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ITEM 1.  Financial Statements Continued:

 

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Mid-Wisconsin Financial Services, Inc. and Subsidiary

Notes to Unaudited Consolidated Financial Statements

Note 1 – Basis of Presentation

General

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly Mid-Wisconsin Financial Services, Inc.’s (the “Company”) and Mid-Wisconsin Bank’s, its wholly owned banking subsidiary (the “Bank”), consolidated balance sheets, results of operations, comprehensive income, changes in stockholders’ equity and cash flows for the periods presented, and all such adjustments are of a normal recurring nature.  The consolidated balance sheets include the accounts of all subsidiaries.  All material intercompany transactions and balances are eliminated.  The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. We have reviewed and evaluated subsequent events through the date this Form 10-Q was filed.

These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been omitted or abbreviated.  The information contained in the consolidated financial statements and footnotes in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”) should be referred to in connection with the reading of these unaudited interim financial statements.

Preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, fair value of financial instruments, the allowance for loan losses, useful lives for depreciation and amortization, deferred tax assets, uncertain income tax positions and contingencies. Management does not anticipate any material changes to estimates in the near term. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to:  external market factors such as market interest rates and employment rates, changes to operating policies and procedures, and changes in applicable banking regulations. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period.

Recent Accounting Pronouncements  

In April 2011, the FASB issued clarifying guidance regarding which loan modifications constitute troubled debt restructurings.  In evaluating whether a restructuring constitutes a troubled debt restructuring, the guidance maintains a creditor must separately conclude that the restructuring constitutes a concession and the debtor is experiencing financial difficulties.  The accounting standard provides further guidance with respect to whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties.  The measurement guidance is effective for interim and annual periods beginning on or after June 15, 2011, while the disclosure guidance is effective for interim and annual periods beginning on or after June 15, 2011 with retrospective application to restructurings occurring on or after the beginning of the fiscal year.  The Company adopted the accounting standard as of the beginning of the third quarter of 2011, as required, with no material impact on its results of operations, financial position, and liquidity.

In April 2011, the FASB issued an accounting standard that modifies the criteria for determining when repurchase agreements would be accounted for as a secured borrowing rather than as a sale.  Currently, an entity that maintains effective control over transferred financial assets must account for the transfer as a secured borrowing rather than as a sale.  The provisions remove from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee.  The FASB believes that contractual rights and obligations determine effective control and that there does not need to be a requirement to assess the ability to exercise those rights.  The accounting standard does not change the other existing criteria used in the assessment of effective control and is effective prospectively for transactions, or modifications of existing transactions, that occur on or after January 1, 2012.  As the Company accounts for all of its repurchase agreements as collateralized financing arrangements, the adoption of this accounting standard had no material impact on the consolidated financial statements of the Company.

 

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In May 2011, the FASB issued an accounting standard that provides a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”).  The changes to U.S. GAAP as a result of the accounting standard are as follows:  (i) the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (ii) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets, while the new accounting standard extends that prohibition to all fair value measurements; (iii) an exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks, which such exception allows the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (iv) the fair value measurement of instruments classified within an entity’s shareholders’ equity have been aligned with the guidance for liabilities; and (v) disclosure requirements have been enhanced for recurring Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to describe the sensitivity of fair value measurements to changes in unobservable inputs and interrelationships between those inputs.  In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. These new disclosures were adopted during the quarter ended March 31, 2012 and did not have a material impact on the consolidated financial statements of the Company.

 In June 2011, the FASB issued an accounting standard that allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income.  The statement(s) are required to be presented with equal prominence as the other primary financial statements.  The accounting pronouncement eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.  The Company has adopted this standard effective March 31, 2012, electing to present a consolidated statement of comprehensive income separate from, but consecutive to, its statement of operations.

In July 2010, the FASB issued new accounting guidance requiring extensive new disclosures surrounding the allowance for loan losses although it did not change any credit loss recognition or measurement rules.  The new rules require disclosure to include a breakdown of allowance for loan loss activity by portfolio segment as well as problem loan disclosures by detailed class of loan.  In addition, disclosures on internal credit grading metrics and information on impaired, non-accrual, and restructured loans are also required.  The period-end disclosures were effective for financial periods ending December 31, 2010 but deferred presentation of loan loss allowance by loan portfolio segment until the quarter ended March 31, 2011.  The Company adopted the rules for loan loss allowance disclosures by loan segment effective March 31, 2011.

 

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Note 2 – Earnings (Loss) per Common Share

Earnings (loss) per common share is calculated by dividing net income (loss) available to common equity by the weighted average number of common shares outstanding.  Diluted earnings (loss) per share is calculated by dividing net income (loss) available to common equity by the weighted average number of shares adjusted for the dilutive effect of common stock awards.  Presented below are the calculations for basic and diluted earnings (loss) per common share.

	Three Months Ended March 31,
	2012	2011
(In thousands, except per share data)
Net income	$ 21	$ 140
Preferred dividends, discount and premium	(162)	(160)
Net loss available to common equity	($141)	($20)
Weighted average common shares outstanding	1,657	1,652
Effect of dilutive stock options	0	0
Diluted weighted average common shares outstanding	1,657	1,652
Basic and diluted loss per common share	($0.09)	($0.01)

Note 3- Securities

The amortized cost, gross unrealized gains and losses, and fair values of investment securities available-for-sale at March 31, 2012 and December 31, 2011 were as follows:

	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
	($ in thousands)
March 31, 2012
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$ 15,961	$ 314	$ 0	$ 16,275
Mortgage-backed securities	66,832	1,158	68	67,922
Obligations of states and political subdivisions	21,388	1,091	1	22,478
Corporate debt securities	831	1	0	832
Total debt securities	105,012	2,564	69	107,507
Equity securities	151	0	0	151
Total securities available-for-sale	$ 105,163	$ 2,564	$ 69	$ 107,658

	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
	($ in thousands)
December 31, 2011
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$18,479	$329	$0	$18,808
Mortgage-backed securities	66,622	1,110	79	67,653
Obligations of states and political subdivisions	21,619	1,316	3	22,932
Corporate debt securities	831	1	0	832
Total debt securities	107,551	2,756	82	110,225
Equity securities	151	0	0	151
Total securities available-for-sale	$107,702	$2,756	$82	$110,376

 

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The following table represents gross unrealized losses and the related fair value of investment securities available-for-sale, aggregated by investment category and length of time individual securities have been in a continuous unrealized loss position, at March 31, 2012 and December 31, 2011.

The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment (“OTTI”) that may result due to adverse economic conditions or other issuer-specific factors. A determination as to whether a security’s decline in market value is temporary or OTTI takes into consideration numerous factors.  Significant inputs used to measure the amount related to credit loss include, but are not limited to:  (i) the length of time and extent to which fair value has been less than cost; (ii) the financial condition and near-term prospects of the issuer, and (iii) our intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  When management identifies a specific security that has a rating lower than “A”, fair value less than 95% of the amortized cost, and has been in a continuous loss position for twelve months a third party vendor may review the specific security for OTTI.  To determine OTTI, a discounted cash flow model is utilized to estimate the fair value of the security.  The use of a discounted cash flow model involves judgment, particularly of interest rates, estimated default rates and prepayment speeds.  Adjustments to market value that are considered temporary are recorded as separate components of equity, net of tax. If an impairment of a security is identified as OTTI it will be recorded in the Consolidated Statement of Operations.  

As of March 31, 2012 the Company has determined that there are no OTTI securities in the investment portfolio.

Based on the Company’s evaluation, management believes that any remaining unrealized losses at March 31, 2012, are primarily attributable to changes in interest rates and the current market conditions, and not credit deterioration.  Management believes that the Company currently has both the intent and ability to hold the securities that are in a continuous unrealized loss position for the time necessary to recover the amortized cost.

The amortized cost and fair values of investment debt securities available-for-sale at March 31, 2012, by contractual maturity, are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Fair values of securities are estimated based on financial models or prices paid for similar securities.  It is possible interest rates could change considerably, resulting in a material change in estimated fair value.

	Amortized Cost	Fair Value
	($ in thousands)
Due in one year or less	$ 1,625	$ 1,645
Due after one year but within five years	18,816	19,374
Due after five years but within ten years	16,379	17,182
Due after ten years or more	1,360	1,384
Mortgage-backed securities	66,832	67,922
Total debt securities available-for-sale	$ 105,012	$ 107,507

 

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Note 4 – Loans, Allowance for Loan Losses, and Credit Quality

The period-end loan composition as of March 31, 2012 and December 31, 2011 are summarized as follows:

	March 31, 2012	December 31, 2011
($ in thousands)
Commercial business	$ 44,927	$ 41,347
Commercial real estate	123,792	123,868
Real estate construction	24,828	28,708
Agricultural	43,851	45,351
Real estate residential	84,215	85,614
Installment	4,388	4,975
Total loans	$ 326,001	$ 329,863

The allowance for loan losses (“ALLL”) represents management’s estimate of probable and inherent credit losses in the Bank’s loan portfolio. Estimating the amount of the ALLL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of other qualitative factors, all of which may be susceptible to significant change.  To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALLL may be made for specific loans but the entire ALLL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.

A summary of the changes in the ALLL by portfolio segment for the periods indicated:

The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment and the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors.  Loan charge-offs and recoveries are based on actual amounts charged-off or recovered by loan category.  Management allocates the ALLL by pools of risk within each loan portfolio.  

 

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At March 31, 2012, the ALLL allocations for the commercial real estate and real estate residential portfolios increased, with all other loan portfolio allocations declining from December 31, 2011.  The increase in commercial real estate and real estate residential was primarily due to the increase in the amount of impaired loans and the related valuation allowances assigned to these loans during the first three months of 2012.  The allocation of the ALLL by loan portfolio is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular category.  

The following table presents nonaccrual loans by portfolio segment as of the dates indicated as follows:

	March 31, 2012	December 31, 2011
	($ in thousands)
Commercial business	$ 371	$ 734
Commercial real estate	4,208	4,076
Real estate construction	1,142	2,519
Agricultural	322	134
Real estate residential	3,751	3,726
Installment	10	5
Total nonaccrual  loans	$ 9,804	$ 11,194

Loans are generally placed on nonaccrual status when management has determined collection of such interest is doubtful or when a loan is contractually past due 90 days or more as to interest or principal payments.  When loans are placed on nonaccrual status or charged-off, all current year unpaid accrued interest is reversed against interest income. The interest on these loans is subsequently accounted for on the cash basis until qualifying for return to accrual status.  If collectability of the principal is in doubt, payments received are applied to loan principal.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.  

 

A summary of loans by credit quality indicator based on internally assigned credit grade is as follows:

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Loans risk rated acceptable or better are credits performing in accordance with the original terms, have adequate sources of repayment and little identifiable collectability risk.  Special mention credits have potential weaknesses that deserve management’s attention.  If left unremediated, these potential weaknesses may result in deterioration of the repayment of the credit.  Substandard loans typically have weaknesses in the paying capability of the obligor and/or guarantor or in collateral coverage.  These loans have a well-defined weakness that jeopardizes the liquidation of the debt and are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Loans classified as doubtful have all the weaknesses of substandard loans with the added characteristic that the collection of all amounts due according to the original contractual terms is highly unlikely and the amount of the loss is reasonably estimable.  Loans classified as loss are considered uncollectible.  

The following table represents loans by past due status as of the dates indicated:

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The following table presents impaired loans as of the dates indicated:

	Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
			($ in thousands)
March 31, 2012
With a related allowance:
Commercial business	$ 1,257	$ 1,479	$ 222	$ 1,157	$ 11
Commercial real estate	11,560	13,820	2,260	11,854	127
Real estate construction	2,245	2,705	460	2,634	42
Agricultural	291	324	33	314	1
Real estate residential	5,203	6,700	1,497	5,195	69
Installment	15	20	5	20	0
Total	$ 20,571	$ 25,048	$ 4,477	$ 21,174	$ 250
December 31, 2011
With no related allowance:
Commercial business	$ 0	$ 0	$ 0	$ 0	$ 0
Commercial real estate	0	0	0	349	0
Real estate construction	0	0	0	96	0
Agricultural	0	0	0	8	0
Real estate residential	0	0	0	165	0
Installment	0	0	0	0	0
With a related allowance:
Commercial business	$ 482	$ 834	$ 352	$ 460	$ 11
Commercial real estate	8,130	9,888	1,758	7,646	392
Real estate construction	2,103	2,563	460	2,080	51
Agricultural	270	305	35	233	4
Real estate residential	3,010	3,690	680	2,586	103
Installment	6	21	15	8	2
Total:
Commercial business	$ 482	$ 834	$ 352	$ 460	$ 11
Commercial real estate	8,130	9,888	1,758	7,995	392
Real estate construction	2,103	2,563	460	2,176	51
Agricultural	270	305	35	241	4
Real estate residential	3,010	3,690	680	2,751	103
Installment	6	21	15	8	2
Total	$ 14,001	$ 17,301	$ 3,300	$ 13,631	$ 563

At March 31, 2012 there were no impaired loans that did not have a related allowance.

Troubled Debt Restructurings

A loan is accounted for as a troubled debt restructuring if the Bank, for economic or legal reasons related to the borrower’s financial condition, grants a significant concession to the borrower that it would not otherwise consider to maximize the collection of amounts due.  A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions.  

Restructured loans can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accrual status.  Nonaccrual restructured loans are included with all other nonaccrual loans.  All accruing restructured loans are reported as troubled debt restructurings. Restructured loans remain on nonaccrual status until the customer has attained a sustained period of repayment performance under the modified loan terms, by internal policy usually a minimum of nine months.  Performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and whether the loan should

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be returned to, or maintained on, accrual status.  If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains on nonaccrual.  

All restructured loans are considered impaired for reporting and measurement purposes.  A loan that has been modified at a below market rate will return to performing status if it satisfies the nine-month performance requirement; however, it will remain classified as a restructured loan.  

The following table provides the number of loans modified and classified as trouble debt restructurings by loan category during the three months ended March 31, 2012 and year ended December 31, 2011.

During the three months ended March 31, 2012, restructured loan modifications made in the commercial lending segment (commercial business, commercial real estate, and real estate construction loans) primarily included maturity date extensions, and payment schedule modifications.  In addition, the Company may work with the borrowers in identifying other changes that will mitigate loss to the Company, which may include additional collateral or guarantees to support the loan.

Restructured loan modifications made in the consumer lending segment (real estate residential and installment loans) during the three months ended March 31, 2012 included maturity date extensions, interest rate concessions, deferrals of payments, and payment schedule modifications.  

The following table summarizes troubled debt restructuring during the previous twelve months that subsequently defaulted during the three months ended March 31, 2012.

	Three Months Ended March 31, 2012
	Number of Loans	Recorded Investment
	($ in thousands)
Commercial business	0	$ 0
Commercial real estate	6	972
Real estate construction	0	0
Agricultural	0	0
Real estate residential	0	0
Installment	0	0
	6	$ 972

All loans modified in a troubled debt restructuring are evaluated for impairment.  The nature and extent of impairment of restructured loans, including those which have experienced a subsequent payment default, are considered in the determination of an appropriate level of the ALLL.

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Note 5 – Other Real Estate Owned (“OREO”)

A summary of OREO, net of valuation allowances for the periods indicated is as follows:

	Three months ended March 31, 2012	Year ended December 31, 2011
	($ in thousands)
Balance at beginning of period	$ 4,404	$ 4,230
Transfer of loans at net realizable value to OREO	465	2,631
Sale proceeds	(552)	(1,995)
Loans made in sale of OREO	0	(75)
Net gain (loss) from sale of OREO	(73)	241
Provision for write-downs charged to operations	(80)	(628)
Balance at end of period	$ 4,164	$ 4,404

An analysis of the valuation allowance on OREO, included in the above table, is as follows:

	Three months ended March 31, 2012	Year ended December 31, 2011
	($ in thousands)
Balance at beginning of period	$ 410	$ 2,788
Provision for write-downs charged to operations	80	628
Amounts related to OREO disposed of	(155)	(3,006)
Balance at end of period	$ 335	$ 410

OREO was $4,164 at March 31, 2012, compared to $4,404 at December 31, 2011.  The properties held as OREO at March 31, 2012 consisted of $3,293 of commercial real estate (the largest being $1,744 related to a hotel/water park project), $718 real estate construction loans, and $153 residential real estate.  OREO as of year -end 2011 consisted of $3,170 of commercial real estate (the largest being $1,744 related to a hotel/water park project), $946 real estate construction, and $288 residential real estate.  Management monitors properties held to minimize the Company’s risk of loss. Evaluations of the fair market value of the OREO properties are done quarterly and valuation adjustments, if necessary, are recorded in our consolidated financial statements.

For the three months ended March 31, 2012, the Bank acquired OREO of $465 measured at fair value less selling costs.  In addition, an impairment write down of $80 was made against OREO properties acquired in prior years and charged to 2012 earnings.  In 2011, the Bank acquired OREO of $2,631 measured at fair value less selling costs.  In addition, an impairment write down of $628 was made against these properties, as well as some of the OREO properties acquired in prior years and charged to earnings for the year ended December 31, 2011.   

Note 6- Short-term Borrowings

Short-term borrowings consisted of $15,611 and $13,655 of securities sold under repurchase agreements at March 31, 2012 and December 31, 2011, respectively.

The Company pledges securities available-for-sale as collateral for repurchase agreements.  The fair value of securities pledged for short-term borrowings totaled $19,229 at March 31, 2012 and $19,481 at December 31, 2011.

The following information relates to federal funds purchased, securities sold under repurchase agreements, and the Bank’s Federal Home Loan Bank of Chicago (“FHLB”) open line of credit for the following periods.

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	Three months ended	Year ended
	March 31, 2012	December 31, 2011
	($ in thousands)
Weighted average rate	0.41%	0.46%
For the period:
Highest month-end balance	$ 16,914	$ 15,817
Daily average balance	$ 15,430	$ 12,285
Weighted average rate	0.23%	1.00%

Note 7- Long-term Borrowings

Long-term borrowings were as follows:

	Three months ended	Year ended
	March 31, 2012	December 31, 2011
	($ in thousands)
FHLB advances	$ 28,061	$ 30,061
Other borrowed funds	10,000	10,000
Total long-term borrowings	$ 38,061	$ 40,061

FHLB Advances – Long-term advances from the FHLB have maturities through 2015 and had a weighted-average interest rate of 2.94% and 2.98% at March 31, 2012 and December 31, 2011, respectively.  FHLB advances decreased $2,000 from year-end 2011 to March 31, 2012, due to the maturity of an advance that was not renewed because the Company’s liquidity position was sufficient without such advances.

  

Other borrowed funds – Other borrowed funds consist of structured repurchase agreements.  The fixed rate structured repurchase agreements mature in 2014 and 2015, are callable in 2013, and had weighted-average interest rates of 4.24% at March 31, 2012 and December 31, 2011.

Note 8 - Fair Value Measurements

Fair value represents the estimated price at which an orderly transaction to sell an asset or to transfer a liability would take place between market participants at the measurement date under current market conditions (i.e., an exit price concept).   As there is no active market for many of the Company’s financial instruments, estimates are made using discounted cash flow or other valuation techniques. Inputs into the valuation methods are subjective in nature, involve uncertainties, and require significant judgment and therefore cannot be determined with precision. Accordingly, the derived fair value estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. Assets and liabilities are categorized into three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. 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 in 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 Company’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. Below is a brief description of each fair value level.

Level 1 – Fair value measurement is based on quoted prices for identical assets or liabilities that the Company has the ability to access.

Level 2 – Fair value measurement is based on: (i) quoted prices for similar assets or liabilities in active markets; (ii) quoted prices for similar assets or liabilities in markets that are not active; or (iii) valuation models and methodologies for which all significant assumptions are or can be corroborated by observable market data.

Level 3 – Fair value measurement is based on valuation models and methodologies that incorporate unobservable inputs, which are typically based on an entity’s own assumptions, as there is little related market activity.

 

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In May 2011, the FASB issued guidance on measuring fair value to create common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments changes the wording used to describe many of the requirements for measuring fair value and for disclosing information about fair value measurements. The amendment also clarifies the application of existing fair value measurement and disclosure requirements. As a result, certain prior period reclassifications and disclosures have been made to conform to the new requirements. The Company now classifies impaired loans and OREO as a Level 3 fair value measurement, compared to a Level 2 fair value measurement in prior periods, and the prior periods have been reclassified to reflect this change. These reclassifications had no impact on the Corporation’s consolidated results of operations, financial position, or liquidity.

The following is a description of the valuation methodology used for the Company’s more significant instruments measured on a recurring basis at fair value, including the general classification of such instruments pursuant to the valuation hierarchy.

Investment securities available-for-sale – Securities available-for-sale may be classified as Level 1, Level 2, or Level 3 measurements within the fair value hierarchy.  The fair value measurement of a Level 1 security is based on the quoted price in an active market.  Level 1 investment securities primarily include U.S. Treasury securities.  The fair value measurement of a Level 2 security is obtained from an independent pricing service and is based on pricing models, quoted prices of securities with similar characteristics or discounted cash flows, with consideration given to the nature of the quote and the relationship of recently evidenced market activity to the fair value estimate. Examples of these investment securities include Federal agency securities, obligations of states and political subdivisions, asset-backed securities, and mortgage related securities.  In certain cases where there is limited activity or less transparency around inputs to the estimated fair value, securities are classified within Level 3 of the fair value hierarchy.  Level 3 securities primarily include trust preferred securities. To validate the fair value estimates, assumptions, and controls, the Company looks to transactions for similar instruments and utilizes relevant market indices. While none of these sources are solely indicative of fair value, they serve as directional indicators for the appropriateness of the Company’s fair value estimates. The Company has determined that the fair value measures of its investment securities are classified predominantly within Level 2 of the fair value hierarchy.  

Loans held for sale – Loans held for sale, which consist generally of current production of certain fixed-rate, first-lien residential mortgage loans, are carried at the lower of cost or estimated fair value.  The estimated fair value of the residential mortgage loans held for sale was based on current secondary market prices for similar loans, which is considered to be Level 2 in the fair value hierarchy of valuation techniques.  

The fair value of loans held for sale is based on observable current prices in the secondary market in which loans trade. All loans held for sale are categorized based on commitments received from secondary sources that the loans qualify for placement at the time of underwriting and at an agreed upon price. A gain or loss is recognized at the time of sale reflecting the present value of the difference between the contractual interest rate of the loan and the yield to investors.

The table below presents the Company’s investment securities available-for-sale and loans held for sale measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011, aggregated by the level in the fair value hierarchy within which those measurements fall.

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The table below presents a roll forward of the balance sheet amounts for the three months ended March 31, 2012 and for the year ended December 31, 2011, for assets measured on a recurring basis and classified within Level 3 of the fair value hierarchy.

Assets Measured at Fair Value Using Significant Unobservable Inputs (Level 3)
($ in thousands)
		Investment Securities Available-for-Sale
Balance at December 31, 2010		$ 2,299
Unrealized holding losses arising during the period:
Included in earnings		(55)
Included in other comprehensive income		7
Principal repayments		(146)
Sales		(641)
Transfers into Level 3		0
Balance at December 31, 2011		1,464
Unrealized holding losses arising during the period:
Included in earnings		0
Included in other comprehensive income		1
Principal repayments		(13)
Sales		0
Transfers in/out Level 3		0
Balance at March 31, 2012		$ 1,452

Level 3 available-for-sale securities include corporate debt and equity securities.  The market for these securities was not active as of March 31, 2012.  

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The following is a description of the valuation methodologies used for the Company’s more significant instruments measured on a nonrecurring basis at fair value.

Impaired loans – The Company considers a loan impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement, including principal and interest.   Loans considered to be impaired are measured at fair value on a nonrecurring basis.  For individually evaluated impaired loans, the amount of impairment is based upon the fair value of the underlying collateral.  

At March 31, 2012 loans with a carrying amount of $25,048 were considered impaired and were written down to their estimated fair value of $20,571.  As a result, the Company recognized a specific valuation allowance against these impaired loans totaling $4,477.  At year end December 31, 2011 loans with a carrying amount of $17,301 were considered impaired and were written down to their estimated fair value of $14,001.  As a result, the Company recognized a specific valuation allowance against these impaired loans totaling $3,300

OREO – Real estate acquired through or in lieu of loan foreclosure is recorded in our consolidated balance sheets at the lower of cost or fair value.  Fair value is determined based on third party appraisals and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the fair value.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to the appraised values necessary to estimate the fair value of the properties, OREO is considered to be Level 3 in the fair value hierarchy of valuation techniques.  Valuation adjustments to OREO totaled $80 and $6 during the three months ended March 31, 2012 and 2011, respectively and are recorded in Foreclosure/OREO expense.  At March 31, 2012 and December 31, 2011, OREO totaled $4,164 and $4,404, respectively.

The table below presents the Company’s impaired loans and OREO measured at fair value on a nonrecurring basis as of March 31, 2012 and December 31, 2011, aggregated by the level in the fair value hierarchy within those measurements fall.

Taxable-equivalent net interest income for the three months ended March 31, 2012, was $3,812, down from $3,949 in the related 2011 period. The decrease in taxable-equivalent net interest income was primarily attributable to unfavorable rate variances (as the impact of changes in the interest rate environment and product pricing reduced taxable-equivalent net interest income by $164) offset by a favorable volume variances (as changes in the balances and mix of earning assets and interest-bearing liabilities increased taxable-equivalent net interest income by $27).

The taxable-equivalent net interest margin for the first three months of 2012 was 3.38%, an increase from 3.36% in the related 2011 period.  Yields on earning assets have compressed year over year as elevated levels of liquidity have been reinvested in lower-yielding investment securities and interest-bearing deposits at other financial institutions as quality loan demand has been weak and levels of nonaccrual loans remain above historical averages.  

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The decline in yields was more than offset by the decline in the cost of interest-bearing deposits due to the reduction in interest rates.  

For 2012, the yield on earning assets of 4.59% was 27 basis points (“bps”) lower than the comparable period last year.  Loan yields decreased 32 bps, to 5.46%, impacted by levels of nonaccrual loans, lower loan yields given the repricing of adjustable rate loans, soft loan demand, and competitive pricing pressures to retain and/or obtain creditworthy borrowers.  The yield on other earning assets decreased 28 bps to 2.29%, impacted by the Company’s excess liquidity position invested in lower-yielding assets resulting from soft loan demand.

The cost of interest-bearing liabilities of 1.47% for the first three months of 2012 was 32 bps lower than the related 2011 period.  The average cost of interest-bearing deposits was 1.16%, down 39 basis points, while the cost of wholesale funding (comprised of short-term borrowings and long-term borrowings) decreased 19 bps to 3.11% for the three months ended March 31, 2012.  The Company’s outstanding $10,310 of subordinated debentures has a floating rate equal to the three-month LIBOR plus 1.43%, adjusted quarterly.  The interest rate at March 31, 2012 was 1.90%.  

Average earning assets of $453,692 for the first three months of 2012 was $22,786 lower than the comparable period last year.   Average investment securities increased $5,668 to $107,323, reflecting the Company’s excess liquidity position invested in lower-yielding assets rather than loans.  Average loans decreased $10,291 to $329,446 as a result of soft loan demand, pay-offs, charge-offs and the Bank’s focus on asset quality rather than loan growth at this time.   Overnight liquidity (comprised of interest-bearing deposits in other financial institutions, federal funds sold, and securities purchased under agreements to sell) decreased $17,795 to $13,676, due to the decrease in total average interest-bearing liabilities without a corresponding liquidation of investment securities.  Taxable-equivalent interest income in 2012 decreased $535 to $5,175 of which $179 was due to unfavorable volume changes and $356 was due to unfavorable rate changes.

Average interest-bearing liabilities of $373,426 for the first three months of 2012 were down $26,099 compared to the related 2011 period. Average interest-bearing deposits decreased $27,171 while noninterest-bearing deposits increased $8,317.  For the first three months of 2012, interest expense decreased $398 of which $192 was due to favorable rate changes and $206 was due to favorable volume changes.

Table 2:  Volume/Rate Variance – Taxable-Equivalent Basis

Comparison of three months ended March 31, 2012 versus 2011
	Volume	Due to Rate (1)	Net
	($ in thousands)
Loans (2)	($148)	($226)	($374)
Taxable investments	39	(128)	(89)
Tax-exempt investments (2)	2	(9)	(7)
Interest-bearing deposits in other financial institutions	0	4	4
Federal funds sold	(3)	0	(3)
Securities purchased under agreements to sell	(68)	1	(67)
Other interest-earning assets	(1)	2	1
Total earning assets	(179)	(356)	(535)
Interest-bearing demand	(2)	(7)	(9)
Savings deposits	17	(15)	2
Time deposits	(194)	(190)	(384)
Short-term borrowings	13	(3)	10
Long-term borrowings	(40)	17	(23)
Subordinated debenture	0	6	6
Total interest-bearing liabilities	(206)	(192)	(398)
Net interest income	$ 27	($164)	($137)
(1)  The change in interest due to both rate and volume has been allocated to rate.
(2)  The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent
basis using a federal tax rate of 34% and adjusted for the disallowance of interest expense.

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Provision for Loan Losses

The provision for loan losses for the first three months of 2012 was $750, compared to $1,050 for the same period in 2011.  The decrease in provision was due primarily to improving economic factors, decreased delinquencies and decreased levels of nonaccrual loans.  Net charge-offs were $498 for the first three months of 2012, compared to $814 for the same period of 2011.  At March 31, 2012, the ALLL was $10,068, an increase of $252 from December 31, 2011.  The ratio of the ALLL to total loans was 3.09% and 2.98% at March 31, 2012 and December 31, 2011, respectively. Nonperforming loans at March 31, 2012, were $9,817, compared to $11,215 at December 31, 2011, representing 3.01% and 3.40% of total loans, respectively.

The provision for loan losses is predominantly a function of the Company’s methodology and judgment as to qualitative and quantitative factors used to determine the adequacy of the ALLL.  The adequacy of the ALLL is affected by changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, historical losses and delinquencies on each portfolio category, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing and future economic conditions, the fair value of underlying collateral, and other factors which could affect potential credit losses.  We believe the provision and level of our ALLL conforms to our policies and was adequate to cover anticipated and unexpected loan losses inherent in our loan portfolio as of March 31, 2012.  However, we may need to increase our provisions for loan losses in the future should the quality of the loan portfolio decline or other factors used to determine the ALLL worsen.  Please refer to the discussion under “Allowance for Loan Losses” also included under Item 2.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for further information.

Noninterest Income

Table 3:  Noninterest Income

	Three months ended
	March 31,	March 31,
	2012	2011	$ Change	% Change
		($ in thousands)
Service fees	$ 189	$ 253	($64)	(25%)
Trust service fees	271	266	5	2%
Investment product commissions	38	44	(6)	(14%)
Mortgage banking	176	149	27	18%
Loss on sale of investments	0	(55)	55	(100%)
Other	311	765	(454)	(59%)
Total noninterest income	$ 985	$ 1,422	($437)	(31%)

Noninterest income for the first three months of 2012 was $985, down $437, or 31%, from the same period in 2011.

Excluding a legal settlement of $500, which is included in “Other” for the three months ended March 31, 2011 and a $55 loss on the sale of investments during that period, noninterest income totaled $977 for the three months ended March 31, 2011 and therefore increased by $8 year-over-year.

Service fees on deposit accounts for the first three months of 2012 were $189, down $64, or 25%, from the comparable period last year.  The decline in service fees was primarily due to a general decrease in the amount of NSF/overdraft fees resulting from regulatory changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Core fee based revenues are expected to remain depressed going forward due to these regulatory changes as well.  

The Wealth Management Services Group generates trust service fees and investment product commissions. Wealth Management income was $309 for the first three months of 2012, relatively unchanged from the same period in 2011, primarily due to the level of assets under management, on which trust service fees are based, remaining relatively flat and investment product sales decreasing slightly.

Mortgage banking income represents income received from the sale of residential real estate loans into the secondary market.  Mortgage banking income for the first three months of 2012 was $176, compared to $149 for same period in 2011.  This increase between the three months ended March 31, 2012 and 2011was primarily attributable to higher volume of loans sold to the secondary market.  Secondary mortgage production was $12,361for the three months ended March 31, 2012, compared to $11,826 for the same period in 2011.  

 

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The Company recognized a $55 loss on the sale of investments in the first quarter 2011.  The security sales were executed in an effort to increase the credit quality of the Company’s investment portfolio.  No such gains were recognized in 2012.  

In the first quarter of 2011 the Company received a $500 legal settlement, the details of which are subject to a confidentiality agreement.  Excluding this legal settlement, other operating income increased $46, or 17%, to $311 for the first three months of 2012 compared to $265 in the same period in 2011, primarily due to $43 of loan fees recovered from charged-off loans.

Noninterest Expense

Table 4:  Noninterest Expense

	Three months ended
	March 31,	March 31,
	2012	2011	$ Change	% Change
	($ in thousands)
Salaries and employee benefits	$ 1,998	$ 2,131	(133)	(6%)
Occupancy	434	484	(50)	(10%)
Data processing	154	173	(19)	(11%)
Foreclosure/OREO expense	237	42	195	464%
Legal and professional fees	189	167	22	13%
FDIC expense	257	314	(57)	(18%)
Other	695	808	(113)	(14%)
Total noninterest expense	$ 3,964	$ 4,119	(155)	(4%)

Total noninterest expense was $3,964 for the first three months of 2012, a decrease of $155, or 4%, compared to the first three months of 2011, primarily due to decreased salaries and employee benefits, occupancy expenses, data processing costs, FDIC expense and marketing expenses, offset by a $195 increase in foreclosure/OREO expense and $22 increase in legal and professional fees.

Salaries and employee benefits of $1,998 for the first three months of 2012 decreased $133, or 6%, from the same period in 2011, primarily due to the decrease in the number of executive management positions at the Company.  Occupancy expense decreased $50, or 10%, in the first three months of 2012, due to the decreased costs of building maintenance, utility costs, and automobile expense in part due to the February 1, 2011 closing of the Bank’s branch located in Lake Tomahawk, Wisconsin.  Data processing costs decreased $19, or 11%, due to decreased maintenance costs.  

Foreclosure/OREO expense consist of OREO carrying costs (maintenance, utilities, real estate taxes), valuation adjustments against the OREO carrying value, and gains or losses from the sale of OREO.  Foreclosure/OREO expense increased $195 between the comparable three-month periods.  Foreclosure/OREO expense for the first three months of 2012 included $80 of valuation adjustments against the carrying costs of various foreclosed properties based on appraisals obtained during the quarter, compared to $6 in such valuation adjustments in the same period in 2011.  Net losses on the sale of foreclosed properties were $73 for the three months ended March 31, 2012 compared to net gains on the sale of foreclosed properties of $51 for the three months ended March 31, 2011.

Legal and professional fees of $189 increased $22, or 13%, primarily due to higher legal costs associated with regulatory compliance in 2012.  The decrease in FDIC expense of $57 was primarily due to the decrease in the Bank’s average assets which is the basis of the FDIC assessment calculation. Other operating expenses decreased $113 compared to the first three months of 2011, primarily due to a $61 decrease in marketing costs, which had been elevated in the 2011 period due to the introduction of a new deposit program at that time.  

Income Taxes

The basic principles for accounting for income taxes require that deferred income taxes be analyzed to determine if a valuation allowance is required.  A valuation allowance is required if it is more likely than not that some portion of the deferred tax asset will not be realized.  Primarily due to net operating loss carryovers in 2011and 2012, the Bank’s net deferred tax asset (prior to any valuation allowance) increased to $4,311 as of March 31, 2012.  In determining whether any impairment of this asset should be recognized, the Company considers all available

 

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evidence, both positive and negative.  Based on consideration of the available evidence including historical losses, which must be treated as substantial negative evidence, and the potential of future taxable income, a $3,081 valuation allowance was determined to be necessary at December 31, 2011 to adjust deferred tax assets to the amount of net operating losses that are expected to be realized.  At March 31, 2012 it was determined that no additional valuation allowance was necessary at this time.  If realized, the tax benefit for this item will reduce current tax expense for that period.  

FINANCIAL CONDITION

Investment Securities Portfolio

The investment securities portfolio is intended to provide the Bank with adequate liquidity, flexible asset/liability management and a source of stable income.  The portfolio is structured with minimum credit exposure to the Bank. All securities are classified as available-for-sale and are carried at fair market value.  Unrealized gains and losses are excluded from earnings, but are reported as other comprehensive income in a separate component of stockholders’ equity, net of income tax.   Premium amortization and discount accretion are recognized as adjustments to interest income using the interest method.  Realized gains or losses on sales are based on the net proceeds and the adjusted carrying value amount of the securities sold using the specific identification method.

At March 31, 2012, the total carrying value of investment securities was $107,658, a decrease of $2,718, or 2%, compared to December 31, 2011, and represented 22% and 23% of total assets at March 31, 2012 and December 31, 2011, respectively.  Primarily due to continued soft loan demand, the Company’s excess liquidity was invested in securities.  As loan demand is anticipated to increase in the future, we anticipate that future investment securities pay downs will be used to fund loans.

Beginning in 2010, the Company determined that OTTI existed in one non-agency mortgage-backed security and two corporate securities held.  The unrealized losses on these securities appeared to be related, in part, to expected credit losses that would not be recovered by the Company.  During 2010, the Company recognized OTTI write-downs of $412 on the two corporate securities.  In the first three months of 2011, the company sold these three OTTI securities, which resulted in net investment security losses of $55, and improved the credit quality within the investment portfolio.  As of March 31, 2012 the Company has determined that there are no securities that would be classified as OTTI in the investment portfolio.

 

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Table 5:  Investments