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Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ   Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
For the quarterly period ended June 30, 2011
OR
     
o   Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission file number 001-34095
FIRST BUSINESS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
     
Wisconsin   39-1576570
     
(State or jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
401 Charmany Drive Madison, WI   53719
     
(Address of Principal Executive Offices)   (Zip Code)
(608) 238-8008
Telephone number
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 and 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 website, if any, every Interactive Data Field required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer o   Smaller reporting company þ
        (Do not check if a smaller reporting company)    
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 number of shares outstanding of the registrant’s sole class of common stock, par value $0.01 per share, on July 20, 2011 was 2,597,190 shares.
 
 

 

 


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FIRST BUSINESS FINANCIAL SERVICES, INC.
INDEX — FORM 10-Q
         
 
       
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    32  
 
       
    49  
 
       
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    50  
 
       
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 EX-31.1
 EX-31.2
 EX-32
 EX-101 INSTANCE DOCUMENT
 EX-101 SCHEMA DOCUMENT
 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

 

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PART I. Financial Information
Item 1.   Financial Statements
First Business Financial Services, Inc.
Consolidated Balance Sheets
                 
    (Unaudited)        
    June 30,     December 31,  
    2011     2010  
    (In Thousands, Except Share Data)  
 
               
Assets
               
Cash and due from banks
  $ 12,552     $ 9,450  
Short-term investments
    30,323       41,369  
 
           
Cash and cash equivalents
    42,875       50,819  
Securities available-for-sale, at fair value
    168,318       153,379  
Loans and leases receivable, net of allowance for loan and lease losses of $15,937 and $16,271, respectively
    844,757       860,935  
Leasehold improvements and equipment, net
    1,041       974  
Foreclosed properties
    1,400       1,750  
Cash surrender value of bank-owned life insurance
    17,293       16,950  
Investment in Federal Home Loan Bank stock, at cost
    2,367       2,367  
Accrued interest receivable and other assets
    18,326       19,883  
 
           
Total assets
  $ 1,096,377     $ 1,107,057  
 
           
 
               
Liabilities and Stockholders’ Equity
               
Deposits
  $ 977,488     $ 988,298  
Federal Home Loan Bank and other borrowings
    39,498       41,504  
Junior subordinated notes
    10,315       10,315  
Accrued interest payable and other liabilities
    9,229       11,605  
 
           
Total liabilities
    1,036,530       1,051,722  
 
           
 
               
Commitments and contingencies
               
 
               
Stockholders’ equity:
               
Preferred stock, $0.01 par value, 2,500,000 shares authorized, none issued or outstanding
           
Common stock, $0.01 par value, 25,000,000 shares authorized, 2,680,360 shares issued, 2,597,190 and 2,597,820 shares outstanding at 2011 and 2010, respectively
    27       27  
Additional paid-in capital
    25,560       25,253  
Retained earnings
    33,306       29,808  
Accumulated other comprehensive income
    2,507       1,792  
Treasury stock (83,170 and 82,540 shares at 2011 and 2010, respectively), at cost
    (1,553 )     (1,545 )
 
           
Total stockholders’ equity
    59,847       55,335  
 
           
Total liabilities and stockholders’ equity
  $ 1,096,377     $ 1,107,057  
 
           
See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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First Business Financial Services, Inc.
Consolidated Statements of Income (Unaudited)
                                 
    For the Three Months Ended     For the Six Months Ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
    (In Thousands, Except Share Data)  
Interest income:
                               
Loans and leases
  $ 13,049     $ 12,742     $ 25,969     $ 25,933  
Securities income, taxable
    1,106       1,166       2,224       2,300  
Short-term investments
    19       32       52       73  
 
                       
Total interest income
    14,174       13,940       28,245       28,306  
 
                       
 
                               
Interest expense:
                               
Deposits
    4,350       5,213       9,000       10,724  
Notes payable and other borrowings
    578       759       1,240       1,493  
Junior subordinated notes
    277       277       552       552  
 
                       
Total interest expense
    5,205       6,249       10,792       12,769  
 
                       
 
                               
Net interest income
    8,969       7,691       17,453       15,537  
Provision for loan and lease losses
    1,474       1,069       2,878       2,413  
 
                       
Net interest income after provision for loan and lease losses
    7,495       6,622       14,575       13,124  
 
                       
 
                               
Non-interest income:
                               
Trust and investment services fee income
    655       599       1,296       1,167  
Service charges on deposits
    417       414       790       812  
Loan fees
    368       285       699       576  
Increase in cash surrender value of bank-owned life insurance
    168       171       335       332  
Credit, merchant and debit card fees
    58       57       111       107  
Other
    78       159       187       321  
 
                       
Total non-interest income
    1,744       1,685       3,418       3,315  
 
                       
 
                               
Non-interest expense:
                               
Compensation
    3,836       3,402       7,573       6,897  
Occupancy
    358       376       699       748  
Professional fees
    345       321       772       840  
Data processing
    324       297       634       595  
Marketing
    248       182       527       378  
Equipment
    105       115       219       260  
FDIC insurance
    571       756       1,330       1,538  
Collateral liquidation costs
    177       333       419       558  
Goodwill Impairment
          2,689             2,689  
Loss (gain) on foreclosed properties
    79       (95 )     130       18  
Other
    595       845       1,096       1,245  
 
                       
Total non-interest expense
    6,638       9,221       13,399       15,766  
 
                       
 
                               
Income (loss) before income tax expense
    2,601       (914 )     4,594       673  
Income tax expense
    88       611       732       1,299  
 
                       
Net income (loss)
  $ 2,513     $ (1,525 )   $ 3,862     $ (626 )
 
                       
 
                               
Earnings (losses) per common share:
                               
Basic
  $ 0.98     $ (0.60 )   $ 1.49     $ (0.25 )
Diluted
    0.98       (0.60 )     1.49       (0.25 )
Dividends declared per share
    0.07       0.07       0.14       0.14  
See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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First Business Financial Services, Inc.
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
(Unaudited)
                                                 
                            Accumulated              
            Additional             other              
    Common     paid-in     Retained     comprehensive     Treasury        
    stock     capital     earnings     income     stock     Total  
    (In Thousands, Except Share Data)  
Balance at December 31, 2009
  $ 26     $ 24,731     $ 29,582     $ 1,544     $ (1,490 )   $ 54,393  
Comprehensive income:
                                               
Net loss
                (626 )                 (626 )
Unrealized securities gains arising during the period
                      1,093             1,093  
Income tax effect
                      (437 )           (437 )
 
                                             
Comprehensive income
                                            30  
Share-based compensation — restricted shares
          261                         261  
Cash dividends ($0.14 per share)
                (356 )                 (356 )
Treasury stock purchased (1,582 shares)
                            (15 )     (15 )
 
                                   
Balance at June 30, 2010
  $ 26     $ 24,992     $ 28,600     $ 2,200     $ (1,505 )   $ 54,313  
 
                                   
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
                                                 
                            Accumulated              
            Additional             other              
    Common     paid-in     Retained     comprehensive     Treasury        
    stock     capital     earnings     income     stock     Total  
    (In Thousands, Except Share Data)  
Balance at December 31, 2010
  $ 27     $ 25,253     $ 29,808     $ 1,792     $ (1,545 )   $ 55,335  
Comprehensive income:
                                               
Net income
                3,862                   3,862  
Unrealized securities gains arising during the period
                      1,173             1,173  
Income tax effect
                      (458 )           (458 )
 
                                             
Comprehensive income
                                            4,577  
Share-based compensation — restricted shares
          307                         307  
Cash dividends ($0.14 per share)
                (364 )                 (364 )
Treasury stock purchased (630 shares)
                            (8 )     (8 )
 
                                   
Balance at June 30, 2011
  $ 27     $ 25,560     $ 33,306     $ 2,507     $ (1,553 )   $ 59,847  
 
                                   
See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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First Business Financial Services, Inc.
Consolidated Statements of Cash Flows (Unaudited)
                 
    For the Six Months Ended  
    June 30,  
    2011     2010  
    (In Thousands)  
Operating activities
               
Net income (loss)
  $ 3,862     $ (626 )
Adjustments to reconcile net income to net cash provided by operating activities:
               
Deferred income taxes, net
    1,051       (1,717 )
Provision for loan and lease losses
    2,878       2,413  
Depreciation, amortization and accretion, net
    1,017       669  
Share-based compensation
    307       261  
Increase in cash surrender value of bank-owned life insurance
    (335 )     (332 )
Origination of loans for sale
    (988 )     (250 )
Sale of loans originated for sale
    993       250  
Gain on sale of loans originated for sale
    (5 )      
Loss on foreclosed properties
    130       18  
Goodwill impairment
          2,689  
Decrease (increase) in accrued interest receivable and other assets
    259       (565 )
(Decrease) increase in accrued interest payable and other liabilities
    (2,376 )     2,336  
 
           
Net cash provided by operating activities
    6,793       5,146  
 
           
 
               
Investing activities
               
Proceeds from maturities of available-for-sale securities
    20,572       17,422  
Purchases of available-for-sale securities
    (35,181 )     (35,941 )
Proceeds from sale of foreclosed properties
    1,327       908  
Net decrease in loans and leases
    12,193       7,564  
Investment in Aldine Capital Fund, L.P.
    (210 )     (150 )
Purchases of leasehold improvements and equipment, net
    (242 )     (72 )
Premium payment on bank owned life insurance policies
    (8 )     (8 )
 
           
Net cash used in investing activities
    (1,549 )     (10,277 )
 
           
 
               
Financing activities
               
Net decrease in deposits
    (10,810 )     (45,748 )
Repayment of FHLB advances
    (2,006 )     (5 )
Cash dividends paid
    (364 )     (356 )
Purchase of treasury stock
    (8 )     (15 )
 
           
Net cash used in financing activities
    (13,188 )     (46,124 )
 
           
 
               
Net decrease in cash and cash equivalents
    (7,944 )     (51,255 )
Cash and cash equivalents at the beginning of the period
    50,819       112,737  
 
           
Cash and cash equivalents at the end of the period
  $ 42,875     $ 61,482  
 
           
 
               
Supplementary cash flow information
               
Interest paid on deposits and borrowings
  $ 11,203     $ 13,232  
Income taxes paid
    2,751       2,375  
Transfer to foreclosed properties
    1,107       577  
See accompanying Notes to Unaudited Consolidated Financial Statements.

 

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Notes to Unaudited Consolidated Financial Statements
Note 1 — Nature of Operations and Summary of Significant Accounting Policies
Nature of Operations. The accounting and reporting practices of First Business Financial Services (“FBFS” or the “Corporation”), its wholly-owned subsidiaries, First Business Bank (“FBB”) and First Business Bank — Milwaukee (“FBB — Milwaukee”) have been prepared in accordance with U.S. generally accepted accounting principles. First Business Bank and First Business Bank — Milwaukee are sometimes referred to together as the “Banks”. FBB operates as a commercial banking institution in the Dane County and surrounding areas market with loan production offices in Oshkosh, Appleton, and Green Bay, Wisconsin. FBB also offers trust and investment services through First Business Trust & Investments (“FBTI”), a division of FBB. FBB — Milwaukee operates as a commercial banking institution in the Waukesha County and surrounding areas market. The Banks provide a full range of financial services to businesses, business owners, executives, professionals and high net worth individuals. The Banks are subject to competition from other financial institutions and service providers and are also subject to state and federal regulations. FBB has the following subsidiaries: First Business Capital Corp. (“FBCC”), First Madison Investment Corp. (“FMIC”), First Business Equipment Finance, LLC and FBB Real Estate, LLC (“FBBRE”). FBCC has a wholly-owned subsidiary, FMCC Nevada Corp. (“FMCCNC”). FMIC and FMCCNC are located in and were formed under the laws of the state of Nevada. FBB-Milwaukee has one subsidiary, FBB — Milwaukee Real Estate, LLC (“FBBMRE”).
Principles of Consolidation. The unaudited consolidated financial statements include the accounts and results of First Business Financial Services, Inc. (“FBFS” or the “Corporation”), and its wholly-owned subsidiaries, First Business Bank and First Business Bank — Milwaukee (“Banks”). In accordance with the provisions of Accounting Standards Codification (ASC) Topic 810, the Corporation’s ownership interest in FBFS Statutory Trust II (“Trust II”) has not been consolidated into the financial statements. All significant intercompany balances and transactions were eliminated in consolidation.
Basis of Presentation. The accompanying unaudited consolidated financial statements were prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The Corporation has not changed its significant accounting and reporting policies from those disclosed in the Corporation’s Form 10-K for the year ended December 31, 2010 except as described further below in Note 1.
In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the unaudited consolidated financial statements were included in the unaudited consolidated financial statements. The results of operations for the three and six month periods ended June 30, 2011 are not necessarily indicative of results that may be expected for any other interim period or the entire fiscal year ending December 31, 2011. Certain amounts in prior periods were reclassified to conform to the current presentation. Subsequent events were evaluated through the issuance of the unaudited consolidated financial statements.
Recent Accounting Pronouncements.
Troubled Debt Restructuring. In April 2011, the FASB issued Accounting Standard Update (“ASU”) 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring”. This accounting guidance provides for clarification and guidance for evaluating whether a restructuring constitutes a troubled debt restructuring. The guidance specifically states that a creditor must separately conclude that both of the following conditions exist for a restructuring to constitute a troubled debt restructuring: 1) the restructuring constitutes a concession and 2) the debtor is experiencing financial difficulties. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011 and should be applied retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. The impact on the allowance for loan and lease losses as a result of the identification of additional troubled debt restructurings, if any, is to be applied prospectively for the first interim or annual period beginning on or after June 15, 2011. Additionally, pursuant to ASU No. 2011-01, “Receivables: Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20”, the disclosures about the credit quality of financing receivables and the allowance for credit losses previously deferred for troubled debt restructurings, is also effective for reporting periods beginning on or after June 15, 2011. The Corporation does not expect the adoption of this standard to have a material impact on the consolidated financial condition and results of operations.

 

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Fair Value Measurement. In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requires in the U.S. GAAP and IFRSs”. This update was issued primarily to provide largely identical guidance about fair value measurement and disclosure requirements for International Financial Reporting Standards (“IFRS”) and U.S. GAAP. The new standards do not extend the use of fair value but rather provide guidance about how fair value should be determined where it already is required or permitted under IFRS or U.S. GAAP. For U.S. GAAP, most of the changes are clarifications of existing guidance or wording changes to align with IFRS. Public companies are required to apply the standard prospectively for interim and annual periods beginning after December 15, 2011. Early adoption is not permitted. In the period of adoption, disclosure is required for changes in any valuation technique and related inputs that result from applying the standard. Quantification of the total effect should be made. The Corporation is currently evaluating the impact of this accounting guidance.
Comprehensive Income. In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income”. This accounting guidance is intended to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The current practice of presenting the components of other comprehensive income as part of the statement of changes in stockholders’ equity is no longer permitted. This amendment does not change the items that must be reported in the other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This amendment will be applied retrospectively and is effective for fiscal years and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. The Corporation is currently evaluating the impact of this statement and expects that a disclosure change is required to present comprehensive income within one of the two permitted formats.
Note 2 — Earnings (Losses) Per Common Share
Earnings per common share are computed using the two-class method. Basic earnings per common share are computed by dividing net income allocated to common shares by the weighted average number of shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include unvested restricted shares. Unvested restricted shares are considered participating securities because holders of these securities receive non-forfeitable dividends at the same rate as holders of the Corporation’s common stock. Diluted earnings per share are computed by dividing net income allocated to common shares adjusted for reallocation of undistributed earnings of unvested restricted shares by the weighted average number of shares determined for the basic earnings per common share computation plus the dilutive effect of common stock equivalents using the treasury stock method.

 

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For the three month periods ended June 30, 2011 and 2010, average anti-dilutive employee share-based awards totaled 139,158 and 193,988, respectively. For the six month periods ended June 30, 2011 and 2010, average anti-dilutive employee share-based awards totaled 138,766 and 196,135, respectively.
                                 
    For the Three Months     For the Six Months  
    Ended June 30,     Ended June 30,  
    2011     2010     2011     2010  
 
                               
Distributed earnings allocated to common stockholders
  $ 174,932     $ 173,319     $ 349,781     $ 346,497  
Undistributed earnings (losses) allocated to common stockholders
    2,242,613       (1,659,926 )     3,365,091       (956,502 )
 
                       
Income (loss) available to common stockholders for basic earnings per share
    2,417,545       (1,486,607 )     3,714,872       (610,005 )
Reallocation of undistributed earnings for diluted earnings per share
                       
 
                       
Income (loss) available to common stockholders for diluted earnings per share
  $ 2,417,545     $ (1,486,607 )   $ 3,714,872     $ (610,005 )
 
                       
 
                               
Basic average shares
    2,499,136       2,476,109       2,498,530       2,474,840  
Dilutive effect of share-based awards
                       
 
                       
Dilutive average shares
    2,499,136       2,476,109       2,498,530       2,474,840  
 
                       
 
                               
Earnings (losses) per common share:
                               
Basic
  $ 0.98     $ (0.60 )   $ 1.49     $ (0.25 )
Diluted
    0.98       (0.60 )     1.49       (0.25 )
Note 3 — Share-Based Compensation
The Corporation adopted the 2001 Equity Incentive Plan and the 2006 Equity Incentive Plan (the “Plans”). The Plans are administered by the Compensation Committee of the Board of Directors of FBFS and provide for the grant of equity ownership opportunities through incentive stock options and nonqualified stock options (“Stock Options”) as well as restricted stock. As of June 30, 2011, 74,554 shares were available for future grants under the 2006 Equity Incentive Plan. Shares covered by awards that expire, terminate or lapse will again be available for the grant of awards under the 2006 Plan. The Corporation may issue new shares and shares from treasury for shares delivered under the Plans. The 2001 Plan expired February 16, 2011. The 2006 plan expires January 30, 2016.
Stock Options
The Corporation may grant Stock Options to senior executives and other employees under the Plans. Stock Options generally have an exercise price that is equal to the fair value of the common shares on the date the option is awarded. Stock Options granted under the 2001 and 2006 Plans are subject to graded vesting, generally ranging from four to eight years, and have a contractual term of 10 years. For any new awards issued, compensation expense is recognized over the requisite service period for the entire award on a straight-line basis. No Stock Options were granted since the Corporation met the definition of a public entity and no Stock Options were modified, repurchased or cancelled. Therefore, no stock-based compensation related to Stock Options was recognized in the consolidated financial statements for the three and six months ended June 30, 2011 and 2010. As of June 30, 2011, all Stock Options granted and not previously forfeited have vested.

 

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Stock Option activity for the year ended December 31, 2010 and six months ended June 30, 2011 was as follows:
                         
                    Weighted  
                    Average  
            Weighted     Remaining  
            Average     Contractual  
    Options     Exercise Price     Life (Years)  
Outstanding at December 31, 2009
    142,790     $ 22.01       3.66  
Granted
                   
Exercised
                   
Expired
    (4,024 )     19.38          
Forfeited
                   
 
                     
Outstanding at December 31, 2010
    138,766       22.09       2.75  
 
                     
Exercisable at December 31, 2010
    138,766               2.75  
 
                     
 
                       
Outstanding as of December 31, 2010
    138,766     $ 22.09       2.75  
Granted
                   
Exercised
                   
Expired
                   
Forfeited
                   
 
                     
Outstanding at June 30, 2011
    138,766     $ 22.09       2.25  
 
                     
Exercisable at June 30, 2011
    138,766     $ 22.09       2.25  
 
                     
Restricted Shares
Under the Plans, the Corporation may grant restricted shares to plan participants, subject to forfeiture upon the occurrence of certain events until the dates specified in the participant’s award agreement. While the restricted shares are subject to forfeiture, the participant may exercise full voting rights and will receive all dividends and other distributions paid with respect to the restricted shares. The restricted shares granted under the Plans are subject to graded vesting. Compensation expense is recognized over the requisite service period of four years for the entire award on a straight-line basis. Upon vesting of restricted share awards, the benefits of tax deductions in excess of recognized compensation expense is recognized as a financing cash flow activity. For the six months ended June 30, 2011, there was one restricted share award that vested on a date at which the market price was greater than the market value on the date of grant; however, the excess tax benefit was less than $1,000. For the six months ended June 30, 2010, all restricted share awards vested on a date at which the market price was lower than the market value on the date of grant; therefore no excess tax benefit is reflected in the unaudited consolidated statement of cash flows for that period.

 

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Restricted share activity for the year ended December 31, 2010 and the six months ended June 30, 2011 was as follows:
                 
            Weighted Average  
    Number of     Grant-Date  
    Restricted Shares     Fair Value  
Nonvested balance as of December 31, 2009
    70,262     $ 17.88  
Granted
    64,725       13.97  
Vested
    (33,430 )     19.28  
Forfeited
    (375 )     14.55  
 
             
Nonvested balance as of December 31, 2010
    101,182       14.93  
Granted
           
Vested
    (3,522 )     18.82  
Forfeited
           
 
             
Nonvested balance as of June 30, 2011
    97,660       14.79  
 
             
As of June 30, 2011, $969,000 of deferred compensation expense was included in additional paid-in capital in the consolidated balance sheet related to unvested restricted shares which the Corporation expects to recognize over three years. As of June 30, 2011, all restricted shares that vested were delivered. For the six months ended June 30, 2011 and 2010, share-based compensation expense included in the consolidated statements of income totaled $307,000 and $261,000, respectively.
Note 4 — Securities
The amortized cost and estimated fair value of securities available-for-sale were as follows:
                                 
    As of June 30, 2011  
            Gross     Gross        
            unrealized     unrealized     Estimated  
    Amortized cost     holding gains     holding losses     fair value  
    (In Thousands)  
Collateralized mortgage obligations — government agencies
  $ 164,009     $ 4,020     $ (12 )   $ 168,017  
Collateralized mortgage obligations — government-sponsored enterprises
    296       5             301  
 
                       
 
  $ 164,305     $ 4,025     $ (12 )   $ 168,318  
 
                       
                                 
    As of December 31, 2010  
            Gross     Gross        
            unrealized     unrealized     Estimated  
    Amortized cost     holding gains     holding losses     fair value  
    (In Thousands)  
Collateralized mortgage obligations — government agencies
  $ 149,948     $ 3,255     $ (427 )   $ 152,776  
Collateralized mortgage obligations — government-sponsored enterprises
    591       12             603  
 
                       
 
  $ 150,539     $ 3,267     $ (427 )   $ 153,379  
 
                       
Collateralized mortgage obligations — government agencies represent securities guaranteed by the Government National Mortgage Association. Collateralized mortgage obligations — government-sponsored enterprises include securities guaranteed by the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association.

 

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The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at June 30, 2011 are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations without call or prepayment penalties.
                 
            Estimated  
    Amortized Cost     Fair Value  
    (In Thousands)  
 
               
Due in one year or less
  $     $  
Due in one year through five years
    558       574  
Due in five through ten years
    1,478       1,534  
Due in over ten years
    162,269       166,210  
 
           
 
  $ 164,305     $ 168,318  
 
           
The table below shows the Corporation’s gross unrealized losses and fair value of investments, aggregated by investment category and length of time that individual investments were in a continuous unrealized loss position at June 30, 2011 and December 31, 2010. At June 30, 2011 and December 31, 2010, the Corporation had five out of 141 securities and 17 out of 133 securities that were in an unrealized loss position, respectively. Such securities have not experienced credit rating downgrades however; they have primarily declined in value due to the current interest rate environment. At June 30, 2011, the Corporation did not hold any securities that had been in a continuous loss position for twelve months or greater. The Corporation also has not specifically identified securities in a loss position that it intends to sell in the near term and does not believe that it will be required to sell any such securities. It is expected that the Corporation will recover the entire amortized cost basis of each security based upon an evaluation of the present value of the expected future cash flows. Accordingly, no other than temporary impairment was recorded in the consolidated results of operations for the three and six months ended June 30, 2011 and 2010.
A summary of unrealized loss information for available-for-sale securities, categorized by security type follows:
                                                 
    As of June 30, 2011  
    Less than 12 months     12 months or longer     Total  
            Unrealized             Unrealized             Unrealized  
    Fair value     losses     Fair value     losses     Fair value     losses  
    (In Thousands)  
Collateralized mortgage obligations — government agencies
  $ 5,704     $ 12     $     $     $ 5,704     $ 12  
 
                                   
 
  $ 5,704     $ 12     $     $     $ 5,704     $ 12  
 
                                   
                                                 
    As of December 31, 2010  
    Less than 12 months     12 months or longer     Total  
            Unrealized             Unrealized             Unrealized  
    Fair value     losses     Fair value     losses     Fair value     losses  
    (In Thousands)  
Collateralized mortgage obligations — government agencies
  $ 31,862     $ 427     $     $     $ 31,862     $ 427  
 
                                   
 
  $ 31,862     $ 427     $     $     $ 31,862     $ 427  
 
                                   

 

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There were no sales of securities available for sale in the three and six month periods ended June 30, 2011 and 2010.
At June 30, 2011 and December 31, 2010, securities with a fair value of $25.6 million and $30.8 million, respectively, were pledged to secure interest rate swap contracts and outstanding Federal Home Loan Bank (FHLB) advances. Securities pledged also provide for future availability for additional advances from the FHLB.
Note 5 —   Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses
Loan and lease receivables consist of the following:
                 
    June 30,     December 31,  
    2011     2010  
    (In Thousands)  
Commercial real estate loans
               
Commercial real estate — owner occupied
  $ 158,191     $ 152,560  
Commercial real estate — non-owner occupied
    304,733       307,307  
Construction and land development
    56,157       61,645  
Multi-family
    46,073       43,012  
1-4 family
    49,516       53,849  
 
           
Total commercial real estate loans
    614,670       618,373  
 
           
 
               
Commercial and industrial loans
    212,326       225,921  
 
               
Direct financing leases, net
    15,958       19,288  
 
               
Consumer and other
               
Home equity loans and second mortgage loans
    5,376       5,091  
Consumer and other
    13,049       9,315  
 
           
 
    18,425       14,406  
 
           
 
               
Total gross loans and lease receivables
    861,379       877,988  
Less:
               
Allowance for loan and lease losses
    15,937       16,271  
Deferred loan fees
    685       782  
 
           
Loans and lease receivables, net
  $ 844,757     $ 860,935  
 
           
The total principal amount of loans transferred to third parties, which consisted solely of participation interests in originated loans, during the three months ended June 30, 2011 and 2010 was $8.6 million and $8.1 million, respectively. For the six months ended June 30, 2011 and 2010, $10.1 million and $11.1 million of loans were transferred to third parties. Each of the transfers of these financial assets met the qualifications for sale accounting and therefore $8.6 million and $10.1 million for the three and six months ended June 30, 2011 and the $8.1 million and $11.1 million for the three and six months ended June 30, 2010 has been derecognized in the unaudited consolidated financial statements. The Corporation has a continuing involvement in each of the agreements by way of relationship management and servicing the loans; however, there are no further obligations required of the Corporation in the event of default, other than standard representations and warranties related to sold amounts. The loans were transferred at their fair value and no gain or loss was recognized upon the transfer as the participation interest was transferred at or near the date of loan origination. There were no other significant purchases or sales of loan and lease receivables or transfers to loans held for sale during the three and six months ended June 30, 2011 and 2010.

 

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The total amount of outstanding loans transferred to third parties as loan participations at June 30, 2011 and December 31, 2010 was $61.2 million and $56.0 million, respectively, all of which were treated as a sale and derecognized under the applicable accounting guidance in effect at the time of the transfers of the financial assets. The Corporation continues to have involvement with these loans by way of partial ownership, relationship management and all servicing responsibilities. As of June 30, 2011 and December 31, 2010, the total amount of loan participations remaining on the Corporation’s balance sheet was $64.7 million and $68.1 million, respectively. As of June 30, 2011 and December 31, 2010, $3.5 million and $3.6 million of the loans in this participation sold portfolio were considered impaired, respectively. In 2010 and 2011, the Corporation recognized a total $1.7 million charge-off associated with specific credits within the retained portion of this portfolio of loans and is measured by the Corporation’s allowance for loan and lease loss measurement process and policies. The Corporation does not share in the participant’s portion of the charge-offs.
The following information illustrates ending balances of the Corporation’s loan and lease portfolio, including impaired loans by class of receivable, and considering certain credit quality indicators as of June 30, 2011 and December 31, 2010:
                                         
    Category        
As of June 30, 2011   I     II     III     IV     Total  
    (Dollars in Thousands)  
Commercial real estate:
                                       
Commercial real estate — owner occupied
  $ 124,150     $ 13,438     $ 14,481     $ 6,122     $ 158,191  
Commercial real estate — non-owner occupied
    232,477       35,167       31,219       5,870       304,733  
Construction and land development
    35,766       6,167       6,219       8,005       56,157  
Multi-family
    34,705       7,028       812       3,528       46,073  
1-4 family
    25,656       14,651       5,424       3,785       49,516  
 
                                       
Commercial and industrial
    171,545       23,287       13,011       4,483       212,326  
 
                                       
Direct financing leases, net
    10,741       4,984       201       32       15,958  
 
                                       
Consumer and other:
                                       
Home equity and second mortgages
    3,799       217       258       1,102       5,376  
Other
    11,197       155             1,697       13,049  
 
                             
 
                                       
Total portfolio
  $ 650,036     $ 105,094     $ 71,625     $ 34,624     $ 861,379  
 
                             
 
                                       
Rating as a % of total portfolio
    75.46 %     12.20 %     8.32 %     4.02 %     100.00 %

 

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    Category        
As of December 31, 2010   I     II     III     IV     Total  
    (Dollars in Thousands)  
Commercial real estate:
                                       
Commercial real estate — owner occupied
  $ 113,002     $ 25,777     $ 6,780     $ 7,001     $ 152,560  
Commercial real estate — non-owner occupied
    232,868       36,128       33,167       5,144       307,307  
Construction and land development
    39,662       7,838       4,870       9,275       61,645  
Multi-family
    31,472       6,049       1,305       4,186       43,012  
1-4 family
    33,310       11,973       4,329       4,237       53,849  
 
                                       
Commercial and industrial
    183,051       24,460       11,974       6,436       225,921  
 
                                       
Direct financing leases, net
    12,666       6,403       219             19,288  
 
                                       
Consumer and other:
                                       
Home equity and second mortgages
    3,726       134       292       939       5,091  
Other
    7,359       50             1,906       9,315  
 
                             
 
                                       
Total portfolio
  $ 657,116     $ 118,812     $ 62,936     $ 39,124     $ 877,988  
 
                             
 
                                       
Rating as a % of total portfolio
    74.84 %     13.53 %     7.17 %     4.46 %     100.00 %
Credit underwriting through a committee process is a key component of the Corporation’s operating philosophy. Business development officers have relatively low individual lending authority limits, therefore requiring that a significant portion of the Corporation’s new credit extensions be approved through various committees depending on the type of loan or lease, amount of the credit, and the related complexities of each proposal. In addition, the Corporation makes every effort to ensure that there is appropriate collateral at the time of origination to protect the Corporation’s interest in the related loan or lease.
Each credit is evaluated for proper risk rating upon origination, at the time of each subsequent renewal, upon evaluation of updated financial information from our borrowers, or as other circumstances dictate. The Corporation uses a nine grade risk rating system to monitor the ongoing credit quality of its loans and leases. The risk rating grades follow a consistent definition, but are then applied to specific loan types based on the nature of the loan. Each risk rating is subjective and depending on the size and nature of the credit subject to various levels of review and concurrence on the stated risk rating. Depending on the type of loan and related risk rating, the Corporation groups loans into four categories, which determine the level and nature of review by management.
Category I — Loans and leases in this category are performing in accordance with the terms of the contract and generally exhibit no immediate concerns regarding the security and viability of the underlying collateral of the debt, financial stability of the borrower, integrity or strength of the borrower’s management team or the business industry in which the borrower operates. Loans and leases in this category are not subject to additional monitoring procedures above and beyond what is required at the origination of the loan or lease. The Corporation monitors Category I loans and leases through payment performance along with personal relationships with our borrowers and monitoring of financial results and compliance per the terms of the agreement.
Category II — Loans and leases in this category are beginning to show signs of deterioration in one or more of the Corporation’s core underwriting criteria such as financial stability, management strength, industry trends and collateral values. Management will place credits in this category to allow for proactive monitoring and resolution with the borrower to possibly mitigate the area of concern and prevent further deterioration or risk of loss to the Corporation. Category II loans are monitored frequently by the assigned business development officer and by a subcommittee of the Banks’ loan committees and are considered performing.

 

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Category III — Loans and leases in this category may be classified by the Banks’ Regulators or identified by the Corporation’s business development officers and senior management as warranting special attention. Category III loans and leases generally exhibit undesirable characteristics such as evidence of adverse financial trends and conditions, managerial problems, deteriorating economic conditions within the related industry, or evidence of adverse public filings and may exhibit collateral shortfall positions. Management continues to believe that it will collect all required principal and interest in accordance with the original terms of the contract and therefore Category III loans are considered performing and no specific reserves are established for this category. Management, loan committees of the Banks, as well as Banks’ Board of Directors monitor loans and leases in this category on a monthly basis.
Category IV — Management considers loans and leases in this category to be impaired. Impaired loans and leases were placed on non-accrual as management has determined that it is unlikely that the Banks will receive the required principal and interest in accordance with the contractual terms of the contract. Impaired loans are individually evaluated to assess the need for the establishment of specific reserves or charge-offs. When analyzing the adequacy of collateral, the Corporation obtains external appraisals at least annually for impaired loans and leases. External appraisals are obtained from the Corporation’s approved appraiser listing and are independently reviewed to monitor the quality of such appraisals. To the extent a collateral shortfall position is present, a specific reserve or charge-off will be recorded to reflect the magnitude of the impairment. Management, loan committees of the Banks, as well as Banks’ Board of Directors monitor loans and leases in this category on a monthly basis.

 

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The delinquency aging of the loan and lease portfolio by class of receivable as of June 30, 2011 and December 31, 2010 were as follows:
                                                 
                    Greater                      
    30-59     60-89     than 90                      
    days past     days past     days past     Total             Total  
As of June 30, 2011   due     due     due     past due     Current     loans  
    (Dollars In Thousands)  
Accruing loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $     $     $ 152,069     $ 152,069  
Non-owner occupied
    171                   171       298,692       298,863  
Construction and land development
                            48,152       48,152  
Multi-family
                            42,545       42,545  
1-4 family
                            45,731       45,731  
Commercial & Industrial
    192                   192       207,651       207,843  
Direct financing leases, net
    161                   161       15,765       15,926  
Consumer and other:
                                               
Home equity and second mortgages
                            4,274       4,274  
Other
          7             7       11,345       11,352  
 
                                   
Total
    524       7             531       826,224       826,755  
 
                                   
 
                                               
Non-accruing loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $ 2,789     $ 2,789     $ 3,333     $ 6,122  
Non-owner occupied
                2,845       2,845       3,025       5,870  
Construction and land development
                1,275       1,275       6,730       8,005  
Multi-family
                1,665       1,665       1,863       3,528  
1-4 family
    317       61       928       1,306       2,479       3,785  
Commercial & Industrial
                410       410       4,073       4,483  
Direct financing leases, net
                            32       32  
Consumer and other:
                                               
Home equity and second mortgages
          173       231       404       698       1,102  
Other
                1,688       1,688       9       1,697  
 
                                   
Total
    317       234       11,831       12,382       22,242       34,624  
 
                                   
 
                                               
Total loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $ 2,789     $ 2,789     $ 155,402     $ 158,191  
Non-owner occupied
    171             2,845       3,016       301,717       304,733  
Construction and land development
                1,274       1,274       54,883       56,157  
Multi-family
                1,665       1,665       44,408       46,073  
1-4 family
    317       61       928       1,306       48,210       49,516  
Commercial & Industrial
    192             410       602       211,724       212,326  
Direct financing leases, net
    161                   161       15,797       15,958  
Consumer and other:
                                               
Home equity and second mortgages
          173       231       404       4,972       5,376  
Other
          7       1,689       1,696       11,353       13,049  
 
                                   
Total
  $ 841   $ 241     $ 11,831     $ 12,913     $ 848,466     $ 861,379  
 
                                   
Percent of portfolio
    0.10 %     0.03 %     1.37 %     1.50 %     98.50 %     100.00 %
 
                                   

 

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                    Greater                      
    30-59     60-89     than 90                      
    days past     days past     days past     Total             Total  
As of December 31, 2010   due     due     due     past due     Current     loans  
    (Dollars In Thousands)  
Accruing loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $     $     $ 146,277     $ 146,227  
Non-owner occupied
          448             448       301,715       302,163  
Construction and land development
          1             1       52,369       52,370  
Multi-family
                            38,826       38,826  
1-4 family
    603                   603       49,009       49,612  
Commercial & Industrial
    58       1,304       1,236       2,598       216,887       219,485  
Direct financing leases, net
                            19,288       19,288  
Consumer and other:
                                               
Home equity and second mortgages
                            4,152       4,152  
Other
    4             9       13       7,396       7,409  
 
                                   
Total
    665       1,753       1,245       3,663       835,919       839,582  
 
                                   
 
                                               
Non-accruing loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $ 2,949     $ 2,949     $ 3,334     $ 6,283  
Non-owner occupied
                2,222       2,222       2,922       5,144  
Construction and land development
    850       420       1,136       2,406       6,869       9,275  
Multi-family
                1,041       1,041       3,145       4,186  
1-4 family
    75             1,900       1,975       2,262       4,237  
Commercial & Industrial
    122             466       588       5,848       6,436  
Direct financing leases, net
                                   
Consumer and other:
                                               
Home equity and second mortgages
                257       257       682       939  
Other
                1,848       1,848       58       1,906  
 
                                   
Total
    1,047       420       11,819       13,286       25,120       38,406  
 
                                   
 
                                               
Total loans and leases
                                               
Commercial Real Estate:
                                               
Owner occupied
  $     $     $ 2,949     $ 2,949     $ 149,611     $ 152,560  
Non-owner occupied
          448       2,222       2,670       304,637       307,307  
Construction and land development
    850       421       1,136       2,407       59,238       61,645  
Multi-family
                1,041       1,041       41,971       43,012  
1-4 family
    678             1,900       2,578       51,271       53,849  
Commercial & Industrial
    180       1,304       1,702       3,186       222,735       225,921  
Direct financing leases, net
                            19,288       19,288  
Consumer and other:
                                               
Home equity and second mortgages
                257       257       4,834       5,091  
Other
    4             1,857       1,861       7,454       9,315  
 
                                   
Total
  $ 1,712     $ 2,173     $ 13,064     $ 16,949     $ 861,039     $ 877,988  
 
                                   
Percent of portfolio
    0.19 %     0.25 %     1.49 %     1.93 %     98.07 %     100.00 %
 
                                   
 
                                               

 

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The Corporation’s non-accrual loans and leases consisted of the following at June 30, 2011 and December 31, 2010, respectively.
                 
    June 30,     December 31,  
    2011     2010  
    (Dollars In Thousands)  
Non-accrual loans and leases
               
Commercial real estate:
               
Commercial real estate — owner occupied
  $ 6,122     $ 6,283  
Commercial real estate — non-owner occupied
    5,870       5,144  
Construction and land development
    8,005       9,275  
Multi-family
    3,528       4,186  
1-4 family
    3,785       4,237  
 
           
Total non-accrual commercial real estate
    27,310       29,125  
 
           
 
               
Commercial and industrial
    4,483       6,436  
Direct financing leases, net
    32        
 
               
Consumer and other:
               
Home equity and second mortgage
    1,102       939  
Other
    1,697       1,906  
 
           
Total non-accrual consumer and other loans
    2,799       2,845  
 
           
 
               
Total non-accrual loans and leases
    34,624       38,406  
Foreclosed properties, net
    1,400       1,750  
 
           
Total non-performing assets
  $ 36,024     $ 40,156  
 
           
Performing troubled debt restructurings
  $     $ 718  
 
           
                 
    June 30,     December 31  
    2011     2010  
 
               
Total non-accrual loans and leases to gross loans and leases
    4.02 %     4.37 %
Total non-performing assets to total assets
    3.29       3.63  
Allowance for loan and lease losses to gross loans and leases
    1.85       1.85  
Allowance for loan and lease losses to non-accrual loans and leases
    46.03       42.37  
As of June 30, 2011 and December 31, 2010, $16.9 million and $18.7 million of the impaired loans were considered troubled debt restructurings, respectively. As of June 30, 2011, there were no unfunded commitments associated with troubled debt restructured loans and leases.

 

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The following represents additional information regarding the Corporation’s impaired loans and leases by class:
                                                         
    Impaired Loans and Leases  
    As of and for the Six Months Ended June 30, 2011  
                            Average                     Net  
            Unpaid             recorded     Foregone     Interest     Foregone  
    Recorded     principal     Impairment     investment     interest     income     Interest  
    investment     balance     reserve     (1)     income     recognized     Income  
    (In Thousands)  
With no impairment reserve recorded:
                                                       
Commercial real estate:
                                                       
Owner occupied
  $ 4,638     $ 5,836     $     $ 5,240     $ 277     $ 105     $ 172  
Non-owner occupied
    3,115       3,791             2,785       130             130  
Construction and land development
    2,231       3,074             2,795       132       48       84  
Multi-family
    1,665       2,221             2,366       181             181  
1-4 family
    2,563       3,271             2,920       143       62       81  
Commercial and industrial
    2,339       2,898             3,770       161       308       (147 )
Direct financing leases, net
                                         
Consumer and other:
                                                       
Home equity loans and second mortgages
    467       467             530       17             17  
Other
    1,688       1,928             1,870       74       5       69  
 
                                         
Total
    18,706       23,486             22,276       1,115       528       587  
 
                                         
With impairment reserve recorded:
                                                       
Commercial real estate:
                                                       
Owner occupied
  $ 1,484     $ 1,484     $ 58     $ 1,143     $ 63     $     $ 63  
Non-owner occupied
    2,755       2,755       812       2,770       73             73  
Construction and land development
    5,774       7,953       308       6,444       97             97  
Multi-family
    1,863       1,863       409       1,888       59             59  
1-4 family
    1,222       1,222       475       1,150       33             33  
Commercial and industrial
    2,144       2,144       746       1,827       70             70  
Direct financing leases, net
    32       32       32                          
Consumer and other:
                                                       
Home equity loans and second mortgages
    635       658       159       590       25             25  
Other
    9       9       10       5                    
 
                                         
Total
    15,918       18,120       3,009       15,817       420             420  
 
                                         
Total:
                                                       
Commercial real estate:
                                                       
Owner occupied
  $ 6,122     $ 7,320     $ 58     $ 6,383     $ 340     $ 105     $ 235  
Non-owner occupied
    5,870       6,546       812       5,555       203             203  
Construction and land development
    8,005       11,027       308       9,239       229       48       181  
Multi-family
    3,528       4,084       409       4,254       240             240  
1-4 family
    3,785       4,493       475       4,070       176       62       114  
Commercial and industrial
    4,483       5,042       746       5,597       231       308       (77 )
Direct financing leases, net
    32       32       32                          
Consumer and other:
                                                       
Home equity loans and second mortgages
    1,102       1,125       159       1,120       42             42  
Other
    1,697       1,937       10       1,875       74       5       69  
 
                                         
Grand total
  $ 34,624     $ 41,606     $ 3,009     $ 38,093     $ 1,535     $ 528     $ 1,007  
 
                                         
     
(1)   Average recorded investment is calculated primarily using daily average balances.
The difference between the loans and leases recorded investment and the unpaid principal balance of $6.9 million represents partial charge-offs resulting from confirmed losses due to the value of the collateral securing the loans and leases being below the carrying values of the loans and leases. As of December 31, 2010, the Corporation had $19.7 million of impaired loans and leases that did not require an impairment reserve, and $19.4 million of impaired loans and leases that did require a specific reserve of $3.5 million. Average total impaired loans and leases was $29.7 million for the year ended December 31, 2010. When a loan is placed on non-accrual, interest accruals are discontinued and previously accrued but uncollected interest is deducted from interest income. Cash payments collected on non-accrual loans are first applied to principal. Foregone interest represents the interest that was contractually due on the note. To the extent the amount of principal on a non-accrual note is fully collected and additional cash is received, the Corporation will recognize interest income. Foregone interest for the six months ended June 30, 2011 was $1.5 million with $528,000 of interest income recognized on previously identified fully collected non-accrual loans and leases. For the six months ended June 30, 2010, net foregone interest was $1.1 million.

 

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To determine the level and composition of the allowance for loan and lease losses, the Corporation breaks out the portfolio by segments and risk ratings. First, the Corporation evaluates loans and leases for potential impairment classification. If a loan or lease is determined to be impaired, then the Corporation analyzes the impaired loans and leases on an individual basis to determine a specific reserve based upon the estimated value of the underlying collateral for collateral-dependent loans, or alternatively, the present value of expected cash flows. The Corporation applies historical trends of the previously identified factors to each category of loans and leases that has not been individually evaluated for the purpose of establishing the general portion of the allowance.
A summary of the activity in the allowance for loan and lease losses by portfolio segment is as follows:
                                         
    As of and for the Six Months Ended June 30, 2011  
            Commercial             Direct        
    Commercial     and     Consumer     Financing        
    real estate     industrial     and other     Lease, Net     Total  
    (Dollars in Thousands)  
Allowance for credit losses:
                                       
Beginning balance
  $ 11,267     $ 4,277     $ 482     $ 245     $ 16,271  
Charge-offs
    (3,538 )     (198 )     (148 )           (3,884 )
Recoveries
    216       376       61       19       672  
Provision
    3,111       (274 )     63       (22 )     2,878  
 
                             
Ending Balance
  $ 11,056     $ 4,181     $ 458     $ 242     $ 15,937  
 
                             
 
Ending balance: individually evaluated for impairment
  $ 2,099     $ 757     $ 121     $ 32     $ 3,009  
 
                             
Ending balance: collectively evaluated for impairment
  $ 8,957     $ 3,424     $ 337     $ 210     $ 12,928  
 
                             
Ending balance: loans acquired with deteriorated credit quality
  $     $     $     $     $  
 
                             
 
                                       
Loans and lease receivables:
                                       
Ending balance, gross
  $ 614,670     $ 212,326     $ 18,425     $ 15,958     $ 861,379  
 
                             
Ending balance: individually evaluated for impairment
  $ 27,310     $ 4,483     $ 2,799     $ 32     $ 34,624  
 
                             
Ending balance: collectively evaluated for impairment
  $ 587,360     $ 207,843     $ 15,626     $ 15,926     $ 826,755  
 
                             
Ending balance: loans acquired with deteriorated credit quality
  $     $     $     $     $  
 
                             
 
Allowance as % of gross loans
    1.80 %     1.97 %     2.49 %     1.52 %     1.85 %

 

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Note 6 — Deposits
Deposits consisted of the following:
                                                 
    June 30, 2011     December 31, 2010  
            Weighted     Weighted             Weighted     Weighted  
            average     average             average     average  
    Balance     balance     rate     Balance     balance     rate  
    (Dollars In Thousands)  
Transaction accounts:
                                               
Demand deposits
  $ 109,356     $ 104,718       %   $ 88,529     $ 68,430       %
NOW accounts
    25,975       28,225       0.27       44,428       74,784       0.35  
 
                                       
Total transaction accounts:
    135,331       132,943               132,957       143,214          
Money market accounts
    265,007       287,022       0.98       276,748       258,569       1.08  
Certificates of deposit
    80,432       81,958       1.42       79,491       84,828       2.03  
Brokered certificates of deposit
    496,718       493,526       2.83       499,102       480,709       3.32  
 
                                       
Total deposits
  $ 977,488     $ 995,449             $ 988,298     $ 967,320          
 
                                       
Note 7 — FHLB Advances, Other Borrowings and Junior Subordinated Notes Payable
The composition of borrowed funds at June 30, 2011 and December 31, 2010 was as follows:
                                                 
    June 30, 2011     December 31, 2010  
            Weighted     Weighted             Weighted     Weighted  
            average     average             average     average  
    Balance     balance     rate     Balance     balance     rate  
    (Dollars In Thousands)  
Federal funds purchased
  $     $ 255       0.85 %   $     $       %
FHLB advances
    488       822       5.65       2,494       13,414       4.78  
Line of credit
    10       4,414       4.02       10       10       4.06  
Subordinated notes payable
    39,000       39,000       5.76       39,000       39,000       5.55  
Junior subordinated notes
    10,315       10,315       10.70       10,315       10,315       10.78  
 
                                       
 
  $ 49,813     $ 54,806       6.54     $ 51,819     $ 62,739       6.26  
 
                                       
 
                                               
Short-term borrowings
  $ 10                     $ 2,010                  
Long-term borrowings
    49,803                       49,809                  
 
                                           
 
  $ 49,813                     $ 51,819                  
 
                                           
As of June 30, 2011, the Corporation was in compliance with its debt covenants under its senior line of credit. The Corporation pays an unused line fee on its secured senior line of credit. For both six-month periods ended June 30, 2011 and 2010, the Corporation incurred unused line fee interest expense of $4,000.
In June 2011, the Corporation renewed $31.0 million of its subordinated debt. This debt has a maturity of August 30, 2016 and bears an interest rate of LIBOR plus 4.75% with an interest rate floor of 6.00%.

 

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Note 8 — Income Taxes
Like many financial institutions located in Wisconsin, FBB established a Nevada subsidiary for the purpose of investing and managing the Bank’s investment portfolio and purchasing a portion of FBB’s loans. FBCC established a Nevada subsidiary for the purpose of purchasing FBCC’s loans. The Nevada investment subsidiaries now hold and manage these assets. The investment subsidiaries have not filed returns with, or paid income or franchise taxes to the State of Wisconsin. The Wisconsin Department of Revenue (the “Department”) implemented a program to audit Wisconsin financial institutions which formed investment subsidiaries located outside of Wisconsin, and the Department has generally indicated that it intends to assess income or franchise taxes on the income of the out-of-state investment subsidiaries of Wisconsin financial institutions. Prior to the formation of the investment subsidiaries the Bank sought and obtained private letter rulings from the Department regarding the non-taxability of the investment subsidiaries in the State of Wisconsin. The Bank believes that it complied with Wisconsin law and the private rulings received from the Department. In April 2011, the Department issued an assessment to FBB and FBCC. In June 2011, FBB, FBCC and the Department entered into a settlement agreement, the terms of which are subject to confidentiality clauses. However, the settlement of this matter with the Department did not result in a liability materially different than that which had been previously accrued in the consolidated results and financial position.
A summary of all of the Corporation’s uncertain tax positions, excluding interest accruals associated with uncertain tax positions are as follows:
                 
    Year Ended December 31,  
    For the six months     Year Ended  
    ended June 30, 2011     December 31, 2010  
    (In Thousands)  
Unrecognized tax benefits at beginning of year
  $ 2,432     $ 2,428  
Additions based on tax positions related to current year
          4  
Reductions for tax positions related to current year
    (5 )     (7 )
Additions for tax positions of prior years
          8  
Reductions for tax positions of prior years
          (1 )
Settlements
    (2,417 )      
 
           
Unrecognized tax benefits at end of year
  $ 10     $ 2,432  
 
           
As of June 30, 2011, State of Wisconsin tax years that remain open to audit are 2009 and 2010. Federal tax years that remain open are 2006 through 2009. As of June 30, 2011, there were no unrecognized tax benefits that are expected to significantly increase or decrease within the next twelve months.
On June 26, 2011, the State of Wisconsin 2011-2013 Budget Bill, Assembly Bill 40, was signed into law. The bill provides that, starting with the first taxable year beginning after December 31, 2011, and thereafter for the next 19 years, a combined group member that has pre-2009 net business loss carryforwards can, after first using such net business loss carryforwards to offset its own income for the taxable year and after using shared losses, use up to five percent of the pre-2009 net business loss carryforwards to offset the Wisconsin income of other group members on a proportionate basis to the extent the income is attributable to the group’s unitary business. If the five percent cannot fully be used, the remainder can be added to the portion that may offset the Wisconsin income of all other combined group members in a subsequent year, until it is completely used or expired.
The Corporation had state net operating losses of $14.4 million and $38.8 million and related deferred tax assets of $755,000 and $2.0 million, as of June 30, 2011 and December 31, 2010, respectively. The valuation allowance associated with these deferred tax assets was $13,000 and $1.2 million as of June 30, 2011 and December 31, 2010, respectively. As of June 30, 2011, management believes it is more likely than not that the net deferred tax assets, in excess of valuation allowance, will be fully realizable.

 

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Note 9 — Fair Value Disclosures
The Corporation determines the fair market values of its financial instruments based on the fair value hierarchy established in ASC Topic 820, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Fair value is defined as the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date and is based on exit prices. Fair value includes assumptions about risk such as nonperformance risk in liability fair values and is a market-based measurement, not an entity-specific measurement. The standard describes three levels of inputs that may be used to measure fair value.
    Level 1 — Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date.
    Level 2 — Level 2 inputs are inputs other than quoted prices included with Level 1 that are observable for the asset or liability either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
    Level 3— Level 3 inputs are inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Corporation’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
Assets and liabilities measured at fair value on a recurring basis, segregated by fair value hierarchy level, are summarized below:
                                 
    Fair Value Measurements Using        
    Level 1     Level 2     Level 3     Total  
    (In Thousands)  
June 30, 2011
                               
Assets:
                               
Collateralized mortgage obligations — government agencies
  $     $ 168,017     $     $ 168,017  
Collateralized mortgage obligations — government sponsored enterprises
          301             301  
Interest rate swaps
          2,862             2,862  
 
                               
Liabilities:
                               
Interest rate swaps
  $     $ 2,862     $     $ 2,862  
                                 
    Fair Value Measurements Using        
    Level 1     Level 2     Level 3     Total  
    (In Thousands)  
December 31, 2010
                               
Assets:
                               
Collateralized mortgage obligations — government agencies
  $     $ 152,776     $     $ 152,776  
Collateralized mortgage obligations — government sponsored enterprises
          603             603  
Interest rate swaps
          2,841             2,841  
 
                               
Liabilities:
                               
Interest rate swaps
  $     $ 2,841     $     $ 2,841  
There were no transfers in or out of Level 1 or 2 during the six months ended June 30, 2011 or the year ended December 31, 2010.

 

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Assets and liabilities measured at fair value on a non-recurring basis, segregated by fair value hierarchy are summarized below:
                                         
            As of and for the Six Months Ended June 30, 2011  
                                    Total  
    Balance at     Fair Value Measurements Using     Gains  
    June 30, 2011     Level 1     Level 2     Level 3     (Losses)  
    (In Thousands)  
 
                                       
Impaired loans
  $ 21,374     $     $ 18,852     $ 2,522     $  
Foreclosed properties
    1,400             1,337       63       (167 )
                                         
            As of and for the year ended December 31, 2010  
                                    Total  
    Balance at     Fair Value Measurements Using     Gains  
    December 31, 2010     Level 1     Level 2     Level 3     (Losses)  
    (In Thousands)  
 
                                       
Impaired loans
  $ 22,241     $     $ 18,112     $ 4,129     $  
Foreclosed properties
    1,750             1,660       90       (326 )
Goodwill
                            (2,689 )
Impaired loans that are collateral dependent were written down to their fair value of $21.4 million and $22.2 million at June 30, 2011 and December 31, 2010, respectively, through the establishment of specific reserves or by recording charge-offs when the carrying value exceeded the fair value. Valuation techniques consistent with the market approach, income approach, or cost approach were used to measure fair value and primarily included observable inputs for the individual impaired loans being evaluated such as recent sales of similar assets or observable market data for operational or carrying costs. In cases where such inputs were unobservable, the loan balance is reflected within Level 3 of the hierarchy.
Certain non-financial assets subject to measurement at fair value on a non-recurring basis included foreclosed properties. Foreclosed properties, upon initial recognition, are re-measured and reported at fair value through a charge-off to the allowance for loan and lease losses, if deemed necessary, based upon the fair value of the foreclosed property. The fair value of a foreclosed property, upon initial recognition, is estimated using Level 2 inputs based on observable market data, typically an appraisal, or Level 3 inputs based upon assumptions specific to the individual property or equipment. Subsequent impairments of foreclosed properties are recorded as a loss on foreclosed properties. During the six months ended June 30, 2011, $1.1 million of outstanding loans were transferred to foreclosed properties as the Corporation claimed title to the respective assets. During the six months ended June 30, 2011, the Corporation completed an evaluation of certain of its foreclosed assets. Based upon the evaluation and the results of the impairment calculation, we recognized impairment losses of $167,000 on foreclosed properties for the six months ended June 30, 2011. At June 30, 2011 and December 31, 2010, foreclosed properties, at fair value, were $1.4 million and $1.8 million, respectively.

 

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Fair Value of Financial Instruments
The Corporation is required to disclose estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions, consistent with exit price concepts for fair value measurements, are set forth below:
                                 
    June 30, 2011     December 31, 2010  
    Carrying             Carrying        
    Amount     Fair Value     Amount     Fair Value  
    (In Thousands)  
Financial assets:
                               
Cash and cash equivalents
  $ 42,875     $ 42,875     $ 50,819     $ 50,819  
Securities available-for-sale
    168,318       168,318       153,379       153,379  
Loans and lease receivables, net
    845,538       841,155       860,935       852,790  
Federal Home Loan Bank stock
    2,367       2,367       2,367       2,367  
Cash surrender value of life insurance
    17,293       17,293       16,950       16,950  
Accrued interest receivable
    3,191       3,191       3,405       3,405  
Interest rate swaps
    2,862       2,862       2,841       2,841  
 
                               
Financial liabilities:
                               
Deposits
  $ 977,488     $ 991,227     $ 988,298     $ 998,713  
Federal Home Loan Bank and other borrowings
    39,498       41,756       41,504       41,567  
Junior subordinated notes
    10,315       7,061       10,315       7,224  
Interest rate swaps
    2,862       2,862       2,841       2,841  
Accrued interest payable
    3,232       3,232       3,643       3,643  
 
                               
Off balance sheet items:
                               
Standby letters of credit
    20       20       41       41  
Commitments to extend credit
          *             *  
     
*   Not meaningful
Disclosure of fair value information about financial instruments, for which it is practicable to estimate that value, is required whether or not recognized in the consolidated balance sheets. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from the disclosure requirements. Accordingly, the aggregate fair value amounts presented do not necessarily represent the underlying value of the Corporation.
The carrying amounts reported for cash and cash equivalents, interest bearing deposits, accrued interest receivable and accrued interest payable approximate fair value because of their short-term nature and because they do not present unanticipated credit concerns.
Securities: The fair value measurements of investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, trade execution data, market consensus prepayment speeds, credit information and the securities’ terms and conditions, among other things.

 

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Loans and Leases: The fair value estimation process for the loan portfolio uses an exit price concept and reflects discounts the Corporation believes are consistent with liquidity discounts in the market place. Fair values are estimated for portfolios of loans with similar financial characteristics. The fair value of performing and nonperforming loans is calculated by discounting scheduled and expected cash flows through the estimated maturity using estimated market rates that reflect the credit and interest rate risk inherent in the portfolio of loans and then applying a discount factor based upon the embedded credit risk of the loan and the fair value of collateral securing nonperforming loans when the loan is collateral dependent. The estimate of maturity is based on the Banks’ historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.
Federal Home Loan Bank Stock: The carrying amount of FHLB stock equals its fair value because the shares may be redeemed by the FHLB at their carrying amount of $100 per share amount.
Cash Surrender Value of Life Insurance: The carrying amount of the cash surrender value of life insurance approximates its fair value as the carrying value represents the current settlement amount.
Deposits: The fair value of deposits with no stated maturity, such as demand deposits and money market accounts, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates do not include the intangible value that results from the funding provided by deposit liabilities compared to borrowing funds in the market.
Borrowed Funds: Market rates currently available to the Corporation and Banks for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.
Financial Instruments with Off-Balance Sheet Risks: The fair value of the Corporation’s off-balance sheet instruments is based on quoted market prices and fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the credit standing of the related counterparty. Commitments to extend credit and standby letters of credit are generally not marketable. Furthermore, interest rates on any amounts drawn under such commitments would generally be established at market rates at the time of the draw. Fair value would principally derive from the present value of fees received for those products.
Interest Rate Swaps: The carrying amount and fair value of existing derivative financial instruments are based upon independent valuation models, which use widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative contract. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The Corporation incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Corporation has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.
Limitations: Fair value estimates are made at a discrete point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holding of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and were not considered in the estimates.

 

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Note 10 — Derivative Financial Instruments
The Corporation offers interest rate swap products directly to qualified commercial borrowers. The Corporation economically hedges client derivative transactions by entering into offsetting interest rate swap contracts executed with a third party. Derivative transactions executed as part of this program are not designated as accounting hedge relationships and are marked-to-market through earnings each period. The derivative contracts have mirror-image terms, which results in the positions’ changes in fair value primarily offsetting through earnings each period. The credit risk and risk of non-performance embedded in the fair value calculations is different between the dealer counterparties and the commercial borrowers which may result in a difference in the changes in the fair value of the mirror image swaps. The Corporation incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the counterparty’s risk in the fair value measurements. When evaluating the fair value of its derivative contracts for the effects of non-performance and credit risk, the Corporation considered the impact of netting and any applicable credit enhancements such as collateral postings, thresholds and guarantees.
At June 30, 2011, the aggregate amortizing notional value of interest rate swaps with various commercial borrowers was $50.1 million. The Corporation receives fixed rates and pays floating rates based upon LIBOR on the swaps with commercial borrowers. The aggregate amortizing notional value of interest rate swaps with dealer counterparties was also $50.1 million. The Corporation pays fixed rates and receives floating rates based upon LIBOR on the swaps with dealer counterparties. These interest rate swaps mature in 2013 through 2019. The commercial borrower swaps were reported on the Corporation’s balance sheet as a derivative asset of $2.9 million and were included in accrued interest receivable and other assets. Dealer counterparty swaps were reported on the Corporation’s balance sheet as a net derivative liability of $2.9 million due to master netting and settlement contracts with dealer counterparties and were included in accrued interest payable and other liabilities as of June 30, 2011.
The table below provides information about the location and fair value of the Corporation’s derivative instruments as of June 30, 2011 and December 31, 2010.
                         
    Interest Rate Swap Contracts  
    Asset Derivatives     Liability Derivatives  
    Balance Sheet           Balance Sheet      
    Location   Fair Value     Location   Fair Value  
    (In Thousands)  
 
                       
Derivatives not designated as hedging instruments
                       
June 30, 2011
  Other assets   $ 2,862     Other liabilities   $ 2,862  
December 31, 2010
  Other assets   $ 2,841     Other liabilities   $ 2,841  
No derivative instruments held by the Corporation for the six months ended June 30, 2011 were considered hedging instruments. All changes in the fair value of these instruments are recorded in other non-interest income. Given the mirror-image terms of the outstanding derivative portfolio the change in fair value for the six months ended June 30, 2011 and 2010 had no net impact to the unaudited consolidated income statement.
Note 11 — Regulatory Capital
The Corporation and the Banks are subject to various regulatory capital requirements administered by Federal and State of Wisconsin banking agencies. Failure to meet minimum capital requirements can result in certain mandatory, and possibly additional discretionary actions on the part of regulators, that if undertaken, could have a direct material effect on the Banks’ assets, liabilities and certain off-balance sheet items as calculated under regulatory practices. The Corporation’s and the Banks’ capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. The Corporation is in the process of updating its Capital and Liquidity Action Plan (the “Plan”), which will be designed to help ensure appropriate capital adequacy, to plan for future capital needs and to ensure that the Corporation serves as a source of financial strength to the Banks. The Corporation’s and the Banks’ Board of Directors and management will work in concert with the appropriate regulatory bodies on decisions which affect their capital position, including but not limited to, decisions relating to the payment of dividends and increasing indebtedness.

 

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As a bank holding company, the Corporation’s ability to pay dividends is affected by the policies and enforcement powers of the Federal Reserve. Federal Reserve guidance urges companies to strongly consider eliminating, deferring or significantly reducing dividends if: (i) net income available to common shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividend; (ii) the prospective rate of earnings retention is not consistent with the bank holding company’s capital needs and overall current prospective financial condition; or (iii) the bank holding company will not meet, or is in danger of not meeting, its minimum regulatory capital ratios. Therefore, management intends to consult with the Federal Reserve Bank of Chicago and provide them with information on the Corporation’s then-current and prospective earnings and capital position, on a quarterly basis, in advance of declaring any cash dividends.
The Banks are also subject to certain legal, regulatory and other restrictions on their ability to pay dividends to the Corporation. As a bank holding company, the payment of dividends by the Banks to the Corporation is one of the sources of funds by which the Corporation could use to pay dividends, if any, in the future and to make other payments. Future dividend decisions by the Banks and the Corporation will continue to be subject to compliance with these various legal, regulatory and other restrictions as defined from time to time.
Qualitative measures established by regulation to ensure capital adequacy require the Corporation and the Banks to maintain minimum amounts and ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Tier 1 capital generally consists of stockholders’ equity plus certain qualifying debentures and other specified items less intangible assets such as goodwill. Risk-based capital requirements presently address credit risk related to both recorded and off-balance sheet commitments and obligations. Management believes, as of June 30, 2011, that the Corporation and the Banks met all applicable capital adequacy requirements.
As of June 30, 2011, the most recent notification from the Federal Deposit Insurance Corporation and the State of Wisconsin Department of Financial Institutions categorized the Banks as well capitalized under the regulatory framework for prompt corrective action. In addition, the Banks exceeded the minimum net worth requirement of 6.0% required by the State of Wisconsin at December 31, 2010, the latest evaluation date.

 

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The following table summarizes the Corporation’s and Banks’ capital ratios and the ratios required by their federal regulators at June 30, 2011 and December 31, 2010, respectively:
                                                 
                                    Minimum Required to be Well  
                                    Capitalized Under Prompt  
                    Minimum Required for Capital     Corrective Action  
    Actual     Adequacy Purposes     Requirements  
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
    (Dollars In Thousands)  
As of June 30, 2011
                                               
 
                                               
Total capital
                                               
(to risk-weighted assets)
                                               
Consolidated
  $ 112,567       12.20 %   $ 73,835       8.00 %     N/A       N/A  
First Business Bank
    103,408       12.54       65,969       8.00     $ 82,461       10.00 %
First Business Bank — Milwaukee
    14,796       15.16       7,810       8.00       9,762       10.00  
 
                                               
Tier 1 capital
                                               
(to risk-weighted assets)
                                               
Consolidated
  $ 67,318       7.29 %   $ 36,917       4.00 %     N/A       N/A  
First Business Bank
    93,052       11.28       32,985       4.00     $ 49,477       6.00 %
First Business Bank — Milwaukee
    13,570       13.90       3,905       4.00       5,857       6.00  
 
                                               
Tier 1 capital
                                               
(to average assets)
                                               
Consolidated
  $ 67,318       6.11 %   $ 44,086       4.00 %     N/A       N/A  
First Business Bank
    93,052       9.77       38,090       4.00     $ 47,612       5.00 %
First Business Bank — Milwaukee
    13,570       9.12       5,954       4.00       7,443       5.00  
                                                 
                                    Minimum Required to be Well  
                                    Capitalized Under Prompt  
                    Minimum Required for Capital     Corrective Action  
    Actual     Adequacy Purposes     Requirements  
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
    (Dollars In Thousands)  
As of December 31, 2010
                                               
 
                                               
Total capital
                                               
(to risk-weighted assets)
                                               
Consolidated
  $ 107,263       11.23 %   $ 76,438       8.00 %     N/A       N/A  
First Business Bank
    100,203       11.72       68,390       8.00     $ 85,488       10.00 %
First Business Bank — Milwaukee
    14,496       14.62       7,930       8.00       9,913       10.00  
 
                                               
Tier 1 capital
                                               
(to risk-weighted assets)
                                               
Consolidated
  $ 63,511       6.65     $ 38,219       4.00 %     N/A       N/A  
First Business Bank
    89,478       10.47       34,195       4.00     $ 51,293       6.00 %
First Business Bank — Milwaukee
    13,243       13.36       3,965       4.00       5,948       6.00  
 
                                               
Tier 1 capital
                                               
(to average assets)
                                               
Consolidated
  $ 63,511       5.68     $ 44,732       4.00 %     N/A       N/A  
First Business Bank
    89,478       9.34       38,335       4.00     $ 47,918       5.00 %
First Business Bank — Milwaukee
    13,243       8.30       6,381       4.00       7,976       5.00  

 

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
When used in this report the words or phrases “may,” “could,” “should,” “hope,” “might,” “believe,” “expect,” “plan,” “assume,” “intend,” “estimate,” “anticipate,” “project,” “likely,” or similar expressions are intended to identify “forward-looking statements.” Such statements are subject to risks and uncertainties, including, without limitation, changes in economic conditions in the market areas of First Business Bank (“FBB”) or First Business Bank — Milwaukee (“FBB — Milwaukee”), changes in policies by regulatory agencies, fluctuation in interest rates, demand for loans in the market areas of FBB or FBB — Milwaukee, borrowers defaulting in the repayment of loans and competition. These risks could cause actual results to differ materially from what First Business Financial Services, Inc. (“FBFS”) has anticipated or projected. These risk factors and uncertainties should be carefully considered by potential investors. See Item 1A — Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2010 for discussion relating to risk factors impacting the Corporation. Investors should not place undue reliance on any such forward-looking statement, which speaks only as of the date on which it was made. The factors described within this Form 10-Q could affect the financial performance of FBFS and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods.
Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, FBFS cautions that, while its management believes such assumptions or bases are reasonable and are made in good faith, assumed facts or bases can vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, an expectation or belief is expressed as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result in, or be achieved or accomplished.
FBFS does not intend to, and specifically disclaims any obligation to, update any forward-looking statements.
The following discussion and analysis is intended as a review of significant events and factors affecting the financial condition and results of operations of FBFS for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto presented in this Form 10-Q.
General
Unless otherwise indicated or unless the context requires otherwise, all references in this Report to “FBFS”, the “Corporation”, “we”, “us”, “our”, or similar references mean First Business Financial Services, Inc. together with our subsidiaries. “FBB” or “FBB — Milwaukee” or the “Banks” are used to refer to our subsidiaries, First Business Bank and First Business Bank — Milwaukee, alone.
Overview
FBFS is a registered bank holding company incorporated under the laws of the State of Wisconsin and is engaged in the commercial banking business through its wholly-owned banking subsidiaries, FBB and FBB-Milwaukee. All of the operations of FBFS are conducted through the Banks and certain subsidiaries of FBB. The Corporation operates as a business bank focusing on delivering a full line of commercial banking products and services tailored to meet the specific needs of small and medium sized businesses, business owners, executives, professionals and high net worth individuals. The Corporation does not utilize a branch network to attract retail clients.

 

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General Overview
    Total assets were $1.096 billion as of June 30, 2011 compared to $1.107 billion as of December 31, 2010.
    Net income for the three months ended June 30, 2011 was $2.5 million compared to net loss of $1.5 million for the three months ended June 30, 2010. Net income for the six months ended June 30, 2011 was $3.9 million compared to a net loss of $626,000 for the six months ended June 30, 2010. The net loss for the three and six months ended June 30, 2010 was impacted by a $2.7 million goodwill impairment charge that was recorded in June 2010. The goodwill impairment was an accounting adjustment that did not affect cash flows, liquidity, regulatory capital, regulatory capital ratios or the future operations of our Corporation.
    Excluding the impact of the goodwill impairment for the 2010 reporting periods, net income for the three months ended June 30, 2010 was $1.2 million and net income for the six months ended June 30, 2010 was $2.1 million. Net income for the three months ended June 30, 2011 represents a $1.3 million increase over net income for the three months ended June 30, 2010, excluding goodwill impairment. Net income for the six months ended June 30, 2011 represents a $1.8 million increase over net income for the six months ended June 30, 2010, excluding goodwill impairment.
    Diluted earnings per common share for the three months ended June 30, 2011 was $0.98 compared to diluted losses per common share of $0.60 for the three months ended June 30, 2010. Diluted earnings per common share for the six months ended June 30, 2011 was $1.49 compared to diluted losses per common share of $0.25. Diluted losses per common share for the three and six month period ended June 30, 2010 included a $1.06 per share goodwill impairment charge. Excluding the impairment of goodwill, diluted earnings per common share was $0.46 and $0.81, respectively for the three and six months ended June 30, 2010.
    Net interest margin increased to 3.39% for the three months ended June 30, 2011 compared to 2.96% for the three months ended June 30, 2010. Net interest margin increased to 3.27% for the six months ended June 30, 2011 compared to 2.98% for the six months ended June 30, 2010.
    Top line revenue, the sum of net interest income and non-interest income, increased 10.71% to $20.9 million for the six months ended June 30, 2011 compared to $18.9 million for the six months ended June 30, 2010.
    Loan and lease loss provision was $1.5 million for the three months ended June 30, 2011 compared to $1.1 million for same time period in the prior year. Loan and lease loss provision was $2.9 million for the six months ended June 30, 2011 compared to $2.4 million for the six months ended June 30, 2010. Allowance for loan and lease loss as a percentage of gross loans and leases was 1.85% at both June 30, 2011 and December 31, 2010.
    Annualized return on average equity and return on average assets were 17.21% and 0.91%, respectively, for the three month period ended June 30, 2011, compared to (10.77)% and (0.56)%, respectively, for the same time period in 2010. Annualized return on average equity and return on average assets were 13.49% and 0.69%, respectively, for the six months ended June 30, 2011, compared to (2.23)% and (0.11)%, respectively, for the six months ended June 30, 2010. Excluding the goodwill impairment, annualized returns on average equity were 8.22% and 7.35% for the three and six months ended June 30, 2010. Excluding the goodwill impairment, annualized returns on average assets were 0.43% and 0.38% for the three and six months ended June 30, 2010.

 

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In the bullet points above, we present for the three and six months ended June 30, 2010 (1) net income and diluted earnings per common share, in each case excluding the goodwill impairment and (2) annualized returns on average assets and annualized returns on average equity, calculated using net income excluding goodwill impairment. Each of those presented measures is a non-GAAP measure. We use these measures because we believe they provide greater comparability of the profitability to all periods presented.
Results of Operations
Top Line Revenue. Top line revenue is comprised of net interest income and non-interest income. This measurement is also commonly referred to as operating revenue. Top line revenue grew 10.71% for the six months ended June 30, 2011, as compared to the same period in the prior year. The components of top line revenue were as follows:
                                                 
    For the Three Months Ended June 30,     For the Six Months Ended June 30,  
    2011     2010     Change     2011     2010     Change  
    (Dollars In Thousands)  
 
                                               
Net interest income
  $ 8,969     $ 7,691       16.62 %   $ 17,453     $ 15,537       12.33 %
Non-interest income
    1,744       1,685       3.50       3,418       3,315       3.11  
 
                                       
Total top line revenue
  $ 10,713     $ 9,376       14.26     $ 20,871     $ 18,852       10.71  
 
                                       
Core Earnings
Core earnings is comprised of our pre-tax income adding back our provision for loan and leases losses, other identifiable costs of credit and other discrete items that are unrelated to our core business activities. In our judgment, the presentation of core earnings allows our management team, investors and analysts to better assess the growth of our core business by removing the volatility that is associated with costs of credit and other discrete items that are unrelated to our core business and facilitates a more streamlined comparison of core growth to our benchmark peers. Core earnings is a non-GAAP financial measure that does not represent and should not be considered as an alternative to net income derived in accordance with GAAP. Our core earnings metric has improved by 31.23% when comparing the six months ended June 30, 2011 to the six months ended June 30, 2010.
                                                 
    For the three months ended June 30,     For the six months ended June 30,  
    2011     2010     Change     2011     2010     Change  
    (Dollars in Thousands)  
 
                                               
Income (loss) before income tax expense
  $ 2,601     $ (914 )     * %   $ 4,594     $ 673       582.62 %
Add back:
                                               
Goodwill impairment
          2,689       (100.00 )           2,689       (100.00 )
Provision for loan and lease losses
    1,474       1,069       37.89       2,878       2,413       19.27  
Loss (gain) on foreclosed properties
    79       (95 )     *       130       18       622.22  
 
                                       
Core earnings
  $ 4,154     $ 2,749       51.11     $ 7,602     $ 5,793       31.23  
 
                                       
     
*   Not meaningful

 

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Return on Average Equity and Return on Average Assets. Annualized return on average equity for the three months ended June 30, 2011 was 17.21% compared to (10.77)% for the three months ended June 30, 2010. Annualized return on average equity for the six months ended June 30, 2011 was 13.49% compared to (2.23)% for the six months ended June 30, 2010. The increase in return on average equity was due to the improvement in net income including the absence of goodwill impairment in 2011. We view return on average equity to be an important measure of profitability, and we are continuing to focus on improving our return on average equity by enhancing the overall profitability of our client relationships, controlling our expenses and minimizing our costs of credit. Annualized return on average assets for the three months ended June 30, 2011 was 0.91% compared to (0.56)% for the three months ended June 30, 2010. Annualized return on average assets for the six months ended June 30, 2011 was 0.69% compared to (0.11)% for the six months ended June 30, 2010. The increase in return on average assets was primarily due to the improvement in net income as well as the absence of goodwill impairment in 2011. Excluding the goodwill impairment, annualized return on average equity and annualized return on average assets for the three months ended June 30, 2010 were 8.22% and 0.43%, respectively. Excluding the goodwill impairment, annualized return on average equity and annualized return on average assets for the six months ended June 30, 2010 were 7.35 and 0.38%, respectively.
Net Interest Income. Net interest income depends on the amounts of and yields on interest-earning assets as compared to the amounts of and rates paid on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest and the asset/liability management procedures to prepare and respond to such changes.
The table below provides information with respect to (1) the change in interest income attributable to changes in rate (changes in rate multiplied by prior volume), (2) the change in interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (3) the change in interest income attributable to changes in rate/volume (changes in rate multiplied by changes in volume) for the three and six months ended June 30, 2011 compared to the same periods of 2010.
                                                                 
    Increase (Decrease) for the Three Months Ended     Increase (Decrease) for the Six Months Ended  
    June 30,     June 30,  
    2011 Compared to 2010     2011 Compared to 2010  
                    Rate/                             Rate/        
    Rate     Volume     Volume     Net     Rate     Volume     Volume     Net  
    (In Thousands)  
Interest-Earning Assets
                                                               
Commercial real estate and other mortgage loans
  $ (43 )   $ 269     $     $ 226     $ (367 )   $ 426     $ (9 )   $ 50  
Commercial and industrial loans
    259       (56 )     (3 )     200       4       206             210  
Direct financing leases
    (45 )     (133 )     14       (164 )     (56 )     (260 )     17       (299 )
Consumer and other loans
    26       16       3       45       52       19       4       75  
 
                                               
Total loans and leases receivable
    197       96       14       307       (367 )     391       12       36  
Mortgage-related securities
    (250 )     241       (51 )     (60 )     (463 )     485       (98 )     (76 )
FHLB Stock
    1                   1       1                   1  
Short-term investments
    (1 )     (13 )           (14 )     (2 )     (20 )           (22 )
 
                                               
Total net change in income on interest-earning assets
    (53 )     324       (37 )     234       (831 )     856       (86 )     (61 )
 
                                               
Interest-Bearing Liabilities
                                                               
NOW accounts
    (37 )     (68 )     26       (79 )     (62 )     (109 )     40       (131 )
Money market
    (27 )     75       (3 )     45       (240 )     164       (26 )     (102 )
Certificates of deposit
    (177 )     6       (3 )     (174 )     (298 )     (27 )     9       (316 )
Brokered certificates of deposit
    (761 )     131       (25 )     (655 )     (1,498 )     396       (73 )     (1,175 )
 
                                               
Total deposits
    (1,002 )     144       (5 )     (863 )     (2,098 )     424       (50 )     (1,724 )
FHLB advances
    46       (213 )     (45 )     (212 )     83       (416 )     (80 )     (413 )
Other borrowings
    31                   31       30       126       4       160  
 
                                               
Total net change in expense on interest-bearing liabilities
    (925 )     (69 )     (50 )     (1,044 )     (1,985 )     134       (126 )     (1,977 )
 
                                               
Net change in net interest income
  $ 872     $ 393     $ 13     $ 1,278     $ 1,154     $ 722     $ 40     $ 1,916  
 
                                               

 

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The table below shows our average balances, interest, average rates, net interest margin and the spread between the combined average rates earned on interest-earning assets and average cost of interest-bearing liabilities for the three months ended June 30, 2011 and 2010. The average balances are derived from average daily balances.
                                                 
    For the Three Months Ended June 30,  
    2011     2010  
    Average             Average     Average             Average  
    balance     Interest     yield/cost     balance     Interest     yield/cost  
    (Dollars In Thousands)  
Interest-Earning Assets
                                               
Commercial real estate and other mortgage loans(1)
  $ 618,877     $ 8,435       5.45 %   $ 599,207     $ 8,209       5.48 %
Commercial and industrial loans(1)
    205,622       4,168       8.11       208,541       3,968       7.61  
Direct financing leases(1)
    16,784       257       6.12       24,558       421       6.86  
Consumer and other loans
    19,354       189       3.91       17,434       144       3.30  
 
                                       
Total loans and leases receivable(1)
    860,637       13,049       6.06       849,740       12,742       6.00  
Mortgage-related securities(2)
    162,460       1,106       2.72       134,613       1,166       3.46  
Federal Home Loan Bank stock
    2,367       1       0.10       2,367              
Short-term investments
    31,624       18       0.24       52,010       32       0.25  
 
                                       
Total interest-earning assets
    1,057,088       14,174       5.36       1,038,730       13,940       5.37  
 
                                           
Non-interest-earning assets
    47,909                       48,067                  
 
                                           
Total assets
  $ 1,104,997                     $ 1,086,797                  
 
                                           
 
                                               
Interest-Bearing Liabilities
                                               
NOW accounts
  $ 25,892       18       0.28     $ 85,774       97       0.45  
Money market
    279,692       679       0.97       250,021       634       1.01  
Certificates of deposits
    81,742       264       1.29       80,708       438       2.17  
Brokered certificates of deposit
    492,041       3,389       2.76       476,642       4,044       3.39  
 
                                       
Total interest-bearing deposits
    879,367       4,350       1.98       893,145       5,213       2.33  
FHLB advances
    489       7       5.73       18,501       219       4.73  
Other borrowings
    39,009       571       5.86       39,010       540       5.54  
Junior subordinated notes
    10,315       277       10.74       10,315       277       10.74  
 
                                       
Total interest-bearing liabilities
    929,180       5,205       2.24       960,971       6,249       2.60  
 
                                           
Non-interest-bearing demand deposit accounts
    107,107                       55,452                  
Other non-interest-bearing liabilities
    10,287                       13,750                  
 
                                           
Total liabilities
    1,046,574                       1,030,173                  
Stockholders’ equity
    58,423                       56,624                  
 
                                           
Total liabilities and stockholders’ equity
  $ 1,104,997                     $ 1,086,797                  
 
                                           
 
                                               
Net interest income
          $ 8,969                     $ 7,691          
 
                                           
Interest rate spread
                    3.12 %                     2.77 %
Net interest-earning assets
  $ 127,908                     $ 77,759                  
 
                                           
Net interest margin
                    3.39 %                     2.96 %
Average interest-earning assets to average interest-bearing liabilities
    113.77 %                     108.09 %                
Return on average assets
    0.91                       (0.56 )                
Return on average equity
    17.21                       (10.77 )                
Average equity to average assets
    5.29                       5.21                  
Non-interest expense to average assets
    2.40                       3.39                  
     
(1)   The average balances of loans and leases include non-performing loans and leases. Interest income related to non-performing loans and leases is recognized when collected.
 
(2)   Includes amortized cost basis of assets available for sale.
Net interest income increased by $1.3 million, or 16.6%, during the three months ended June 30, 2011 compared to the same period in 2010. The increase in net interest income is primarily attributable to favorable rate variances from lower cost of deposits. The Federal Reserve held interest rates constant across the three-month periods ended June 30, 2011 and June 30, 2010. Therefore the majority of the increase in net interest income associated with rate variances was caused by pricing deposits commensurate with current market conditions and demand along with replacing higher yielding maturing brokered certificates of deposits at lower current market rates.

 

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The yield on average earning assets for the three months ended June 30, 2011 was 5.36% compared to 5.37% for the three months ended June 30, 2010. The yield on average earning assets for the three months ended June 30, 2011 was negatively affected by the overall change in the investment portfolio. We have invested in collateralized mortgage obligations with structured cash flow payments. The cash flows generated from these expected prepayments are typically reinvested in additional collateralized mortgage obligations. Given the continued low rate environment, the overall coupon on new security purchases has typically been lower than the rates on securities that experience prepayments. This has caused the investment yield to decline by approximately 68 basis points.
The total loans and leases receivable yield was 6.06% for the three months ended June 30, 2011 compared to 6.00% for the three months ended June 30, 2010. The slight increase in the overall yields on the loan and lease portfolio is mainly the result of increased yields associated with previous foregone interest, increased levels of loan fees collected in lieu of interest offset by an increase in average level of nonperforming loans. The effects of these items are also influenced by pricing and mix of the loan and lease portfolio as we continue to improve our credit spreads on our fixed rate loan portfolio commensurate with current economic conditions and market demand and a continued increase in the dollar amount and number of variable rate loans with interest rate floors in excess of the current market rates.
Loan and lease receivable interest income can be significantly influenced by the collection of previous foregone interest, one-time prepayment fees and other fees collected in lieu of interest when the activity of collection is not consistent between reporting periods. The yield on commercial and industrial loans and leases receivable increased by approximately 69 basis points to 8.11% for the three months ended June 30, 2011 from 7.42% for the comparable period of the prior year. The primary reason for the increase in commercial and industrial yields is related to the collection of previous foregone interest. During the three months ended June 30, 2011, the Banks recognized interest income on fully collected commercial and industrial non-accrual loans of approximately $308,000. Total previous foregone interest recorded during the three months ended June 30, 2011 was $403,000, with $91,000 attributable to commercial real estate loans. For the three months ended June 30, 2011, total fees in lieu of interest collected that influence net interest income were $932,000 as compared to $864,000 for the three months ended June 30, 2010.
The overall weighted average rate paid on interest-bearing liabilities was 1.98% for the three months ended June 30, 2011, a decrease of 36 basis points from 2.34% for the three months ended June 30, 2010. The decrease in the overall rate on the interest-bearing liabilities was primarily caused by the replacement of maturing certificates of deposits, including brokered certificates of deposits, at lower current market rates and a lower rate paid on our money market accounts. The continued low rate environment coupled with our maturity structure of our brokered certificate of deposit portfolio has provided us the opportunity to be able to manage our liability structure in both terms of composition and rate to assist in providing an enhanced net interest margin.
Net interest margin increased 43 basis points to 3.39% for the three months ended June 30, 2011 from 2.96% for the three months ended June 30, 2010. The improvement in net interest margin correlates to a 35 basis point increase in the net interest rate spread coupled with an increase in the value of the net free funds. We have experienced a significant increase in the overall size of our average non-interest bearing deposits portfolio. This increase is partially caused by the change in the regulations for which types of accounts qualify for unlimited FDIC insurance coverage. As discussed, our loan and lease yields can be influenced by significant interest collected from loans previously carried on non-accrual and one-time collection of fees in lieu of interest; therefore, we may not always have the benefit of this additional interest income positively impacting our net interest margin.

 

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The table below shows our average balances, interest, average rates, net interest margin and the spread between the combined average rates earned on interest-earning assets and average cost of interest-bearing liabilities for the six months ended June 30, 2011 and 2010. The average balances are derived from average daily balances.
                                                 
    For the Six Months Ended June 30,  
    2011     2010  
    Average             Average     Average             Average  
    balance     Interest     yield/cost     balance     Interest     yield/cost  
    (Dollars In Thousands)  
Interest-Earning Assets
                                               
Commercial real estate and other mortgage loans(1)
  $ 617,112     $ 16,727       5.42 %   $ 601,734     $ 16,677       5.54 %
Commercial and industrial loans(1)
    211,466       8,334       7.88       206,235       8,124       7.88  
Direct financing leases(1)
    17,607       537       6.10       25,561       836       6.54  
Consumer and other loans
    19,209       371       3.86       18,043       296       3.28  
 
                                       
Total loans and leases receivable(1)
    865,394       25,969       6.00       851,573       25,933       6.09  
Mortgage-related securities(2)
    157,668       2,224       2.82       130,218       2,300       3.53  
Federal Home Loan Bank stock
    2,367       1       0.10       2,367              
Short-term investments
    43,342       51       0.24       59,164       73       0.25  
 
                                       
Total interest-earning assets
    1,068,771       28,245       5.29       1,043,322       28,306       5.43  
 
                                           
Non-interest-earning assets
    49,132                       47,699                  
 
                                           
Total assets
  $ 1,117,903                     $ 1,091,021                  
 
                                           
 
                                               
Interest-Bearing Liabilities
                                               
NOW accounts
  $ 28,225       38       0.27     $ 79,237       169       0.43  
Money market
    287,022       1,401       0.98       258,840       1,503       1.16  
Certificates of deposits
    81,958       583       1.42       84,460       899       2.13  
Brokered certificates of deposit
    493,526       6,978       2.83       470,682       8,153       3.46  
 
                                       
Total interest-bearing deposits
    890,731       9,000       2.02       893,219       10,724       2.40  
FHLB advances
    822       23       5.65       18,502       435       4.70  
Other borrowings
    43,669       1,217       5.57       39,010       1,058       5.42  
Junior subordinated notes
    10,315       552       10.70       10,315       552       10.70  
 
                                       
Total interest-bearing liabilities
    945,537       10,792       2.28       961,046       12,769       2.66  
 
                                           
Non-interest-bearing demand deposit accounts
    104,718                       61,377                  
Other non-interest-bearing liabilities
    10,395                       12,454                  
 
                                           
Total liabilities
    1,060,650                       1,034,877                  
Stockholders’ equity
    57,253                       56,144                  
 
                                           
Total liabilities and stockholders’ equity
  $ 1,117,903                     $ 1,091,021                  
 
                                           
 
                                               
Net interest income
          $ 17,453                     $ 15,537          
 
                                           
Interest rate spread
                    3.01 %                     2.77 %
Net interest-earning assets
  $ 123,234                     $ 82,276                  
 
                                           
Net interest margin
                    3.27 %                     2.98 %
Average interest-earning assets to average interest-bearing liabilities
    113.03 %                     108.56 %                
Return on average assets
    0.69                       (0.11 )                
Return on average equity
    13.49                       (2.23 )                
Average equity to average assets
    5.12                       5.15                  
Non-interest expense to average assets
    2.40                       2.89                  
     
(1)   The average balances of loans and leases include non-performing loans and leases. Interest income related to non-performing loans and leases is recognized when collected.
 
(2)   Includes amortized cost basis of assets available for sale.

 

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Net interest income increased by $1.9 million, or 12.3%, during the six months ended June 30, 2011 compared to the same period in 2010. The increase in net interest income was primarily attributable to favorable rate variances from lower cost of deposits. Overall, favorable rate variances added $1.2 million to net interest income and favorable volume increases primarily in our loan and lease and investment portfolio contributed $722,000 to net interest income. The Federal Reserve held interest rates relatively consistent for the six months ended June 30, 2011 and June 30, 2010. Therefore, consistent with the three months ended June 30, 2011 discussion, the majority of the increase in net interest income associated with rate variances was caused by pricing loans and deposits commensurate with current market conditions and demand.
Net interest margin increased 29 basis points to 3.27% for the six months ended June 30, 2011 from 2.98% for the six months ended June 30, 2010. The improvement in net interest margin was primarily due to a 38 basis point decline in cost of interest-bearing liabilities to 2.28% for the six months ended June 30, 2011 from 2.66% for the comparable period of 2010. This was partially offset by a decline of 14 basis points of yield on average earning assets to 5.29% for the six months ended June 30, 2011 from 5.43% for the six months ended June 30, 2010. Further, net interest margin improved by five basis points with a reduction in the average amount of cash held at the Federal Reserve Bank.
We expect to have continued elevated levels of non-accrual loans and the predictability of the payments collected in lieu of interest is uncertain; however, we believe that current market conditions will support continued improvement in pricing on our loan and deposit products. Taking into consideration both positive and negative influences, we believe that our net interest margin will remain stable at this level for the remainder of 2011, although no assurances can be given. The net interest margin is dependent upon various factors, including competitive pricing pressures, balance sheet mix from client behavior relative to loan or deposit products, asset liability management strategies employed by us and the slope of the yield curve in the future.
Provision for Loan and Lease Losses. The provision for loan and lease losses totaled $1.5 million and $1.1 million for the three months ended June 30, 2011 and 2010, respectively. The provision for loan and lease losses was $2.9 million and $2.4 million for the six months ended June 30, 2011 and 2010, respectively. We determine our provision for loan and lease losses based upon credit risk and other subjective factors pursuant to our allowance for loan and lease loss methodology, the magnitude of current and historical net charge-offs recorded in the period and the amount of reserves established for impaired loans that present collateral shortfall positions.
During the three and six months ended June 30, 2011 and 2010, the factors influencing the provision for loan and lease losses were the following:
                                 
    For the three months ended     For the six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
    (In Thousands)  
Changes in the provision for loan and lease losses associated with:
                               
Establishment/modification of specific reserves on impaired loans, net
  $ 404     $ 638     $ 809     $ 1,906  
Increase in allowance for loan and lease loss reserve due to subjective factor changes
    8             61        
Charge-offs in excess of specific reserves
    1,809       572       2,625       699  
Recoveries
    (644 )     (4 )     (672 )     (5 )
Change in inherent risk of the loan and lease portfolio
    (103 )     (137 )     55       (187 )
 
                       
Total provision for loan and lease losses
  $ 1,474     $ 1,069     $ 2,878     $ 2,413  
 
                       
The establishment/modification of specific reserves represents new specific reserves established on impaired loans where, although collateral shortfalls are present, we believe that we will be able to recover our principal. Charge-offs in excess of specific reserves represents an additional provision for loan and lease losses required to maintain the allowance for loan and leases at a level deemed appropriate by management. This amount is net of the release of any specific reserve that may have already been provided. Charge-offs in excess of specific reserves can occur in situations where a loan has previously been partially written down to its estimated fair value and continues to decline, rapid deterioration of a credit that requires an immediate partial or full charge-off, or amounts where the specific reserve was not adequate to cover the amount of the required charge-off. Change in the inherent risk of the portfolio can be influenced by growth or migration in and out of an impaired loan classification where a specific evaluation of a particular credit may be required rather than the application of a general reserve ratio. Refer to Asset Quality for further information regarding the overall credit quality of our loan and lease portfolio.

 

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Non-interest income. Non-interest income, consisting primarily of fees earned for trust and investment services, service charges on deposits, income from bank-owned life insurance and loan fees experienced a modest increase of $59,000, or 3.5%, to $1.7 million for the three months ended June 30, 2011 from $1.7 million for the three months ended June 30, 2010. The increase was primarily due to an increase in trust and investment services fee income and loan fees partially offset by a decline in other non-interest income.
Trust and investment services fee income increased by $56,000, or 9.35%, to $655,000 for the three months ended June 30, 2011 from $599,000 for the three months ended June 30, 2010. Trust and investment services fee income is driven by the amount of assets under management and administration and is influenced by the timing and volatility of the equity markets coupled with our ability to continue to add clients to our portfolio. At June 30, 2011, we had $456.1 million of trust assets under management compared to $399.4 million at December 31, 2010 and $324.9 million at June 30, 2010. Assets under administration were $132.5 million at June 30, 2011 compared to $127.5 million at December 31, 2010 and $106.9 million at June 30, 2010. Our sales pipeline continues to be strong and we expect to continue to add to our assets under management during the remainder of 2011, but we expect that assets under management and trust and investment services fee income will continue to be affected by market volatility.
Loan fees increased by $83,000, or 29.1%, to $368,000 for the three months ended June 30, 2011 from $285,000 for the three months ended June 30, 2010. The increase in loan fees was primarily related to an increase of other asset based loan fees collected.
Other non-interest income decreased by $81,000, or 50.9%, to $78,000 for the three months ended June 30, 2011 from $159,000 for the three months ended June 30, 2010. The decrease in other non-interest income is directly related to the level of gains on sales of leased equipment. During the second quarter of 2011, we experienced fewer end of lease terminations than during the second quarter of 2010.
Non-interest income increased $103,000, or 3.1%, to $3.4 million for the six months ended June 30, 2011 from $3.3 million for the six months ended June 30, 2010. Similar to the three month discussion, the primary increase in non-interest income was due to an increase in trust and investment services fee income and loan fees partially offset by a decrease in other non-interest income. Trust and investment services fee income was influenced by trading activity and market volatility. Loan fees increased due to additional increased collections of asset-based lending fees. Other non-interest income declined due to a disparity in the volume and magnitude of gains associated with lease end termination activity.
Non-interest expense. Non-interest expense decreased by $2.6 million, or 28.0%, to $6.6 million for the three months ended June 30, 2011 from $9.2 million for the comparable period of 2010. The decrease in non-interest expense was primarily caused by the absence of goodwill impairment, a decline in FDIC insurance expense, a decline in collateral liquidation costs, and a decline in other non-interest expense, partially offset by an increase in compensation expense, an increase in marketing expense and an increase in loss on foreclosed properties.
During the three months ended June 30, 2010, we recorded a goodwill impairment of $2.7 million, which represented the full amount of goodwill outstanding. No further impairments were recorded in subsequent periods.
FDIC insurance expense decreased by $185,000, or 24.5%, to $571,000 for the three months ended June 30, 2011 from $756,000 for the three months ended June 30, 2010. Effective April 1, 2011, the FDIC amended the Federal Deposit Insurance Act to implement revisions required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), including, among other changes, modifying the definition of an institution’s deposit insurance assessment base from a deposit-based calculation to an average assets less average tangible equity-based calculation and changing the assessment rate adjustments. This amendment resulted in a reduced FDIC insurance cost for our Banks.

 

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Collateral liquidation costs decreased by $156,000, or 46.8%, to $177,000 for the three months ended June 30, 2011 from $333,000 for the three months ended June 30, 2010. Collateral liquidation costs are expenses incurred by us to facilitate resolution of certain problem commercial loans. The amount of collateral liquidation costs recorded in any particular period are influenced by the timing and level of effort required for each individual loan. Our ability to recoup these costs from our clients is uncertain and therefore we have expensed them as incurred through our consolidated results of operations. To the extent we are successful in recouping these expenses from our clients; the recovery of expense is shown as a net reduction to this line item.
Other non-interest expense decreased by $250,000, or 29.6%, to $595,000 for the three months ended June 30, 2011 from $845,000 for the three months ended June 30, 2010. The primary reason for the decrease was due to a permanent write-down on an underlying investment owned by Aldine Capital L.P. during the second quarter of 2010. We account for our investment in Aldine Capital L.P. using the equity method and recorded our share of the loss. No similar permanent write-down was incurred during the three months ended June 30, 2011.
Compensation expense increased by $434,000, or 12.8%, to $3.8 million for the three months ended June 30, 2011 from $3.4 million for the three months ended June 30, 2010. The increase was primarily caused by an additional accrual to record the appropriate level of compensation expense affiliated with our non-equity incentive compensation program. Based upon established targets for 2011, we have accrued for a higher level of performance in the program’s established criteria as compared to the prior year.
During the three months ended June 30, 2011, we recorded a loss on foreclosed properties of $79,000. This loss is primarily caused by an impairment adjustment required on the valuation of a parcel of land that we own. We have continued to experience further declines in values on these types of properties and therefore to reflect the foreclosed properties at the lower of cost or fair value, we recorded an impairment. For the three months ended June 30, 2010, we recorded a gain on foreclosed properties of $95,000. The gain was associated with the disposition of certain previously owned assets at prices greater than our then-current carrying value.
Marketing expense increased by $66,000, or 36.3%, to $248,000 for the three months ended June 30, 2011 from $182,000 for the three months ended June 30, 2010. The increase in marketing expense was a direct result of the timing associated with the execution of certain marketing strategies and a renewed corporate-wide marketing effort.
Non-interest expense for the six months ended June 30, 2011 decreased $2.4 million, or 15.0%, to $13.4 million from $15.8 million for the six months ended June 30, 2010. The primary reasons for the decrease in non-interest expense are similar to those discussed for the three month comparison including the absence of goodwill impairment, a decline in FDIC insurance expense, and a decline in collateral liquidation costs, partially offset by an increase in compensation expense and an increase in marketing expense. In June 2010, we recorded an impairment of goodwill of $2.7 million as we concluded at that time that the implied fair value of our reporting unit’s goodwill was less than the current carrying value of the reporting unit’s goodwill. We wrote-off the entire carrying value of the goodwill in 2010. FDIC insurance expense has declined period over period due to the new rates and assessment base utilized by the FDIC effective April 1, 2011. Collateral liquidation costs have also declined period over period. While we continue to have elevated levels of non-accruals, we have had success in resolving older matters and the level of required third party costs to resolve these issues has declined for this reporting period. However, the amount of collateral liquidation costs recorded in any particular period are influenced by the timing and level of effort required for each individual loan and may increase in future reporting periods. Compensation expense increased period over period due to three primary factors, including increased salary levels, increased level of accrual associated with the non-equity incentive plan, and an employer match on Social Security taxes on the 2010 non-equity incentive payment made in the first quarter of 2011 where a similar payment was not made the year prior. Marketing expense increased period over period due to the timing of execution of certain marketing strategies.

 

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Income Taxes. Income tax expense was $732,000 for the six months ended June 30, 2011, compared to income tax expense $1.3 million for the six months ended June 30, 2010. Income tax expense is recorded at an effective rate which we believe to the best estimate of the annualized effective tax rate recognizing discrete items. The effective tax rate for the six months ended June 30, 2011 was 15.9%. The effective tax rate for the three months ended March 31, 2011 was 32.2%. The primary difference between the effective tax rate as of June 30, 2011 and March 31, 2011 was due to the recognition of two discrete items in the second quarter of 2011 that had a net positive impact on the effective tax rate. In June 2011, FBB and FBCC entered into a confidential settlement with the Wisconsin Department of Revenue. The settlement of this matter with the Wisconsin Department of Revenue did not result in a liability materially different than that which had been previously accrued. In addition, on June 26, 2011, the State of Wisconsin 2011-2013 Budget Bill, Assembly Bill 40, was signed into law. The bill provides that, starting with the first taxable year beginning after December 31, 2011, and thereafter for the next 19 years, a combined group member that has pre-2009 net business loss carryforwards can, after first using such net business loss carryforwards to offset its own income for the taxable year and after using shared losses, use up to five percent of the pre-2009 net business loss carryforwards to offset the Wisconsin income of other group members on a proportionate basis to the extent the income is attributable to the group’s unitary business. If the five percent cannot fully be used, the remainder can be added to the portion that may offset the Wisconsin income of all other combined group members in a subsequent year, until it is completely used or expired.
Generally, the provision for income taxes is determined by applying an estimated annual effective income tax rate to income before taxes and adjusting for discrete items. Typically, the rate is based on the most recent annualized forecast of pretax income, book versus tax differences and tax credits, if any. If we determine that a reliable estimated annual effective tax rate cannot be determined, the actual effective tax rate for the year-to-date period may be used. We re-evaluate the income tax rates each quarter. Therefore, the current projected effective tax rate for the entire year may change.
Financial Condition
General. Our total assets decreased by $10.7 million to $1.096 billion at June 30, 2011 from $1.107 billion at December 31, 2010.
Short-term investments. Short-term investments decreased by $11.0 million to $30.3 million at June 30, 2011 from $41.4 million at December 31, 2010. Our short-term investments primarily consist of interest-bearing deposits held at the Federal Reserve Bank. The level of our short-term investments will be influenced by the timing of deposit gathering, scheduled maturities of brokered deposits, funding of loan growth when opportunities are presented, and the level of our available-for-sale securities portfolio. We value the safety and soundness provided by the Federal Reserve Bank and therefore we incorporate short-term investments in our on-balance sheet liquidity program. Please refer to Liquidity and Capital Resources for further discussion.
Securities. Securities available-for-sale increased by $14.9 million, or 9.7%, to $168.3 million at June 30, 2011 from $153.4 million at December 31, 2010, primarily due to additional purchases of government agency collateralized mortgage obligations. Our available-for-sale investment portfolio primarily consists of collateralized mortgage obligations and is used to provide a source of liquidity, including the ability to pledge securities, while contributing to the earnings potential of the Banks. We purchase investment securities intended to protect our net interest margin while maintaining an acceptable risk profile. In addition, we will purchase investments to utilize our cash position effectively within appropriate policy guidelines and estimates of future cash demands. While collateralized mortgage obligations present prepayment risk and extension risk, we believe the overall credit risk associated with these investments is minimal as substantially all of the obligations we hold were issued by the Government National Mortgage Association (GNMA), a U.S. Government agency. The estimated prepayment streams associated with this portfolio also allow us to better match our short-term liabilities. The Banks’ investment policies allow for various types of investments including tax-exempt municipal securities.

 

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During the six months ended June 30, 2011, we recognized unrealized holding gains of $1.2 million through other comprehensive income. All of the securities we hold have active trading markets, and we are not currently experiencing difficulties in pricing our securities. Our portfolio is sensitive to fluctuations in the interest rate environment and has limited sensitivity to credit risk due to the nature of the issuers of our securities as previously discussed. If interest rates decline and the credit quality of the securities remain positive, the market value of our debt securities portfolio should improve. If interest rates increase and the credit quality of the securities remain positive, the market value of our debt securities portfolio should decline. No securities within our portfolio were deemed to be other-than-temporarily impaired as of June 30, 2011.
Loans and Leases Receivable. Loans and leases receivable, net of allowance for loan and lease losses, decreased by $16.2 million, or 1.9%, to $844.8 million at June 30, 2011 from $860.9 million at December 31, 2010. We principally originate commercial business loans and commercial real estate loans. The overall mix of the loan and lease portfolio at June 30, 2011 remained generally consistent with the mix at December 31, 2010, with a continued concentration in commercial real estate mortgage loans at 71.4% of our total loan and lease portfolio. We are seeing demand for new loans. However, our new loan and lease growth is primarily offset by the contractual amortization of our existing loan and lease portfolio. The overall decline was primarily caused by non-accrual loans and leases refinancing with other financial institutions. For the six months ended June 30, 2011, $6.2 million of non-accrual loans and leases were fully paid. In addition, we received an additional $1.7 million of payments on non-accrual loans and leases that were applied directly to principal. No non-accrual loans were returned to accruing status. This is a positive decline in our overall portfolio as it allows us to improve the overall asset quality of our loan and lease portfolio. The economic environment continues to present challenges, yet we remain committed to our underwriting standards and foresee that our loan growth will continue to be significantly lower than growth rates experienced in our past history.
The allowance for loan and lease losses as a percentage of gross loans and leases was 1.85% as of June 30, 2011 and December 31, 2010. Non-accrual loans and leases as a percentage of gross loans and leases decreased to 4.02% at June 30, 2011 compared to 4.37% at December 31, 2010. We continue to work through our problem loans and are experiencing success in certain of our exit strategies; however, we continue to identify new loans or leases where we believe that the borrowers do not have adequate liquidity to make their payments in accordance with the terms of the contractual arrangements. The exit strategies undertaken, including but not limited to foreclosure actions, charge-offs, and pay-offs, have outpaced the identification of new impaired loans and therefore we experienced a net reduction in our non-accrual loans and leases. During the six months ended June 30, 2011, we recorded net charge-offs of approximately $3.2 million, comprised of $3.9 million of charge-offs and $672,000 of recoveries, on impaired loans and leases. The charge-offs recorded are primarily due to declining real estate values supporting our loans where the collateral is no longer sufficient to cover the outstanding principal and the borrowers do not have other means to repay the obligation. During the six months ended June 30, 2011, approximately 40.4% of the charge-offs were related to construction and land development loans with various borrowers.
Given the level of charge-offs in excess of specific reserves and increased indicators of impairment within our loans and lease portfolio, we recorded a $2.9 million provision for loan and lease losses for the six months ended June 30, 2011. Taking into consideration the level of charge-offs recorded and the appropriate level of specific reserves on impaired loans with estimated collateral shortfalls, we concluded that the adequate allowance for loan and lease losses as of June 30, 2011 was $15.9 million, or 1.85% of gross loans and leases. Refer to the Asset Quality section for more information.

 

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Deposits. As of June 30, 2011, deposits decreased by $10.8 million to $977.5 million from $988.3 million at December 31, 2010. Deposits are the primary source of the Banks’ funds for lending and other investment activities. A variety of accounts are designed to attract both short- and long-term deposits. These accounts include demand, NOW, money market and time deposits. Deposit terms offered by the Banks vary according to the minimum balance required, the time period the funds must remain on deposit, the rates and products offered by marketplace competition and the interest rates charged on other sources of funds, among other factors. Attracting in-market deposits has been a renewed focus of the Banks’ business development officers. With two separately chartered financial institutions within our Corporation, we have the ability to offer our clients additional FDIC insurance coverage by maintaining separate deposits with each Bank. With the change in the regulations regarding the interest limits on NOW accounts to qualify for unlimited FDIC insurance, we have seen a shift in our balances out of NOW accounts and into non-interest bearing demand deposit accounts. The ending balances within the various deposit types fluctuate based upon maturity of time deposits, client demands for the use of their cash coupled with servicing and maintaining client relationships. We focus on attracting and servicing deposit relationships, as compared to rate sensitive clients, and therefore we monitor the success of growth of in-market deposits based on the average balances of our deposit accounts. Rate sensitive clients may create an element of volatility to our deposit balances.
Our Banks’ in-market deposits are obtained primarily from Dane, Waukesha and Outagamie Counties. Of our total year-to-date average deposits, approximately $501.9 million, or 50.4%, were considered in-market deposits at June 30, 2011. This compares to in-market deposits of $483.9 million, or 50.6%, for the year-to-date average at June 30, 2010. Attracting and increasing overall market presence of our client deposits is currently a competitive environment. We continue to remain focused on increasing our in-market deposit base and reducing our overall dependency on brokered certificates of deposits; however, as changes in regulation occur, specifically as outlined in the Dodd-Frank Act, and other amendments by the FDIC, we cannot be assured that our clients will maintain their balances solely with our institution. Our competition and the banking industry as a whole will also face this challenge, and we believe that new opportunities to develop relationships and attract new money will be available.
At June 30, 2011, $496.7 million of the Banks’ time deposits were comprised of brokered deposits compared to $499.1 million at December 31, 2010. Brokered deposits are generally a lower cost source of funds when compared to the interest rates on deposits with similar terms that would need to be offered in the local markets to generate a sufficient level of funds. Brokered certificates of deposit represented 50.8% and 50.5% of ending balance total deposits at June 30, 2011 and December 31, 2010, respectively. The Banks’ liquidity policy limits the amount of brokered deposits to 75% of total deposits. The Banks were in compliance with the policy limits throughout 2011 and 2010. Please refer to Liquidity and Capital Resources for more information.
Asset Quality
Non-performing Assets. Non-performing assets consisted of non-accrual loans and leases and foreclosed properties totaling $36.0 million, or 3.29% of total assets, as of June 30, 2011, a decrease in non-performing assets of 10.3%, or $4.1 million, from December 31, 2010. Non-performing assets were $40.2 million, or 3.63% of total assets, at December 31, 2010. The decrease in non-performing assets was the result of further charge-offs, the receipt of full pay-offs for previously identified impaired loans, payments received that were applied directly to principal, sales of foreclosed properties as well as further impairment recorded on foreclosed properties. For the six months ended June 30, 2011, approximately $6.2 million of nonperforming loans were refinanced with other institutions. We continue to actively monitor the credit quality of our loan and lease portfolios. We continue to identify loans and leases for which the borrowers or lessees are having difficulties making the required principal and interest payments based upon factors including but not limited to, the inability to sell land, inadequate cash flow from the operations of the underlying businesses, or bankruptcy filings. Therefore we are experiencing new additions of non-accrual loans. We believe current economic conditions will remain largely the same for the near term. As a result, we expect that we will continue to experience elevated levels of impaired loans and leases.
Impaired loans and leases exhibit weaknesses that inhibit repayment in compliance with the original note or lease terms. However, the measurement of impairment on loans and leases may not always result in a specific reserve included in the allowance for loan and lease losses. As part of the underwriting process as well as our ongoing monitoring efforts, we try to ensure that we have adequate collateral to protect our interest in the related loan or lease. As a result of this practice, a significant portion of our outstanding balance of non-performing loans or leases either do not require additional specific reserves or a minimal amount of required specific reserve as we believe the loans and leases are adequately collateralized as of the measurement period. In addition, management is proactive in recording charge-offs to bring loans to their estimated fair value in situations where it is determined with certainty that we will not recover our entire principal. This practice leads to a lower allowance for loan and lease loss to non-accrual loans and leases ratio. As of June 30, 2011 and December 31, 2010, our allowance for loan and lease losses to total non-accrual loans and leases was 46.03% and 42.37%, respectively. Given our business practices, management believes that this coverage ratio is appropriate for the probable losses inherent in our portfolio as of June 30, 2011.

 

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Our non-accrual loans and leases consisted of the following at June 30, 2011 and December 31, 2010, respectively:
                 
    June 30,     December 31,  
    2011     2010  
    (Dollars In Thousands)  
 
               
Non-accrual loans and leases
               
Commercial real estate:
               
Commercial real estate — owner occupied
  $ 6,122     $ 6,283  
Commercial real estate — non-owner occupied
    5,870       5,144  
Construction and land development
    8,005       9,275  
Multi-family
    3,528       4,186  
1-4 family
    3,785       4,237  
 
           
Total non-accrual commercial real estate
    27,310       29,125  
 
           
 
               
Commercial and industrial
    4,483       6,436  
Direct financing leases, net
    32        
 
               
Consumer and other:
               
Home equity and second mortgage
    1,102       939  
Other
    1,697       1,906  
 
           
Total non-accrual consumer and other loans
    2,799       2,845  
 
           
 
               
Total non-accrual loans and leases
    34,624       38,406  
Foreclosed properties, net
    1,400       1,750  
 
           
Total non-performing assets
  $ 36,024     $ 40,156  
 
           
Performing troubled debt restructurings
  $     $ 718  
 
           
 
               
Total non-accrual loans and leases to gross loans and leases
    4.02 %     4.37 %
Total non-performing assets to total assets
    3.29       3.63  
Allowance for loan and lease losses to gross loans and leases
    1.85       1.85  
Allowance for loan and lease losses to non-accrual loans and leases
    46.03       42.37  

 

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A summary of our current period non-accrual loan activity is as follows (In Thousands):
         
Non-accrual loans and leases as of December 31, 2010
  $ 38,406  
Loans and leases transferred into non-accrual status
    9,092  
Non-accrual loans and leases returned to accrual status
     
Non-accrual loans and leases transferred to foreclosed properties
    (1,107 )
Non-accrual loans and leases partially or fully charged-off
    (3,862 )
Non-accrual loans and leases fully paid-off
    (6,189 )
Principal payments applied to non-accrual loans and leases
    (1,716 )
 
     
Non-accrual loans and leases as of June 30, 2011
  $ 34,624  
 
     
A summary of our current period foreclosed properties activity is as follows (In Thousands):
         
Foreclosed properties as of December 31, 2010
  $ 1,750  
Loans transferred to foreclosed properties
    1,107  
Proceeds from sale of foreclosed properties
    (1,327 )
Gain on sale of foreclosed properties
    37  
Impairment valuation
    (167 )
 
     
Foreclosed properties as of June 30, 2011
  $ 1,400  
 
     
The following represents information regarding our impaired loans:
                         
    As of and for the     As of and for the     As of and for the  
    Six Months Ended     Six Months Ended     Year Ended  
    June 30, 2011     June 30, 2010     December 31, 2010  
    (In Thousands)  
Impaired loans and leases with no impairment reserves required
  $ 18,706     $ 15,660     $ 19,749  
Impaired loans and leases with impairment reserves required
    15,918       15,796       19,375  
 
                 
Total impaired loans and leases
    34,624       31,456       39,124  
Less:
                       
Impairment reserve (included in allowance for loan and lease losses)
    3,009       3,000       3,459  
 
                 
Net impaired loans and leases
  $ 31,615     $ 28,456     $ 35,665  
 
                 
Average impaired loans and leases
  $ 38,093     $ 28,821     $ 29,714  
 
                 
 
                       
Foregone interest income attributable to impaired loans and leases
  $ 1,535     $ 1,103     $ 2,702  
Interest income recognized on impaired loans and leases
    (528 )     (36 )     (102 )
 
                 
Net foregone interest income on impaired loans and leases
  $ 1,007     $ 1,067     $ 2,600  
 
                 

 

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Specific reserves are established on impaired loans when evidence of a collateral shortfall exists and we believe that there continues to be potential for us to recover our outstanding principal. When we are certain that we will not recover our principal on a loan or lease, we record a charge-off for the amount we deem uncollectible. We record the charge-off through our allowance for loan and lease losses. For the six months ended June 30, 2011, we recorded net charge-offs of $3.2 million compared to recording net charge-offs for the six months ended June 30, 2010 of $1.4 million. We continue to proactively monitor our loan and lease portfolio for further deterioration and apply our prescribed allowance for loan and lease loss reserve methodology. We believe that our allowance for loan and lease loss reserve was recorded at the appropriate level at June 30, 2011. However, given ongoing complexities with current workout situations, the lack of significant improvement in economic conditions and continued declines in collateral values, further charge-offs and increased provisions for loan losses could be recorded if additional facts and circumstances lead us to a different conclusion. In addition, various federal and state regulatory agencies review the allowance for loan and lease losses. These agencies may require that certain loan and lease balances be classified differently or 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.
A summary of the activity in the allowance for loan and lease losses follows:
                                 
    For the Three Months     For the Six Months  
    Ended June 30,     Ended June 30,  
    2011     2010     2011     2010  
    (Dollars In Thousands)  
 
                               
Allowance at beginning of period
  $ 16,802     $ 15,342     $ 16,271     $ 14,124  
 
                       
Charge-offs:
                               
Commercial real estate
                               
Commercial real estate — owner occupied
    (829 )     (120 )     (1,016 )     (120 )
Commercial real estate — non-owner occupied
    (688 )           (688 )      
Construction and land development
    (1,112 )     (445 )     (1,570 )     (460 )
Multi-family
          (102 )     (3 )     (102 )
1-4 family
    (107 )     (84 )     (261 )     (194 )
Commercial and industrial
    (197 )     (246 )     (198 )     (248 )
Consumer and other
                               
Home equity and second mortgage
    (24 )           (113 )      
Other
    (26 )     (327 )     (35 )     (327 )
 
                       
 
                               
Total charge-offs
    (2,983 )     (1,324 )     (3,884 )     (1,451 )
 
                       
 
                               
Recoveries:
                               
Commercial real estate
                               
Commercial real estate — non-owner occupied
    1             1        
Construction and land development
    13             13        
Multi-family
    202             202        
1-4 family
          4             4  
Commercial and industrial
    367             376       1  
Direct financing leases
    11             19        
Consumer and other
                               
Home equity and second mortgage
    50             61        
 
                       
 
                               
Total recoveries
    644       4       672       5  
 
                       
Net charge-offs
    (2,339 )     (1,320 )     (3,212 )     (1,446 )
Provision for loan and lease losses
    1,474       1,069       2,878       2,413  
 
                       
Allowance at end of period
  $ 15,937     $ 15,091     $ 15,937     $ 15,091  
 
                       
 
                               
Annualized net charge-offs as a % of average gross loans and leases
    1.09 %     0.62 %     0.74 %     0.34 %

 

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Liquidity and Capital Resources
During the six months ended June 30, 2011 and the year ended December 31, 2010, the Banks did not make any dividend payments to the Corporation. The Banks are subject to certain regulatory limitations regarding their ability to pay dividends to the Corporation. We believe that the Corporation will not be adversely affected by these dividend limitations. The Corporation expects to meet its liquidity needs through existing cash on hand, established cash flow sources, its third party senior line of credit, or dividends received from the Banks, if any. The Corporation’s principal liquidity requirements at June 30, 2011 are the repayment of the outstanding balance on its senior line of credit, interest payments due on subordinated notes and interest payments due on junior subordinated notes. The capital ratios of the Corporation and its subsidiaries continue to meet all applicable regulatory capital adequacy requirements and have either remained stable or have shown signs of improvement from December 31, 2010.
The Banks maintain liquidity by obtaining funds from several sources. The Banks’ primary sources of funds are principal and interest repayments on loans receivable and mortgage-related securities, deposits and other borrowings such as federal funds and FHLB advances. The scheduled payments of loans and mortgage-related securities are generally a predictable source of funds. Deposit flows and loan prepayments, however, are greatly influenced by general interest rates, economic conditions and competition.
We view on-balance sheet liquidity as a critical element to maintaining adequate liquidity to meet our cash and collateral obligations. We define our on-balance sheet liquidity as the total of our short-term investments and our unpledged securities available-for-sale. As of June 30, 2011, our immediate on-balance sheet liquidity was $224.2 million. At June 30, 2011 and December 31, 2010, the Banks had $30.2 million and $40.8 million on deposit with the Federal Reserve Bank, respectively. Any excess funds not used for loan funding or satisfying other cash obligations were maintained as part of our on-balance sheet liquidity in our interest bearing accounts with the Federal Reserve Bank, as we value the safety and soundness provided by the Federal Reserve Bank. We plan to utilize excess liquidity to pay down maturing debt, pay down maturing brokered certificates of deposit, or invest in securities to maintain adequate liquidity at an improved margin. Should loan growth opportunities be presented, we would also expect to utilize excess liquidity to fund loan portfolio growth.
We had $496.7 million of outstanding brokered deposits at June 30, 2011, compared to $499.1 million of brokered deposits as of December 31, 2010. We are committed to our continued efforts to raise in-market deposits and reduce our overall dependence on brokered certificates of deposit. However, brokered deposits are an efficient source of funding for the Banks and allow them to gather funds across a larger geographic base at price levels and maturities that are more attractive than single service deposits when required to raise a similar level of deposits within a short time period. Access to such deposits allows us the flexibility to decline pursuing single service deposit relationships in markets that have experienced unfavorable pricing levels. In addition, the administrative costs associated with brokered deposits are considerably lower than those that would be incurred to administer a similar level of local deposits with a similar maturity structure. Our in-market relationships remain stable; however, deposit balances associated with those relationships will fluctuate. We expect to establish new client relationships and continue marketing efforts aimed at increasing the balances in existing clients’ deposit accounts. Nonetheless, we will likely continue to use brokered deposits to compensate for shortfalls in deposit gathering in maturity periods, typically three to five years, needed to effectively match the interest rate sensitivity measured through our defined asset/liability management process. In order to provide for ongoing liquidity and funding, all of our brokered deposits are certificates of deposit that do not allow for withdrawal at the option of the depositor before the stated maturity.

 

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The Banks were able to access the brokered certificate of deposit market as needed at rates and terms comparable to market standards during the six-month period ending June 30, 2011. In the event that there is a disruption in the availability of brokered deposits at maturity, the Banks have managed the maturity structure so that at least one year of maturities could be funded through borrowings with the Federal Home Loan Bank or Federal Reserve Discount Window utilizing currently unencumbered securities as collateral. We believe the Banks will also have access to the unused federal funds lines, cash flows from borrower repayments, and cash flows from security maturities and have the ability to raise local market deposits by offering attractive rates to generate the level required to fulfill their liquidity needs.
The Banks are required by federal regulation to maintain sufficient liquidity to ensure safe and sound operations. We believe that the Banks have sufficient liquidity to match the balance of net withdrawable deposits and short-term borrowings in light of present economic conditions and deposit flows.
Contractual Obligations and Off-balance Sheet Arrangements
There were no significant changes to the Corporation’s contractual obligations and off-balance arrangements disclosed in our Form 10-K for the year ended December 31, 2010. We continue to believe that we have adequate capital and liquidity available from various sources to fund projected contractual obligations and commitments.
Item 3.   Quantitative and Qualitative Disclosures about Market Risk
Interest rate risk, or market risk, arises from exposure of our financial position to changes in interest rates. It is our strategy to reduce the impact of interest rate risk on net interest margin by maintaining a favorable match between the maturities and repricing dates of interest-earning assets and interest-bearing liabilities. This strategy is monitored by the Banks’ respective Asset/Liability Management Committees, in accordance with policies approved by the Banks’ respective Boards of Directors. These committees meet regularly to review the sensitivity of each Bank’s assets and liabilities to changes in interest rates, liquidity needs and sources, and pricing and funding strategies.
We use two techniques to measure interest rate risk. The first is simulation of earnings. The balance sheet is modeled as an ongoing entity whereby future growth, pricing, and funding assumptions are implemented. These assumptions are modeled under different rate scenarios.
The second measurement technique used is static gap analysis. Gap analysis involves measurement of the difference in asset and liability repricing on a cumulative basis within a specified time frame. A positive gap indicates that more interest-earning assets than interest-bearing liabilities reprice/mature in a time frame and a negative gap indicates the opposite. In addition to the gap position, other determinants of net interest income are the shape of the yield curve, general rate levels, reinvestment spreads, balance sheet growth and mix and interest rate spreads. We manage the structure of interest-earning assets and interest-bearing liabilities by adjusting their mix, yield, maturity and/or repricing characteristics based on market conditions. Currently, we do not employ any derivatives to assist in managing our interest rate risk exposure; however, management has the authorization and ability to utilize such instruments should they be necessary to manage interest rate exposure.
The process of asset and liability management requires management to make a number of assumptions as to when an asset or liability will reprice or mature. Management believes that its assumptions approximate actual experience and considers them reasonable, although the actual amortization and repayment of assets and liabilities may vary substantially. Our economic sensitivity to changes in interest rates at June 30, 2011 has not changed materially since December 31, 2010.
Item 4.   Controls and Procedures
The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has evaluated the Corporation’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer have concluded that the Corporation’s disclosure controls and procedures were effective as of June 30, 2011.
There was no change in the Corporation’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

 

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PART II. Other Information
Item 1.   Legal Proceedings
From time to time, the Corporation and its subsidiaries are engaged in legal proceedings in the ordinary course of their respective businesses. Management believes that any liability arising from any such proceedings currently existing or threatened will not have a material adverse effect on the Corporation’s financial position, results of operations, or cash flows.
Item 1A.   Risk Factors
There were no material changes to risk factors as previously disclosed in Item 1A. to Part I of the Corporation’s Form 10-K for the year ended December 31, 2010.
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds
  (a)   None.
  (b)   None.
  (c)   Issuer Purchases of Equity Securities
                                 
                            Approximate  
                    Total Number of     Dollar Value of  
                    Shares Purchased     Shares that May  
    Total             as Part of     Yet Be  
    Number of     Average     Publicly     Purchased Under  
    Shares     Price Paid     Announced Plans     the Plans or  
Period   Purchased(1)     Per Share     or Programs     Programs(2)  
 
                               
April 1, 2011 — April 30, 2011
    301     $ 11.75           $ 177,150  
May 1, 2011 — May 31, 2011
    47       12.58             177,150  
June 1, 2011 — June 30, 2011
                      177,150  
     
(1)   The shares in this column represent the 348 shares that were surrendered to us to satisfy income tax withholding obligations in connection with the vesting of restricted shares during the three months ended June 30, 2011.
 
(2)   On November 20, 2007, the Corporation publicly announced a stock repurchase program whereby the Corporation may repurchase up to $1,000,000 of the Corporation’s outstanding stock. As of June 30, 2011, approximately $177,150 remains available to repurchase the Corporation’s outstanding stock. There currently is no expiration date to this stock repurchase program.
Item 3.   Defaults Upon Senior Securities
    Not applicable.
Item 4.   Reserved

 

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Item 5.   Other Information
None.
Item 6.   Exhibits
         
  (31.1 )  
Certification of the Chief Executive Officer.
  (31.2 )  
Certification of the Chief Financial Officer.
  (32 )  
Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. paragraph 1350.
  (101 )  
The following financial information from First Business Financial Services, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of June 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income for the three- and six- months ended June 30, 2011 and 2010, (iii) Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the six months ended June 30, 2011 and 2010, (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2011 and 2010, and (v) the Notes to Unaudited Consolidated Financial Statements tagged as blocks of text.*+

* Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability.
+ Submitted electronically with this Quarterly Report.

Signatures
Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
 
  FIRST BUSINESS FINANCIAL SERVICES, INC.    
 
       
July 29, 2011
 
/s/ Corey A. Chambas
    Corey A. Chambas    
 
  Chief Executive Officer    
 
       
July 29, 2011
 
/s/ James F. Ropella
    James F. Ropella    
 
  Chief Financial Officer    

 

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FIRST BUSINESS FINANCIAL SERVICES, INC.
Exhibit Index to Quarterly Report on Form 10-Q
Exhibit Number
         
  31.1    
Certification of the Chief Executive Officer
       
 
  31.2    
Certification of the Chief Financial Officer
       
 
  32    
Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. paragraph 1350
       
 
  (101)    
The following financial information from First Business Financial Services, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of June 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income for the three- and six- months ended June 30, 2011 and 2010, (iii) Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the six months ended June 30, 2011 and 2010, (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2011 and 2010, and (v) the Notes to Unaudited Consolidated Financial Statements tagged as blocks of text.*+
     
*   Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability.
 
+   Submitted electronically with this Quarterly Report.

 

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