of holders of its preferred stock.

 

In September 2009, the Corporation reduced its quarterly dividend on its common shares to $0.01 per share and does not expect to increase the quarterly dividend above $0.01 for the foreseeable future. The Corporation could determine to eliminate its common shares dividend altogether. Furthermore, as long as the Series B Preferred Stock is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Corporation’s common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. This could adversely affect the market price of the Corporation’s common shares. Also, the Corporation is a bank holding company and its ability to declare and pay dividends is dependent on certain federal regulatory considerations, including the guidelines of the Federal Reserve Board regarding capital adequacy and dividends.

 

In addition, the terms of the Corporation’s outstanding trust preferred securities prohibit it from declaring or paying any dividends or distributions on its capital stock, including its common shares, if an event of default has occurred and is continuing under the applicable indenture or if the Corporation has given notice of its election to defer interest payments but the related deferral period has not yet commenced or a deferral period is continuing.

 

Additional capital may not be available to the Corporation if and when it is needed.

 

The Corporation and the Bank are subject to capital-based regulatory requirements. The ability of the Corporation and the Bank to meet capital requirements is dependent upon a number of factors, including results of operations, level of nonperforming assets, interest rate risk, future economic conditions, future changes in regulatory and accounting policies and capital requirements, and the ability to raise additional capital if and when it is needed. Certain circumstances, such as a reduction of capital due to losses from nonperforming assets or otherwise, could cause the Corporation or the Bank to become unable to meet applicable regulatory capital requirements, which may materially and adversely affect the Corporation’s financial condition, liquidity and results of operations. In such an event, additional capital may be required to meet requirements. The Corporation’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time which are outside its control, and on the Corporation’s financial performance. Accordingly, additional capital, if needed, may not be available on terms acceptable to the Corporation. Furthermore, if any such additional capital is raised through the offering of equity securities, it may dilute the holdings of the Corporation’s existing shareholders or reduce the market price of the Corporation’s common shares, or both.

If the Corporation is required to write down goodwill recorded in connection with its acquisitions, the Corporation’s profitability would be negatively impacted.

 

Applicable accounting standards require the Corporation to use the purchase method of accounting for all business combinations. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of the acquired company’s net assets, the excess is carried on the acquirer’s balance sheet as goodwill. At December 31, 2009, the Corporation had approximately $21.5 million of goodwill on its balance sheet. Goodwill must be evaluated for impairment at least annually. Write downs of the amount of any impairment, if necessary, are to be charged to the results of operations in the period in which the impairment occurs. There can be no assurance that future evaluations of goodwill will not result in findings of impairment and related write downs, which would have an adverse effect on the Corporation’s financial condition and results of operations.

 

 

Not applicable.

 

 

The Corporation’s offices are located at the Corporation’s Main Banking Center, 457 Broadway, Lorain, Ohio, 44052. The Corporation owns the land and buildings occupied by nine of its banking centers, corporate offices, operations, maintenance, purchasing and training center. The Corporation leases the other 13 banking centers and loan centers from various parties on varying lease terms. There is no outstanding mortgage debt on any of the properties which the Corporation owns. Listed below are the banking centers, loan production offices and service facilities of the Corporation and their addresses, all of which are located in Lorain, eastern Erie, western Cuyahoga and Summit counties of Ohio:

 

The Corporation also owns and leases equipment for use in its business. The Corporate headquarters at 457 Broadway is currently 75% occupied. The remaining space is expected to be utilized to accommodate future growth. The Corporation considers all its facilities to be in good condition, well-maintained and more than adequate to conduct the business of banking.

 

 

On April 18, 2008, the Corporation and Richard M. Osborne and certain other parties entered into a settlement agreement (the “Settlement Agreement”) to settle certain contested matters relating to the Corporation’s 2008 annual meeting of shareholders. Under the Settlement Agreement, among other things, Mr. Osborne agreed not to seek representation on the Corporation’s Board of Directors or to solicit proxies with respect to the voting of the Corporation’s common shares for a period of at least 18 months after April 18, 2008. In proxy materials filed with the SEC on March 20, 2009, Mr. Osborne indicated his intent to solicit proxies in favor of the election of two nominees for election as directors at the Corporation’s 2009 annual meeting of shareholders. On March 24, 2009, the Corporation filed a complaint against Mr. Osborne for a declaratory judgment and preliminary and permanent injunctive relief in the United States District Court for the Northern District of Ohio, Eastern Division, to restrain Mr. Osborne from (a) engaging in any solicitation of proxies or consents, (b) seeking to advise, encourage or influence any person or entity with respect to the voting of any voting securities of the Corporation, (c) initiating, proposing or otherwise soliciting shareholders of the Corporation for the approval of shareholder proposals, (d) entering into any discussions, negotiations, agreements, arrangements or understanding with any third party with respect to any of the foregoing and (e) disseminating his proposed proxy materials to shareholders of the Corporation. The Corporation also sought an order from the Court temporarily restraining Mr. Osborne from engaging in any of the foregoing activities. On March 28, 2009, the Court issued an order granting the Corporation’s motion for a temporary restraining order. On April 3, 2009, the Court issued an order granting the Corporation’s motion for a preliminary injunction restraining Mr. Osborne from engaging in any of the foregoing activities. On February 15, 2010, Mr. Osborne filed a motion to dissolve the preliminary injunction, which the Corporation has opposed. The Court has not indicated when it will rule on the motion or whether it will do so in advance of the trial on the merits. Fact discovery has been completed. Dispositive motions are due on March 19, 2010. A trial on the merits of the Corporation’s claims has been set to commence on June 14, 2010.

 

 

During the fourth quarter of the year ended December 31, 2009 there were no matters submitted to a vote of security holders.

 

Pursuant to Form 10-K, General Instruction G(3), the following information on Executive Officers is included as an additional item in this Part I:

 

 

 

Market Information; Equity Holders; Dividends.  LNB Bancorp, Inc. common shares, par value $1.00 per share, are traded on The NASDAQ Stock Market^® under the ticker symbol “LNBB”. The prices below represent the high and low sales prices reported on The NASDAQ Stock Market for each specified period. All prices reflect inter-dealer prices without markup, markdown or commission and may not necessarily represent actual transactions.

 

LNB Bancorp, Inc. has paid a cash dividend to shareholders each year since becoming a holding company in 1984. At present, the Corporation expects to pay cash dividends to shareholders in an amount equal to $0.01 per share if approved by the Board of Directors. The Corporation could decide to eliminate its common share dividend altogether. Furthermore, the terms of the Corporation’s sale of $25.2 million of its Series B Preferred Stock to the U.S. Treasury in conjunction with the CPP include limitations on the Corporation’s ability to pay dividends. For three years after the issuance or until the U.S. Treasury no longer holds any Series B Preferred Stock, the Corporation will not be able to increase its dividends above the level of its quarterly dividend declared during the third quarter of 2008 ($0.09 per common share on a quarterly basis) without, among other things, U.S. Treasury approval. In addition, as long as the Series B Preferred Stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Corporation’s common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions.

 

The common shares of LNB Bancorp, Inc. are usually listed in publications as “LNB Bancorp”. LNB Bancorp Inc.’s common stock CUSIP is 502100100.

 

As of March 1, 2010, LNB Bancorp, Inc. had 1,905 shareholders of record and a closing price of $4.47. Prospective shareholders may contact the Corporation’s Investor Relations Department at (440) 244-7317 for more information.

 

Common Stock Trading Ranges and Cash Dividends Declared

 

 

 

The following graph shows a five-year comparison of cumulative total returns for LNB Bancorp, the Standard & Poor’s 500 Stock Index^© and the Nasdaq Bank Index.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among LNB Bancorp, Inc., The S&P 500 Index
And The NASDAQ Bank Index

 

 

 

 

The graph shown above is based on the following data points:

 

 

Issuer Purchases of Equity Securities

 

The following table summarizes share repurchase activity for the quarter ended December 31, 2009:

 

 

On July 28, 2005, the Corporation announced a share repurchase program of up to 5 percent, or about 332,000, of its common shares outstanding. Repurchased shares can be used for a number of corporate purposes, including the Corporation’s stock option and employee benefit plans. The share repurchase program provides that share repurchases are to be made primarily on the open market from time-to-time until the 5 percent maximum is repurchased or the earlier termination of the repurchase program by the Board of Directors, at the discretion of management based upon market, business, legal and other factors. However, the terms of the Corporation’s sale of

$25.2 million of its Series B Preferred Stock to the U.S. Treasury in conjunction with the CPP include limitations on the Corporation’s ability to repurchase its common shares. For three years after the issuance or until the U.S. Treasury no longer holds any Series B Preferred Stock, the Corporation will not be able to repurchase any of its common shares or preferred stock without, among other things, U.S. Treasury approval or the availability of certain limited exceptions, e.g., purchases in connection with the Corporation’s benefit plans. Furthermore, as long as the Series B Preferred Stock issued to the U.S. Treasury is outstanding, repurchases or redemptions relating to certain equity securities, including the Corporation’s common shares, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. As of December 31, 2009, the Corporation had repurchased an aggregate of 202,500 shares under this program.

 

 

 

 

 

The following commentary presents a discussion and analysis of the Corporation’s financial condition and results of operations by the Management. The review highlights the principal factors affecting earnings and significant changes in the balance sheet for 2009, 2008 and 2007. Financial information for the prior five years is presented where appropriate. The objective of this financial review is to enhance the reader’s understanding of the accompanying tables and charts, the consolidated financial statements, notes to the financial statements and financial statistics appearing elsewhere in the report. Where applicable, this discussion also reflects Management’s insights of known events and trends that have or may reasonably be expected to have a material effect on the Corporation’s operations and financial condition.

 

Summary (Dollars in thousands except per share data)

 

The Corporation’s 2009 financial performance continued to be affected by the recession which began in 2008 and the weakness of the national and local economies. During 2009, the Corporation saw a significant increase in credit cost as nonperforming loans increased and the valuation of the underlying collateral decreased. The result was an increase to the provision for loan losses. Even with the weak economy, the Corporation was able to grow both deposits and loans by increasing market share in its existing markets as well as expanding its presence into new markets and, as a result, revenues grew 11.39% compared to 2008. During this time, Management continued to focus on controlling expenses. Excluding the increased FDIC assessment in 2009, operating expenses decreased 2.54%.

 

Net loss for 2009 was $2,001. Net loss available to common shareholders was $3,257, or $0.45 per diluted common share. Net income in 2008 was $3,396. Net income available to common shareholders was $3,305, or $0.45 per diluted common share in 2008 and $5,512 or $0.79 per diluted common share in 2007. Earnings per diluted share in 2007 were affected by the issuance of 851,990 common shares in May, 2007 as part of the acquisition of Morgan Bancorp. Earnings per diluted common share in 2009 were affected by the increased loan loss provision as well as the dividends and discount accretion on preferred shares discussed below.

 

On December 12, 2008, in connection with its participation in the CPP, the Corporation issued 25,223 shares of fixed rate cumulative perpetual Series B Preferred Stock. In conjunction with the issuance of the Preferred Stock, the Corporation also issued a warrant to purchase 561,343 common shares. No shares of Series B Preferred Stock, or any other class of preferred stock, were outstanding during the year ended December 31, 2007.

 

Net loss as a percent of average assets in 2009 was 0.17%. This compares to a return of 0.31% and 0.58% in 2008 and 2007, respectively. Return on assets is one measurement of operating efficiency. As a percentage of average shareholders’ equity this represents a loss of 1.86% for 2009 as compared to a return of 4.09% and 7.06% in 2008 and 2007, respectively. Return on shareholders’ equity is a measure of how well the Corporation employs leverage to maximize the return on the capital it employs.

 

Net interest income grew 17.37% to $37,722 in 2009 from $32,139 in 2008. Since the Corporation is highly dependent on net interest income for its revenue, minimizing net interest margin compression is a very important factor in the Corporation’s financial performance. The net interest margin (FTE) for 2009 was 3.39% versus 3.23% for 2008. The Corporation experienced solid growth in its loan portfolio during 2009 with an increase in average loans of 4.25% over 2008. Average interest-bearing deposits in 2009 also grew 12.38% in comparison to 2008. The spread between the yield on portfolio loans and the cost of interest-bearing deposits increased 20 basis points during 2009.

 

Noninterest income in 2009 was $11,956, a decrease of $530 compared to 2008. The largest component of noninterest income is deposit and other service charges and fees. Deposit service charges decreased in 2009 over the prior year while other service charges and fees increased $65. Other service charges and fees include electronic banking and merchant service fees. Noninterest income derived from trust and investment management services increased during 2009 as compared to 2008. Many of the fees earned by the trust department are market-based, and the increase is reflective of an improving stock market.

 

Noninterest expense was $35,330 in 2009, compared to $34,281 in 2008. There were two significant increases in expense in 2009 as compared to 2008. FDIC assessments significantly increased in connection with higher

standard maximum deposit insurance coverage limits and a special assessment of approximately $580. Expenses related to the collection of delinquent loans and foreclosed properties increased as well. These expenses increased $1,900 and $438, respectively, compared to 2008. The increase in loan and collection expense is primarily the result of increased delinquencies and foreclosures due to the declining economic conditions in 2009. Included in noninterest expense during 2008 was $572 related to the special shareholders meeting requested by a shareholder of the Corporation. This affected third party services, marketing and public relations and postage expenses. Third party services for 2009 include $195 related to this same shareholder.

 

The Corporation experienced solid growth in commercial loans, home equity lines of credit and installment loans during 2009. Average portfolio balances for the year ended December 31, 2009 increased 2.94% in commercial loans, 18.04% in home equity lines of credit and 9.82% in installment loans, in comparison to average portfolio balances for the year ended December 31, 2008. The overall yield on portfolio loans in 2009 was down 67 basis points from 2008 as a result of the steadily falling Treasury yield curve. Average interest-bearing deposits for the year ended December 31, 2009 were up 12.38% in comparison to average interest-bearing deposits for the year ended December 31, 2008. The cost of deposits was down 87 basis points from 2008. The resulting net interest margin (FTE) was 3.39% for 2009 versus 3.23% for 2008.

 

Asset quality is one key indicator of financial strength, and the Corporation continues to manage credit risk aggressively. Net charged-off loans for 2009 increased to $11,877 from $2,977 for 2008 and the ratio of charged off loans to total loans increased to 1.48% for 2009 compared to 0.37% for 2008. The declining housing market and general economic decline of 2009 continued to impact the Corporation’s commercial and residential real estate portfolios. Total delinquency as a percentage of total loans increased from 3.76% at December 31, 2008 to 5.51% at December 31, 2009. In 2009, the level of nonperforming loans increased over the prior year from $19,592 at December 31, 2008 to $38,837 at December 31, 2009, primarily due to an increase in nonperforming construction and development loans. As a result, the Corporation increased the allowance for loan losses to $18,792 during 2009, increasing the allowance to 2.34% of total loans.

 

Since the ability to generate deposits is a key indication of the Corporation’s ability to meet its liquidity needs and fund profitable asset growth, it is a significant measure of the success of the Corporation’s business plan. As measured by the FDIC at June 30, 2009, the Corporation’s market share of deposits in Lorain County grew to 23.64% from 21.22% in 2008. This compares to 17.99% five years ago. The Corporation continues to maintain strong market share in the city markets of Lorain, Elyria and Amherst, where the Corporation has a long-time presence, and is pleased with the performance of its newer offices in the eastern parts of Lorain county, as well as Summit county.

 

As the local and national economic environments progressively weakened during 2009, asset quality issues negatively impacted the Corporation’s overall performance. The Corporation recorded a loan loss provision of $19,017 in 2009, in light of the continuing unpredictability of the economy, the continued decline in real estate values and the credit quality issues inherent in the portfolio. The provision for loan loss was $6,809 in 2008 and $2,255 in 2007.

Table 1: Condensed Consolidated Average Balance Sheets

 

Interest, Rate, and Rate/ Volume differentials are stated on a Fully-Tax Equivalent (FTE) Basis.

 

Table 1 presents the condensed consolidated average balance sheets for the three years ended December 31, 2009, December 31, 2008 and December 31, 2007.

 

Results of Operations (Dollars in thousands except per share data)

 

2009 versus 2008 Net Interest Income Comparison

 

Net interest income, the Corporation’s primary source of earnings, is the difference between interest income earned on interest-earning assets and the interest expense incurred on interest-bearing liabilities. Net interest income is affected by market interest rates on both earning assets and interest-bearing liabilities, the level of earning assets being funded by interest-bearing liabilities, noninterest-bearing liabilities, the mix between interest-bearing liabilities, noninterest-bearing liabilities and equity and the growth of earning assets.

 

While earnings were impacted by a significant loan loss provision during 2009, net interest income reflected solid revenue increases during the year. In 2009, net interest income increased 17.37% to $37,722 from $32,139 in 2008. Average portfolio loans increased from $779,659 at December 31, 2008 to $812,692 at December 31, 2009.

 

The Corporation reviews net interest income on a fully taxable equivalent basis, which presents interest income with an adjustment for tax-exempt interest income on an equivalent pre-tax basis assuming a 34% statutory Federal tax rate. These rates may differ from the Corporation’s actual effective tax rate. Net interest income is affected by changes in the volumes, rates and the composition of interest-earning assets and interest-bearing liabilities. The net interest margin is net interest income as a percentage of average earning assets.

 

Table 2 summarizes net interest income and the net interest margin for the three years ended December 31, 2009.

 

Table 2: Net Interest Income

 

 

The Corporation’s net interest income on a fully tax equivalent basis was $38,247 in 2009, which compares to $32,578 in 2008. This follows an increase of $2,526, or 8.41%, between 2008 and 2007. The net interest margin, which is determined by dividing tax equivalent net interest income by average earning assets, was 3.39% in 2009, or an increase of 16 basis points from 2008. This follows a decrease of 16 basis points for 2008 compared to 2007.

 

The growth in net interest income in 2009 was largely driven by lower funding cost due to lower market interest rates. Interest expense ended 2009 at $19,925 compared to $26,189 in 2008 as the cost of funds dropped by 87 basis points over this period. Interest income totaled $58,172 for 2009 compared to $58,767 in 2008, a decline of $595, or 1.01%. The decline in interest income was a result of a lower yield on earning assets due to lower market interest rates and a change in mix as investment securities and Federal funds sold equaled 27.96% of average earning assets in 2009 compared to 22.71% in 2008.

 

Average earning assets increased $119,541, or 11.85%, to $1,128,107 in 2009 as compared to $1,008,566 in 2008. Average loans increased $33,123, or 4.25%, to $812,692 in 2009 as compared to $779,569 in 2008. Investment securities, both taxable and tax-free, increased $60,394 to $273,724 in 2009 compared to $213,330 in 2008 while Federal funds sold increased $26,024 over the same period. Loan growth in all areas of the portfolio except real estate mortgage loans contributed to the average increase of $33,123, with an increase in the commercial loan portfolio of $12,886, an increase in installment loans of $15,064, an increase in home equity loans of $16,208, which was primarily offset by a decrease of $11,035 in real estate mortgage loans.

 

The increase in average loans was primarily funded with $106,510 of deposit growth. During 2009, average consumer time deposits increased $86,796 as well as public time deposits which increased $21,109 compared to

2008. Noninterest-bearing deposits increased in 2009 by $8,428, or 9.65%, offset by a decrease in interest-bearing demand deposits of $1,351, or 0.57%, compared to 2008. The Bank uses FHLB advances and brokered time deposits as alternative wholesale funding sources. The use of alternative funding sources decreased $20,527, or 22.80%, during 2009 in comparison to 2008. While brokered time deposits have become an important and comparably priced substitute for FHLB advances as they require no collateralization compared to FHLB advances which require collateral in the form of real estate mortgage loans and securities, there were no outstanding brokered time deposits at the end of 2009.

 

Net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense. Table 3 presents an analysis of increases and decreases in interest income and expense due to changes in volume (changes in the balance sheet) and rate (changes in interest rates) during the two years ended December 31, 2009. Changes that are not due solely to either a change in volume or a change in rate have been allocated proportionally to both changes due to volume and rate. The table is presented on a tax-equivalent basis.

 

Table 3: Rate/Volume Analysis of Net Interest Income (FTE)

 

 

Total interest income on a fully tax equivalent basis was $58,172 in 2009 as compared to $58,767 in 2008, a decrease of $595, or 1.01%. An increase of $4,473 attributable to volume was offset by a decrease of $5,068 attributable to rate, when comparing 2009 to 2008. Of the $4,473 increase due to volume, loans accounted for $1,753 and investment securities and Federal funds sold accounted for $2,720 as increases in funding exceeded loan growth. Commercial loans by their structure are the group of assets most sensitive to interest rates accounting for $3,397 of the change in interest income due to rate. Total interest expense was $19,925 in 2009 compared to $26,189 in 2008. This is a decrease of $6,264, or 23.92%. Interest expense increased $2,131 attributable to volume, but was offset $8,395 as a result of a decline in rates. Time deposits, both consumer and public funds, had a significant

impact on both volume and rate as new accounts grew and existing accounts renewed at the lower market interest rates.

 

Although difficult to isolate, changing customer preferences and competition impact the rate and volume factors. Deposits were more sensitive to falling interest rates than loans, resulting in an increase in net interest income due to rate. While experiencing growth in both loans and deposits in 2009, deposits grew at a faster rate than loans. As a result, net interest income from volume decreased. The effect of changes in both rate and volume was an increase of $5,669 during 2009 in net interest income.

 

2008 versus 2007 Net Interest Income Comparison

 

The Corporation’s net interest income on a fully tax equivalent basis was $32,578 in 2008, which compares to $30,052 in 2007. The net interest margin was 3.23% in 2008, or a decrease of 16 basis points from 2007. This decrease was primarily the result of a steepening Treasury yield curve and competitive pressures.

 

Average earning assets increased $121,734, or 13.73%, to $1,008,566 in 2008 as compared to $886,832 for the same period of 2007. Average loans increased $81,168, or 11.62%, to $779,569 in 2008 as compared to $698,401 in 2007. Loan growth in all areas of the portfolio except real estate mortgage loans contributed to the average increase of $81,168, with an increase in the commercial loan portfolio of $37,799, an increase in installment loans of $30,739, an increase in home equity loans of $14,394, offset by a decrease of $1,764 in real estate mortgage loans. The increase in average loans was primarily funded with $85,538 of deposit growth. During 2008, average consumer time deposits increased $105,780 compared to 2007 offset by a decline in public time deposits of $6,152, or 8.81%. Noninterest-bearing deposits increased in 2008 by $2,950, or 3.50%, as well as interest-bearing demand deposits which grew $3,804, or 1.63%. The Bank was more reliant on alternative funding which, including brokered time deposits, increased $4,012, or 4.02%, from 2007.

 

Total interest income on a fully tax equivalent basis was $58,767 in 2008 as compared to $59,144 in 2007. This is a decrease of $377 or 0.64%. Of this decrease, $5,895 was attributable to volume and $6,272 to a decline in rate. When comparing 2008 to 2007, the contribution from balance sheet growth improved, and rates provided a positive contribution as well. Total interest expense was $26,189 in 2008 as compared to $29,092 in 2007. This is a decrease of $2,903, or 10.00%. Of this decrease, $8,191 was attributable to volume and $11,094 to a decline in rate. Competitive margin pressure and stiff competition in the Corporation’s markets resulted in a $2,296 reduction in net interest income due to rates. This was offset by an increase in net interest income of $4,822 due to increases in the volume of loans and deposits, for a resulting increase in net interest income (FTE) of $2,526.

 

Noninterest Income

 

Table 4: Details of Noninterest Income

 

2009 vs 2008 Noninterest Income Comparison

 

Generation of noninterest income is important to the long-term success of the Corporation. Total noninterest income was $11,956 in 2009 as compared to $12,459 in 2008. This was a decrease of $503, or 4.04%. Core noninterest income, which consists of noninterest income before other income and gains and losses, was $9,865 in 2009 as compared to $10,357 in 2008. This was a decrease of $492, or 4.75%.

 

Noninterest income from investment and trust services increased slightly in 2009. Trust and investment management fees increased $11, or 0.58%, during 2009 in comparison to 2008. Net trust fees, which are primarily based on market valuation, decreased $21, or 1.22%, in 2009 from the same period of 2008. During 2009, the fee-assessed trust accounts were increased to offset the effect of lower market valuations. In 2009 the Corporation added resources and focus to grow its investment services as a result, brokerage fee income was $242 in 2009 compared to $207 in 2008.

 

Overall, deposit service charges and electronic banking fees decreased 2.90%, to $7,253 in 2009, compared to $7,470 in 2008. Deposit service charges which consist largely of overdraft, stop payment and return item fees, amounted to $4,478 during 2009. The Corporation experienced a decrease in the number of overdrawn accounts as customers challenged by the economy managed their accounts more closely. This trend may also be indicative of the uncertainty related to new legislation scheduled to become effective in the second half of 2010 related to overdrafts. Although the Corporation charged a fee to business accounts during the later part of 2009 to recapture a portion of the Corporation’s FDIC assessments, fee income from deposit service charges declined during 2009. Electronic banking fees include debit, ATM and merchant services and were $2,775 during 2009.

 

During 2009, income from bank owned life insurance decreased $286, or 29.21%, in comparison to 2008. During 2008, $216 was received for the redemption of a bank owned life insurance policy.

 

Other income was $315 in 2009 as compared to $856 in 2008. This is a decrease of $541. Other income consists of miscellaneous fees such as safe deposit box rentals and fees, gift card income and Other Real Estate Owned rental income. During 2008, as a result of a membership interest, the Corporation received stock from an initial public offering completed by VISA and a subsequent mandatory partial redemption of stock in the amount of $460 which was recorded as noninterest income. Also included in other income are servicing fees from sold loans. The Corporation retains the servicing rights for both sold mortgage loans and indirect auto loans. Net servicing fee income for 2009 decreased $104 compared to 2008 primarily due to an impairment charge of $96 recorded for mortgage servicing rights as of December 31, 2009.

 

The Corporation originates residential mortgage loans and indirect auto loans in the normal course of business. In managing its interest rate risk, fixed rate mortgage loans are sold into the secondary market with the Corporation retaining servicing. Given the low interest rate environment, mortgage loan activity increased significantly in 2009 due largely to the number of customers refinancing existing mortgages. As a result, the gains on the sale of mortgages during 2009 were $672 compared to $307 for 2008. In addition, the Corporation originates indirect auto loans for a niche market of high quality loans. A portion of these loans are booked to the Corporation’s portfolio and the remainder is sold to a number of other financial institutions with servicing retained. The gain on the sale of indirect auto loans was $474 for 2009, compared to $490 for 2008.

 

During 2009, available-for-sale securities which were due to be called or mature during the year were assessed and, in some cases, sold and replaced with purchases of primarily mortgage-backed securities and some agency securities. Because of the falling interest rate environment, the interest rates available on mortgage-backed securities made these securities more attractive to holders than agency securities. Prior to the decline in interest rates, agency securities had been producing a similar yield to mortgage-backed securities, but without the prepayment option and the longer term to maturity. The Corporation sold approximately $37,808 of its available-for-sale securities prior to call or maturity in order to reinvest the proceeds in other securities before any further interest rate cuts reduced the yield on securities available for purchase. Gains on the sale of available-for-sale securities and mark-to-market adjustments of trading securities were $690 during 2009, including $154 in unrealized gain on trading securities.

2008 vs 2007 Noninterest Income Comparison

 

Total noninterest income was $12,459 in 2008 as compared to $11,499 in 2007. This was an increase of $960, or 8.35%. Core noninterest income was $10,357 in 2008 as compared to $9,966 in 2007. This was an increase of $391, or 3.92%.

 

Trust and investment management fees decreased $262, or 12.07%, during 2008 in comparison to 2007. Net trust commission decreased $301, or 15.07%, in 2008 from the same period in 2007. Net brokerage fee income was $207 in 2008, in comparison to $136 in 2007.

 

Overall, deposit service charges and electronic banking fees increased 5.75% to $7,470 in 2008, compared to $7,064 in 2007. Other income was $856 in 2008 compared to $396 in 2007. This was an increase of $460, or 116.16%. During 2008, a mandatory redemption of VISA stock resulted in additional income of $460. Net servicing fee income for 2008 decreased $71 compared to 2007. Gains on the sale of mortgage and indirect auto loans during 2008 were $307 and $490, respectively.

 

Noninterest Expense

 

Table 5: Details on Noninterest Expense