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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

xQuarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2014

 

OR

 

¨Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number: 000-31207

 

BANK MUTUAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Wisconsin   39-2004336
(State or other jurisdiction of   (IRS Employer Identification No.)
incorporation or organization)    

 

4949 West Brown Deer Road
Milwaukee, Wisconsin  53223
(414) 354-1500
(Address, including Zip Code, and telephone number,
including area code, of registrant’s principal executive offices)

  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.

 

Yes x                No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File 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 x                No ¨

 

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

 

Large accelerated filer o  Accelerated filer x
Non-accelerated filer o  Small reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨                No x

 

The number of shares outstanding of the issuer’s common stock, $0.01 par value per share, was 46,564,284 shares, at November 4, 2014.

 

 
 

 

BANK MUTUAL CORPORATION

 

FORM 10-Q QUARTERLY REPORT

 

Table of Contents

 

Item   Page
     
PART I    
     
Item l. Financial Statements  
     
  Unaudited Condensed Consolidated Statements of Financial Condition as of September 30, 2014, and December 31, 2013 3
     
  Unaudited Condensed Consolidated Statements of Income  for the Three and Nine Months Ended September 30, 2014 and 2013 4
     
  Unaudited Condensed Consolidated Statements of Total Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2013 6
     
  Unaudited Condensed Consolidated Statements of Equity for the Nine Months Ended September 30, 2014 and 2013 7
     
  Unaudited Condensed Consolidated Statements of Cash Flows  for the Nine Months Ended September 30, 2014 and 2013 8
     
  Notes to Unaudited Condensed Consolidated Financial Statements 9
     
Item 2. Management's Discussion and Analysis of Financial  Condition and Results of Operations 33
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 49
     
Item 4. Controls and Procedures 53
     
PART II    
     
Item 1A. Risk Factors 54
     
Item 6. Exhibits 54
     
SIGNATURES   55
2
 

 

PART I

 

Item 1. Financial Statements

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Financial Condition

 

   September 30   December 31 
   2014   2013 
   (Dollars in thousands) 
Assets          
           
Cash and due from banks  $27,003   $23,747 
Interest-earning deposits   7,291    18,709 
Cash and cash equivalents   34,294    42,456 
Mortgage-related securities available-for-sale, at fair value   348,046    446,596 
Mortgage-related securities held-to-maturity, at amortized cost (fair value of $154,094 in 2014 and $153,223 in 2013)   153,626    155,505 
Loans held-for-sale   4,678    1,798 
Loans receivable (net of allowance for loan losses of $22,540 in 2014 and $23,565 in 2013)   1,597,280    1,508,996 
Mortgage servicing rights, net   8,045    8,737 
Other assets   181,139    183,261 
           
Total assets  $2,327,108   $2,347,349 
           
Liabilities and equity          
           
Liabilities:          
Deposit liabilities  $1,685,706   $1,762,682 
Borrowings   278,983    244,900 
Advance payments by borrowers for taxes and insurance   31,518    3,431 
Other liabilities   39,662    52,414 
Total liabilities   2,035,869    2,063,427 
Equity:          
Preferred stock–$0.01 par value:          
Authorized–20,000,000 shares in 2014 and 2013          
Issued and outstanding–none in 2014 and 2013        
Common stock–$0.01 par value:          
Authorized–200,000,000 shares in 2014 and 2013          
Issued–78,783,849 shares in 2014 and 2013          
Outstanding–46,564,284 shares in 2014 and 46,438,284 in 2013   788    788 
Additional paid-in capital   488,262    489,238 
Retained earnings   157,094    151,384 
Accumulated other comprehensive loss   (2,159)   (2,319)
Treasury stock–32,219,565 shares in 2014 and 32,345,565 in 2013   (356,516)   (358,054)
Total shareholders’ equity   287,469    281,037 
Non-controlling interest in real estate partnership   3,770    2,885 
Total equity including non-controlling interest   291,239    283,922 
           
Total liabilities and equity  $2,327,108   $2,347,349 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

3
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

   Three Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands,
except per share data)
 
Interest income:          
Loans  $16,588   $16,132 
Mortgage-related securities   3,043    3,597 
Investment securities   35    9 
Interest-earning deposits   5    20 
Total interest income   19,671    19,758 
Interest expense:          
Deposit liabilities   1,087    1,787 
Borrowings   1,204    1,190 
Advance payment by borrowers for taxes and insurance        
Total interest expense   2,291    2,977 
Net interest income   17,380    16,781 
Provision for loan losses   98    707 
Net interest income after provision for loan losses   17,282    16,074 
Non-interest income:          
Deposit-related fees and charges   3,110    3,166 
Brokerage and insurance commissions   534    658 
Mortgage banking revenue, net   810    1,069 
Income from bank-owned life insurance (“BOLI”)   1,103    817 
Gain on sales of investments   102     
Other non-interest income   434    433 
Total non-interest income   6,093    6,143 
Non-interest expense:          
Compensation, payroll taxes, and other employee benefits   10,356    10,766 
Occupancy and equipment   3,167    2,923 
Federal insurance premiums   367    438 
Advertising and  marketing   369    377 
Losses and expenses on foreclosed real estate, net   44    716 
Other non-interest expense   2,381    2,605 
Total non-interest expense   16,684    17,825 
Income before income taxes   6,691    4,392 
Income tax expense   2,284    1,497 
Net income before non-controlling interest   4,407    2,895 
Net loss attributable to non-controlling interest   2    13 
           
Net income  $4,409   $2,908 
           
Per share data:          
Earnings per share–basic  $0.09   $0.06 
Earnings per share–diluted  $0.09   $0.06 
Cash dividends per share paid  $0.04   $0.03 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

4
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

   Nine Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands,
except per share data)
 
Interest income:          
Loans  $49,399   $48,314 
Mortgage-related securities   9,642    11,062 
Investment securities   90    32 
Interest-earning deposits   11    86 
      Total interest income   59,142    59,494 
Interest expense:          
Deposit liabilities   3,675    6,725 
Borrowings   3,536    3,613 
Advance payment by borrowers for taxes and insurance   1    1 
      Total interest expense   7,212    10,339 
      Net interest income   51,930    49,155 
Provision for loan losses   432    3,329 
      Net interest income after provision for loan losses   51,498    45,826 
Non-interest income:          
Deposit-related fees and charges   8,972    9,132 
Brokerage and insurance commissions   1,912    2,328 
Mortgage banking revenue, net   2,232    6,185 
Income from bank-owned life insurance (“BOLI”)   2,153    1,966 
Gain on sales of investments   102     
Other non-interest income   1,321    1,031 
      Total non-interest income   16,692    20,642 
Non-interest expense:          
Compensation, payroll taxes, and other employee benefits   30,368    32,827 
Occupancy and equipment   9,532    8,862 
Federal insurance premiums   1,112    1,481 
Advertising and  marketing   1,338    1,432 
Losses and expenses on foreclosed real estate, net   1,012    2,291 
Other non-interest expense   7,301    7,339 
      Total non-interest expense   50,663    54,232 
      Income before income taxes   17,527    12,236 
Income tax expense   6,711    4,173 
      Net income before non-controlling interest   10,816    8,063 
Net loss attributable to non-controlling interest   15    39 
           
      Net income  $10,831   $8,102 
           
Per share data:          
Earnings per share–basic  $0.23   $0.17 
Earnings per share–diluted  $0.23   $0.17 
Cash dividends per share paid  $0.11   $0.07 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

5
 

 

Bank Mutual Corporations and Subsidiaries

Unaudited Condensed Consolidated Statements of Total Comprehensive Income

 

   Three Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands) 
Net income before non-controlling interest  $4,407   $2,895 
Other comprehensive income (loss), net of tax:          
Unrealized holding gains (losses) during the period:          
Change in net unrealized gain on securities available-for-sale, net of deferred income taxes of $(747) in 2014 and $(220) in 2013   (1,116)   (327)
Reclassification adjustment for gain on securities included in income, net of income taxes of $(41) in 2014   (61)    
    (1,177)   (327)
Defined benefit pension plans:          
Amortization of net prior service costs and unrecognized loss included in net  periodic benefit cost, net of deferred income taxes of $67 in 2014 and $216 in 2013   101    318 
    101    318 
Total other comprehensive income (loss), net of tax   (1,076)   (9)
Total comprehensive income before non-controlling interest   3,331    2,886 
Comprehensive loss attributable to non-controlling interest   2    13 
           
Total comprehensive income  $3,333   $2,899 

 

   Nine Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands) 
Net income before non-controlling interest  $10,816   $8,063 
Other comprehensive income (loss), net of tax:          
Unrealized holding gains (losses) during the period:          
Change in net unrealized gain on securities available-for-sale, net of deferred income taxes of $(54) in 2014 and $(1,300) in 2013   (81)   (1,940)
Reclassification adjustment for gain on securities included in income, net of income taxes of $(41) in 2014   (61)    
    (142)   (1,940)
Defined benefit pension plans:          
Amortization of net prior service costs and unrecognized loss included in net  periodic benefit cost, net of deferred income taxes of $202 in 2014 and $640 in 2013   302    955 
    302    955 
Total other comprehensive income (loss), net of tax   160    (985)
Total comprehensive income before non-controlling interest   10,976    7,078 
Comprehensive loss attributable to non-controlling interest   15    39 
           
Total comprehensive income  $10,991   $7,117 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

6
 

 

Bank Mutual Corporations and Subsidiaries

Unaudited Condensed Consolidated Statements of Equity

 

               Accumulated       Non-Controlling     
       Additional       Other       Interest in     
   Common   Paid-In   Retained   Comprehensive   Treasury   Real Estate     
   Stock   Capital   Earnings   Income (Loss)   Stock   Partnership   Total 
   (Dollars in thousands, except per share data) 
                             
Balance at January 1, 2014  $788   $489,238   $151,384   $(2,319)  $(358,054)  $2,885   $283,922 
Net income           10,831                10,831 
Net loss attributable to non-controlling interest                       (15)   (15)
Other comprehensive income               160            160 
Equity contribution by non-controlling interest                       900    900 
Issuance of restricted stock       (1,538)           1,538         
Share based payments       562                    562 
Cash dividends ($0.11 per share)           (5,121)               (5,121)
                                    
   Balance at September 30, 2014  $788   $488,262   $157,094   $(2,159)  $(356,516)  $3,770   $291,239 
                                    
Balance at January 1, 2013  $788   $489,960   $145,231   $(4,717)  $(359,409)  $2,933   $274,786 
Net income           8,102                8,102 
Net loss attributable to non-controlling interest                       (39)   (39)
Other comprehensive loss               (985)           (985)
Issuance of restricted stock       (1,134)           1,134         
Exercise of stock options       (91)           148        57 
Share based payments       417                    417 
Cash dividends ($0.07 per share)           (3,250)               (3,250)
                                    
   Balance at September 30, 2013  $788   $489,152   $150,083   $(5,702)  $(358,127)  $2,894   $279,088 

  

Refer to Notes to Unaudited Condensed Consolidated Financial Statement

  

7
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows

 

   Nine Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands) 
Operating activities:    
Net income  $10,831   $8,102 
Adjustments to reconcile net income to net cash from operating activities:          
Provision for loan losses   432    3,329 
Loss on foreclosed real estate, net   903    1,949 
Provision for depreciation   2,151    1,975 
Amortization of mortgage servicing rights   1,332    2,335 
Decrease in MSR valuation allowance   (1)   (2,319)
Net premium amortization on securities   1,330    1,694 
Loans originated for sale   (57,284)   (222,684)
Proceeds from loan sales   55,220    232,756 
Gain on loan sales activities, net   (1,454)   (4,036)
Gain on sales of investments   (102)    
Other, net   (8,974)   (1,375)
   Net cash provided by operating activities   4,384    21,726 
Investing activities:          
Purchases of mortgage-related securities available-for-sale       (88,094)
Principal repayments on mortgage-related securities available-for-sale   79,753    159,061 
Proceeds from sales of mortgage-related securities available-for-sale   17,794     
Principal repayments on mortgage-related securities held-to-maturity   1,416    1,008 
Proceeds from redemption of FHLB of Chicago stock       4,178 
Purchases of FHLB of Chicago stock   (1,964)    
Net increase in loans receivable   (90,845)   (48,897)
Proceeds from sale of foreclosed properties   2,718    7,925 
Net purchases of premises and equipment   (2,341)   (2,688)
   Net cash provided  by investing activities   6,531    32,493 
Financing activities:          
Net decrease in deposit liabilities   (76,976)   (99,149)
Net increase in short-term borrowings   5,000     
Proceeds from long-term borrowings   30,000     
Repayments of long-term borrowings   (917)   (5,587)
Net increase in advance payments by borrowers for taxes and insurance   28,087    25,668 
Cash dividends   (5,121)   (3,250)
Other, net   850    60 
   Net cash used by financing activities   (19,077)   (82,258)
 Decrease in cash and cash equivalents   (8,162)   (28,039)
Cash and cash equivalents at beginning of period   42,456    87,059 
Cash and cash equivalents at end of period  $34,294   $59,020 
           
Supplemental information:          
Cash paid in period for:          
Interest on deposit liabilities and borrowings  $7,212   $10,330 
Income taxes   1,058    351 
Non-cash transactions:          
Loans  transferred to foreclosed properties and repossessed assets   2,718    5,219 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

8
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

1. Basis of Presentation

 

The Unaudited Condensed Consolidated Financial Statements include the accounts of Bank Mutual Corporation (the “Company”), its wholly-owned subsidiary Bank Mutual (the “Bank”), and the Bank’s subsidiaries.

 

The accompanying Unaudited Condensed Consolidated Financial Statements have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information, Rule 10-01 of Regulation S-X, and the instructions to Form 10-Q. The financial statements do not include all of the information and footnotes required by GAAP for complete financial information. However, in the opinion of management, all adjustments (consisting of normal recurring entries) necessary for a fair presentation of operations, cash flows, and financial position have been included in the accompanying financial statements. This report should be read in conjunction with the Company’s 2013 Annual Report on Form 10-K. Operating results for the three and nine months ended September 30, 2014, are not necessarily indicative of the results that may be expected for the year ending December 31, 2014.

 

Certain components of non-interest income in 2013 were reclassified to conform to the 2014 presentation format.  For the three and nine months ended September 30, 2013, $1,780 and $5,058 that had been previously reported as “service charges on deposits” in such periods, respectively, were renamed as “deposit-related fees and charges.” This amount was combined with $1,386 and $4,074 of transaction and other fee income from deposit customers in the periods, respectively, that had been previously included in “other non-interest income.”  Also, for the same three- and nine-month periods in 2013, net loan servicing revenue of $275 and $2,148 was reclassified from “loan-related fees and servicing revenue, net” and was combined with $794 and $4,037 in “gain on loan sales activities, net,” in such periods, respectively, and the aggregate amount reported as “mortgage banking revenue, net.”   Finally, $196 and $510 in the respective periods that was previously included in “loan related fees and servicing revenue, net,” was reclassified to “other non-interest income.”

 

In 2013 the Financial Accounting Standards Board (“FASB”) issued new accounting guidance relating to the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. This new guidance was effective for fiscal years beginning after December 15, 2013, which was the first quarter of 2014 for the Company. Adoption of this item did not have a material impact on the Company’s results of operations, financial condition, or liquidity.

 

In 2013 the FASB issued new accounting guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carry forward, a similar tax loss, or a tax credit carry forward exists. The guidance was effective for fiscal years and interim periods beginning after December 15, 2013, which was the first quarter of 2014 for the Company. Adoption of this item did not have a material impact on the Company’s results of operations, financial condition, or liquidity.

 

In the first quarter of 2014 the FASB issued new accounting guidance related to troubled debt restructurings by creditors to clarify when an in-substance repossession or foreclosure occurs as satisfaction of a consumer mortgage loan. Although the new guidance is effective for fiscal years beginning after December 15, 2014, which would be the first quarter of 2015 for the Company, early adoption of the new guidance is permitted. Accordingly, the Company adopted the new guidance in the first quarter of 2014 using a prospective transition method. Adoption of this new guidance did not have a material impact on the Company’s financial condition, results of operations, or liquidity. However, it did affect how certain matters are disclosed in the financial statements.

 

In the second quarter of 2014 the FASB issued new accounting guidance related to the recognition of revenue from contracts with customers. The guidance is effective for fiscal years and interim periods beginning after December 15, 2016, which will be the first quarter of 2017 for the Company. The Company’s adoption of this item is not expected to have a material impact on its results of operations, financial condition, or liquidity.

 

9
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

1. Basis of Presentation (continued)

 

In the third quarter of 2014 the FASB issued new accounting guidance related to the classification and measurement of certain government-guaranteed mortgages upon foreclosure. The guidance is effective for fiscal years and interim periods beginning after December 15, 2014, which will be the first quarter of 2015 for the Company. The Company’s adoption of this item is not expected to have a material impact on its results of operations, financial condition, or liquidity.

 

2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity

 

The amortized cost and fair value of mortgage-related securities available-for-sale and held-to-maturity are as follows:

 

   September 30, 2014 
       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Securities available-for-sale:                    
Federal Home Loan Mortgage Corporation  $179,893   $4,564   $(42)  $184,415 
Federal National Mortgage Association   130,357    1,748    (156)   131,949 
Government National Mortgage Association   26    4        30 
Private-label CMOs   30,904    890    (142)   31,652 
Total available-for-sale  $341,180   $7,206   $(340)  $348,046 
Securities held-to-maturity:                    
Federal National Mortgage Association  $153,626   $579   $(111)  $154,094 
Total held-to-maturity  $153,626   $579   $(111)  $154,094 

 

   December 31, 2013 
       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Securities available-for-sale:                    
Federal Home Loan Mortgage Corporation  $223,690   $5,235   $(52)  $228,873 
Federal National Mortgage Association   177,683    1,796    (458)   179,021 
Government National Mortgage Association   29    4        33 
Private-label CMOs   38,089    855    (275)   38,669 
Total available-for-sale  $439,491   $7,890   $(785)  $446,596 
Securities held-to-maturity:                    
Federal National Mortgage Association  $155,505   $1   $(2,283)  $153,223 
Total held-to-maturity  $155,505   $1   $(2,283)  $153,223 

 

10
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity (continued)

 

The following tables summarize mortgage-related available-for-sale securities by amount of time the securities have had a gross unrealized loss as of the dates indicated:

 

   September 30, 2014 
   Less Than 12 Months   Greater Than 12 Months         
   in an Unrealized Loss Position   in an Unrealized Loss Position   Gross   Total 
   Unrealized
Loss
Amount
   Number of
Securities
   Estimated
Fair
Value
   Unrealized
Loss
Amount
   Number of
Securities
   Estimated
Fair
Value
   Unrealized
Loss
Amount
   Estimated
Fair
Value
 
Securities available-for-sale:                                        
Federal Home Loan Mortgage Corporation  $25    2   $6,183   $17    1   $5,648   $42   $11,831 
Federal National Mortgage  Association               156    4    22,596    156    22,596 
Private-label CMOs               142    6    7,246    142    7,246 
Total available-for-sale  $25    2   $6,183   $315    11   $35,490   $340   $41,673 
                                         
Securities held-to-maturity:                                        
Federal National Mortgage   Association  $1    2   $15,352   $110    1   $7,600   $111   $22,952 
Total held-to-maturity  $1    2   $15,352   $110    1   $7,600   $111   $22,952 

  

   December 31, 2013 
   Less Than 12 Months   Greater Than 12 Months         
   in an Unrealized Loss Position   in an Unrealized Loss Position   Gross   Total 
   Unrealized
Loss
Amount
   Number of
Securities
   Estimated
Fair
Value
   Unrealized
Loss
Amount
   Number of
Securities
   Estimated
Fair
Value
   Unrealized
Loss
Amount
   Estimated
Fair
Value
 
Securities available-for-sale:                                        
Federal Home Loan Mortgage  Corporation  $52    1   $7,375               $52   $7,375 
Federal National Mortgage  Association   458    6    45,822                458    45,822 
Private-label CMOs   39    3    5,990   $236    7   $10,244    275    16,234 
Total available-for-sale  $549    10   $59,187   $236    7   $10,244   $785   $69,431 
                                         
Securities held-to-maturity:                                        
Federal National Mortgage  Association  $2,283    16   $125,537               $2,283   $125,537 
Total held-to-maturity  $2,283    16   $125,537               $2,283   $125,537 

 

The Company determined that the unrealized losses on its private-label collateralized mortgage obligations (“CMOs”) and securities held-to-maturity were temporary as of September 30, 2014, and December 31, 2013. The Company does not intend to sell these securities and it is unlikely that it will be required to sell these securities before the recovery of their amortized cost. The Company believes it is probable that it will receive all future contractual cash flows related to these securities. This determination was based on management’s judgment regarding the nature of the loan collateral that supports the securities, a review of the current ratings issued on the securities by various credit rating agencies, recent trends in the fair values of the securities and, in the case of private-label CMOs, a review of the actual delinquency and/or default performance of the loan collateral that supports the securities.

 

As of September 30, 2014, and December 31, 2013, the Company had private-label CMOs, with a fair value of $24,973 and $28,844, respectively, with net unrealized gains of $684 and $501, respectively, that were rated less than investment grade. These private-label CMOs were analyzed using modeling techniques that considered the priority of cash flows in the CMO structure and various default and loss rate scenarios that management considered appropriate given the nature of the loan collateral.

 

11
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity (continued)

 

The following table contains a summary of other-than-temporary impairment (“OTTI”) related to credit losses that have been recognized in earnings as of the dates indicated, as well as the end of period values for securities that have experienced such losses:

   Three Months Ended
September 30
   Nine Months Ended
September 30
 
   2014   2013   2014   2013 
Beginning balance of unrealized OTTI related to credit losses  $789   $789   $789   $789 
Additional unrealized OTTI related to credit losses for which OTTI was not previously recognized                
Additional unrealized OTTI related to credit losses for which OTTI was previously recognized                
Net OTTI losses recognized in earnings                
Ending balance of unrealized OTTI related to credit losses  $789   $789   $789   $789 
Adjusted cost at end of period  $5,999   $7,600   $5,999   $7,600 
Estimated fair value at end of period  $6,587   $8,068   $6,587   $8,068 

 

Results of operations included $102 in realized gains and no realized losses on the sale of securities during both the three- and nine-month periods ended September 30, 2014. Results of operations include no realized gains or losses on the sale of securities during the three- and nine-month periods ended September 30, 2013.

 

Mortgage-related securities with a fair value of approximately $93,413 and $74,988 at September 30, 2014, and December 31, 2013, respectively, were pledged to secure deposits, borrowings, and for other purposes as permitted or required by law.

 

12
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable

 

The following table summarizes the components of loans receivable as of the dates indicated:

 

   September 30   December 31 
   2014   2013 
Commercial loans:          
Commercial and industrial  $213,217   $166,788 
Commercial real estate   249,874    276,547 
Multi-family real estate   303,438    265,841 
Construction and development loans:          
Commercial real estate   53,155    27,815 
Multi-family real estate   195,126    164,685 
Land and land development   5,402    6,962 
Total construction and development   253,683    199,462 
Total commercial loans   1,020,212    908,638 
Retail loans:          
One- to four-family first mortgages:          
Permanent   459,844    449,230 
Construction   43,663    40,968 
Total one- to four-family first mortgages   503,507    490,198 
Home equity loans:          
Fixed term home equity   142,759    148,688 
Home equity lines of credit   79,076    79,470 
Total home equity loans   221,835    228,158 
Other consumer loans:          
Student   9,981    11,177 
Other   13,095    12,942 
Total other consumer loans   23,076    24,119 
Total retail loans   748,418    742,475 
Gross loans receivable   1,768,630    1,651,113 
Undisbursed loan proceeds   (147,698)   (117,439)
Allowance for loan losses   (22,540)   (23,565)
Deferred fees and costs, net   (1,112)   (1,113)
Total loans receivable, net  $1,597,280   $1,508,996 

 

The Company’s commercial and retail borrowers are primarily located in the Company’s local lending areas in Wisconsin, Illinois, Michigan, and Minnesota, as is the real estate and non-real estate collateral that secures the Company’s loans.

 

At September 30, 2014, and December 31, 2013, certain one- to four-family mortgage loans, multi-family mortgage loans, and home equity loans with aggregate carrying values of approximately $372,000 and $327,000, respectively, were pledged to secure advances from the Federal Home Loan Bank (“FHLB”) of Chicago.

 

The unpaid principal balance of loans serviced for others was $1,098,430 and $1,148,109 at September 30, 2014, and December 31, 2013, respectively. These loans are not reflected in the consolidated financial statements.

 

13
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables summarize the activity in the allowance for loan losses by loan portfolio segment for the periods indicated. The tables also summarize the allowance for loan loss and loans receivable by the nature of the impairment evaluation, either individually or collectively, at the dates indicated (the loans receivable amounts in the table are net of undisbursed loan proceeds).

 

   At or for the Nine Months Ended September 30, 2014 
   Commercial
and
Industrial
   Commercial
Real
Estate
   Multi-
Family
Real Estate
   Construction
and
Development
   One- to
Four-
Family
   Home Equity
and Other
Consumer
   Total 
Allowance for loan losses:                                   
Beginning balance  $2,603   $6,377   $5,931   $4,160   $3,220   $1,274   $23,565 
Provision   34    795    71    (1,193)   432    293    432 
Charge-offs   (59)   (561)   (241)   (34)   (798)   (399)   (2,092)
Recoveries   61    160        142    225    47    635 
Ending balance  $2,639   $6,771   $5,761   $3,075   $3,079   $1,215   $22,540 
                                    
Loss allowance individually evaluated for impairment          $653               $653 
                                    
Loss allowance collectively evaluated for impairment  $2,639   $6,771   $5,108   $3,075   $3,079   $1,215   $21,887 
                                    
Loan receivable balances at  the end of the period:                                   
Loans individually evaluated for impairment  $12,717   $16,958   $10,719   $2,214   $4,431   $533   $47,572 
Loans collectively evaluated for impairment   200,500    232,916    292,719    124,157    478,690    244,378   $1,573,360 
Total loans receivable  $213,217   $249,874   $303,438   $126,371   $483,121   $244,911   $1,620,932 

 

   At or for the Nine Months Ended September 30, 2013 
   Commercial
and
Industrial
   Commercial
Real
Estate
   Multi-
Family
Real Estate
   Construction
and
Development
   One- to
Four-
Family
   Home Equity
and Other
Consumer
   Total 
Allowance for loan losses:                                   
Beginning balance  $1,686   $7,354   $5,195   $2,617   $3,267   $1,458   $21,577 
Provision   905    (295)   223    1,487    408    601    3,329 
Charge-offs   (199)   (493)   (536)   (148)   (934)   (1,108)   (3,418)
Recoveries   5    633        77    475    92    1,282 
Ending balance  $2,397   $7,199   $4,882   $4,033   $3,216   $1,043   $22,770 
                                    
Loss allowance individually evaluated for impairment      $442   $599   $227           $1,268 
Loss allowance collectively evaluated for impairment  $2,397   $6,757   $4,283   $3,806   $3,216   $1,043   $21,502 
                                    
Loan receivable balances at the end of the period:                                   
Loans individually evaluated for impairment  $522   $16,682   $8,172   $17,207   $5,523   $840   $48,946 
Loans collectively evaluated for impairment   156,316    238,424    248,438    89,604    437,595    247,139    1,417,516 
Total loans receivable  $156,838   $255,106   $256,610   $106,811   $443,118   $247,979   $1,466,462 

 

The Company adjusts certain factors used to determine the allowance for loan losses on loans that are collectively evaluated for impairment. Management considered these adjustments necessary and prudent in light of trends in real estate values, economic conditions, and unemployment. The Company estimates that these changes, as well as overall changes in the balance of loans to which these factors were applied, resulted in a decrease in the total allowance for loan losses of $220 and $678 during the three and nine months ended September 30, 2014, respectively, and an increase of $307 and $1,966 during the three and nine months ended September 30, 2013, respectively.

14
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables present information regarding impaired loans that have a related allowance for loan loss and those that do not as of the dates indicated (the loans receivable amounts in the table are net of undisbursed loan proceeds).

 

   September 30, 2014 
   Loans
Receivable
Balance, Net
   Unpaid
Principal
Balance
   Related
Allowance
for Loss
   Average Loan
Receivable
Balance, Net
   Interest
Income
Recognized
 
Impaired loans with an allowance recorded:                         
Commercial and industrial:                         
Term loans              $8     
Lines of credit                    
Total commercial and industrial               8     
Commercial real estate:                         
Office                    
Retail/wholesale/mixed               469     
Industrial/warehouse               591     
Other                    
Total commercial real estate               1,060     
Multi-family real estate  $1,413   $1,413   $653    1,429   $31 
Construction and development:                         
Commercial real estate                    
Multi-family real estate                    
Land and land development                    
Total construction and development                    
One- to four-family                    
Home equity and other consumer:                         
Home equity                    
Student                    
Other                    
Total home equity and other consumer                    
Total with an allowance recorded  $1,413   $1,413   $653   $2,497   $31 
Impaired loans with no allowance recorded:                         
Commercial and industrial:                         
Term loans  $178   $318       $209   $10 
Lines of credit   35    40        18    2 
Total commercial and industrial   213    358        227    12 
Commercial real estate:                         
Office   667    809        711    22 
Retail/wholesale/mixed   1,572    1,956        1,397    72 
Industrial/warehouse   215    265        162    13 
Other   33    160        59    10 
Total commercial real estate   2,487    3,190        2,329    117 
Multi-family real estate               170     
Construction and development:                         
Commercial real estate   597    597        597     
Multi-family real estate                    
Land and land development   8    42        56     
Total construction and development   605    639        653     
One- to four-family   3,727    4,377        3,969    65 
Home equity and other consumer:                         
Home equity   486    704        540    8 
Student                    
Other   47    50        74     
Total home equity and other consumer   533    754        614    8 
Total with no allowance recorded  $7,565   $9,318       $7,962   $202 

 

15
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

   December 31, 2013 
   Loans
Receivable
Balance, Net
   Unpaid
Principal
Balance
   Related
Allowance
for Loss
   Average Loan
Receivable
Balance, Net
   Interest
Income
Recognized
 
Impaired loans with an allowance recorded:                         
Commercial and industrial:                         
Term loans              $20     
Lines of credit                    
Total commercial and industrial               20     
Commercial real estate:                         
Office               26     
Retail/wholesale/mixed  $716   $716   $188    667   $26 
Industrial/warehouse   1,196    1,268    224    996    88 
Other                    
Total commercial real estate   1,912    1,984    412    1,689    114 
Multi-family real estate   1,443    1,443    588    1,940    72 
Construction and development:                         
Commercial real estate                    
Multi-family real estate                    
Land and land development               386     
Total construction and development               386     
One- to four-family                    
Home equity and other consumer:                         
Home equity                    
Student                    
Other                    
Total home equity and other consumer                    
Total with an allowance recorded  $3,355   $3,427   $1,000   $4,035   $186 
Impaired loans with no allowance recorded:                         
Commercial and industrial:                         
Term loans  $284   $917       $413   $38 
Lines of credit       115        23     
Total commercial and industrial   284    1,032        436    38 
Commercial real estate:                         
Office   810    1,693        837    41 
Retail/wholesale/mixed   1,392    5,191        2,556    148 
Industrial/warehouse   205    312        421    11 
Other   82    201        541    17 
Total commercial real estate   2,489    7,397        4,355    217 
Multi-family real estate   340    2,070        2,802     
Construction and development:                         
Commercial real estate   597    597        241    32 
Multi-family real estate       107             
Land and land development   131    1,325        285    24 
Total construction and development   728    2,029        526    56 
One- to four-family   4,556    5,717        6,079    138 
Home equity and other consumer:                         
Home equity   676    1,004        946    22 
Student                     
Other   104    116        59    1 
Total home equity and other consumer   780    1,120        1,005    23 
Total with no allowance recorded  $9,177   $19,365       $15,203   $472 

 

 

16
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables present information relating to the Company’s internal risk ratings of its loans receivable as of the dates indicated (all amounts in the tables are net of undisbursed loan proceeds):

 

   September 30, 2014 
   Pass   Watch   Special
Mention
   Substandard   Total 
Commercial and industrial:                         
Term loans  $73,739   $2,571   $503   $952   $77,765 
Lines of credit   112,988    8,986    1,713    11,765    135,452 
Total commercial and industrial   186,727    11,557    2,216    12,717    213,217 
Commercial real estate:                         
Office   55,727    9,065    15,509    5,048    85,349 
Retail/wholesale/mixed use   88,972    9,100    17,102    8,794    123,968 
Industrial/warehouse   31,330    1,100    80    3,083    35,593 
Other   4,931            33    4,964 
Total commercial real estate   180,960    19,265    32,691    16,958    249,874 
Multi-family real estate   281,995    10,724        10,719    303,438 
Construction and development:                         
Commercial real estate   25,818            597    26,415 
Multi-family real estate   94,555                94,555 
Land and land development   3,694    90        1,617    5,401 
Total construction/development   124,067    90        2,214    126,371 
One- to four-family   476,061    733    1,896    4,431    483,121 
Home equity and other consumer:                         
Home equity   221,349            486    221,835 
Student   9,981                9,981 
Other   13,048            47    13,095 
Total home equity and other consumer   244,378            533    244,911 
Total  $1,494,188   $42,369   $36,803   $47,572   $1,620,932 

 

17
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

   December 31, 2013 
   Pass   Watch   Special
Mention
   Substandard   Total 
Commercial and industrial:                         
Term loans  $64,181   $6,877   $553   $389   $72,000 
Lines of credit   66,838    19,721    8,182    47    94,788 
Total commercial and industrial   131,019    26,598    8,735    436    166,788 
Commercial real estate:                         
Office   53,425    9,206    15,240    5,268    83,139 
Retail/wholesale/mixed use   89,367    9,213    15,772    9,590    123,942 
Industrial/warehouse   45,931    670    9,237    1,400    57,238 
Other   12,143            82    12,225 
Total commercial real estate   200,866    19,089    40,249    16,340    276,544 
Multi-family real estate   239,985    14,242    3,593    8,021    265,841 
Construction and development:                         
Commercial real estate   21,279            597    21,876 
Multi-family real estate   66,767            15,666    82,433 
Land and land development   4,814    257        1,846    6,917 
Total construction/development   92,860    257        18,109    111,226 
One- to four-family   454,662    834    125    5,377    460,998 
Home equity and other consumer:                         
Home equity   227,482            676    228,158 
Student   11,177                11,177 
Other   12,838            104    12,942 
Total home equity and other consumer   251,497            780    252,277 
Total  $1,370,889   $61,020   $52,702   $49,063   $1,533,674 

 

Loans rated “pass” or “watch” are generally current on contractual loan and principal payments and comply with other contractual loan terms. Pass loans generally have no noticeable credit deficiencies or potential weaknesses. Loans rated watch, however, will typically exhibit early signs of credit deficiencies or potential weaknesses that deserve management’s close attention. Loans rated “special mention” do not currently expose the Company to a sufficient degree of risk to warrant a lower rating, but possess clear trends in credit deficiencies or potential weaknesses that deserve management’s close attention. The allowance for loan losses on loans rated pass, watch, or special mention is typically evaluated collectively for impairment using a homogenous pool approach. This approach utilizes quantitative factors developed by management from its assessment of historical loss experience, qualitative factors, and other considerations.

 

Loans rated “substandard” involve a distinct possibility that the Company could sustain some loss if deficiencies associated with the loan are not corrected. Loans rated “doubtful” indicate that full collection is highly questionable or improbable. The Company did not have any loans that were rated doubtful at September 30, 2014, or December 31, 2013. Loans rated substandard or doubtful that are also considered in management’s judgment to be impaired are generally analyzed individually to determine an appropriate allowance for loan loss. A loan rated “loss” is considered uncollectible, even if a partial recovery could be expected in the future. The Company generally charges off loans that are rated as a loss. As such, the Company did not have any loans that were rated loss at September 30, 2014, or December 31, 2013.

 

18
 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables contain information relating to the past due and non-accrual status of the Company’s loans receivable as of the dates indicated (all amounts in the table are net of undisbursed loan proceeds):

 

   September 30, 2014 
   Past Due Status           Total 
   30-59
Days
   60-89
Days
   > 90
Days
   Total
Past Due
   Total
Current
   Total
Loans
   Non-
Accrual
 
Commercial and industrial:                                   
Term loans  $257   $30   $32   $319   $77,446   $77,765   $178 
Lines of credit                   135,452    135,452    35 
Total commercial and industrial   257    30    32    319    212,898    213,217    213 
Commercial real estate:                                   
Office   2,318        287    2,605    82,744    85,349    667 
Retail/wholesale/mixed   549    556    339    1,444    122,524    123,968    1,572 
Industrial/warehouse   2,164            2,164    33,429    35,593    215 
Other                   4,964    4,964    33 
Total commercial real estate   5,031    556    626    6,213    243,661    249,874    2,487 
Multi-family real estate   662            662    302,776    303,438    1,413 
Construction and development:                                   
Commercial real estate           597    597    25,818    26,415    597 
Multi-family real estate                   94,555    94,555     
Land and land development                   5,401    5,401    8 
Total construction           597    597    125,774    126,371    605 
One- to four-family   6,923    2,510    3,618    13,051    470,070    483,121    3,727 
Home equity and other consumer:                                   
Home equity   646    215    486    1,347    220,488    221,835    486 
Student   285    252    406    943    9,038    9,981     
Other   90    39    47    176    12,919    13,095    47 
Total home equity and other consumer   1,021    506    939    2,466    242,445    244,911    533 
Total  $13,894   $3,602   $5,812   $23,308   $1,597,624   $1,620,932   $8,978 
19
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

   December 31, 2013 
   Past Due Status           Total 
   30-59
Days
   60-89
Days
   > 90
Days
   Total
Past Due
   Total
Current
   Total
Loans
   Non-
Accrual
 
Commercial and industrial:                                   
Term loans          $140   $140   $71,860   $72,000   $284 
Lines of credit  $98            98    94,690    94,788     
Total commercial and industrial   98        140    238    166,550    166,788    284 
Commercial real estate:                                   
Office   429        381    810    82,329    83,139    810 
Retail/wholesale/mixed   1,665        233    1,898    122,044    123,942    2,108 
Industrial/warehouse   1,196        160    1,356    55,882    57,238    1,401 
Other                   12,225    12,225    82 
Total commercial real estate   3,290        774    4,064    272,480    276,544    4,401 
Multi-family real estate      $616    340    956    264,885    265,841    1,783 
Construction and development:                                   
Commercial real estate           597    597    21,279    21,876    597 
Multi-family real estate                   82,433    82,433     
Land and land development                   6,917    6,917    131 
Total construction           597    597    110,629    111,226    728 
One- to four-family   6,334    1,564    4,556    12,454    448,544    460,998    4,556 
Home equity and other consumer:                                   
Home equity   566    444    676    1,686    226,472    228,158    676 
Student   238    172    443    853    10,324    11,177     
Other   49    39    104    192    12,750    12,942    104 
Total home equity and other consumer   853    655    1,223    2,731    249,546    252,277    780 
Total  $10,575   $2,835   $7,630   $21,040   $1,512,634   $1,533,674   $12,532 

 

As of September 30, 2014, and December 31, 2013, $406 and $443 in student loans, respectively, were 90-days past due, but remained on accrual status because such loans were originated under programs guaranteed by the federal government. No other loans 90-days past due were in accrual status as of either date.

 

The Company classifies a loan modification as a troubled debt restructuring (“TDR”) when it has granted a borrower experiencing financial difficulties a concession that it would otherwise not consider. Loan modifications that result in insignificant delays in the receipt of payments (generally six months or less) are not considered TDRs under the Company’s TDR policy. TDRs are relatively insignificant and/or infrequent in the Company and generally consist of loans placed in interest-only status for a short period of time or payment forbearance for greater than six months. As of September 30, 2014, and December 31, 2013, TDRs were $4,972 and $4,298, respectively, and consisted primarily of one- to four-family mortgage loans. TDRs in accrual status as of those same dates were $3,379 and $3,310, respectively. Additions to TDRs during the nine-month periods ended September 30, 2014 and 2013, were immaterial. In addition, TDRs that experienced a payment default within one year of their restructuring during these same three- and nine-month periods were also immaterial. TDRs are evaluated for impairment and appropriate credit losses are recorded in accordance with the Company’s accounting policies and GAAP.

 

20
 

 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

4. Mortgage Servicing Rights

 

The following table presents the activity in the Company’s mortgage servicing rights (“MSRs”) for the periods indicated:

 

   Nine Months Ended
September 30
 
   2014   2013 
MSRs at beginning of the period  $8,737   $9,217 
Additions   640    2,084 
Amortization   (1,332)   (2,335)
MSRs at end of period   8,045    8,966 
Valuation allowance at end of period       (77)
MSRs at end of the period, net  $8,045   $8,889 

 

The following table shows the estimated future amortization expense for MSRs for the periods indicated:

 

       Amount 
Estimate for three months ending December 31:   2014   $298 
Estimate for years ending December 31:   2015    1,088 
    2016    964 
    2017    841 
    2018    732 
    2019    732 
    Thereafter    3,390 
    Total   $8,045 

 

The projections of amortization expense shown above for MSRs are based on existing asset balances and the existing interest rate environment as of September 30, 2014. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates, and market conditions.

 

21
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

5. Other Assets

 

The following table summarizes the components of other assets as of the dates indicated:

 

   September 30   December 31 
   2014   2013 
Accrued interest:          
Loans receivable  $1,121   $4,582 
Mortgage-related securities   4,663    1,328 
Total accrued interest   5,784    5,910 
Foreclosed properties and repossessed assets:          
Commercial real estate   2,935    4,236 
Land and land development   1,786    2,171 
One-to four-family   523    329 
Total foreclosed properties and repossessed assets   5,244    6,736 
Bank-owned life insurance   61,182    59,451 
Premises and equipment, net   51,726    51,565 
Deferred tax asset, net   21,369    27,387 
Federal Home Loan Bank stock, at cost   14,209    12,245 
Other assets   21,625    19,967 
Total other assets  $181,139   $183,261 

 

Residential one-to four-family mortgage loans that were in the process of foreclosure were $3,527 and $3,060 at September 30, 2014 and December 31, 2013, respectively.

  

6. Deposit Liabilities

 

The following table summarizes the components of deposit liabilities as of the dates indicated:

 

   September 30   December 31 
   2014   2013 
Checking accounts:          
Non-interest-bearing  $178,398   $161,639 
Interest-bearing   235,237    245,923 
Total checking accounts   413,635    407,562 
Money market accounts   520,714    501,020 
Savings accounts   223,089    220,236 
Certificates of deposit:          
Due within one year   425,513    523,690 
After one but within two years   61,938    83,192 
After two but within three years   12,842    8,502 
After three but within four years   9,408    8,152 
After four but within five years   18,567    10,328 
Total certificates of deposits   528,268    633,864 
Total deposit liabilities  $1,685,706   $1,762,682 

 

22
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

7. Borrowings

 

The following table summarizes borrowings as of the dates indicated:

 

   September 30, 2014   December 31, 2013 
       Weighted-       Weighted- 
       Average       Average 
   Balance   Rate   Balance   Rate 
FHLB overnight advances  $45,000    0.13%  $40,000    0.13%
FHLB term advances maturing in:                    
2014                
2015   23,450    0.80    23,450    0.80 
2016   53,450    0.85    23,450    1.04 
2017   37,772    1.48    37,795    1.48 
2018   42,338    2.10    42,470    2.11 
2019 and thereafter   76,973    3.49    77,735    3.51 
Total borrowings  $278,983    1.73%  $244,900    1.91%

 

All of the Company’s advances from the FHLB of Chicago are subject to prepayment penalties if voluntarily repaid by the Company prior to stated maturity.

 

The Company is required to maintain certain unencumbered mortgage loans and certain mortgage-related securities as collateral against its outstanding advances from the FHLB of Chicago. Total advances from the FHLB of Chicago are limited to the lesser of: (i) 35% of the Bank’s total assets; (ii) twenty times the capital stock of the FHLB of Chicago that is owned by the Bank; or (iii) the total of 60% of the book value of certain multi-family mortgage loans, 75% of the book value of one- to four-family mortgage loans, and 95% of certain mortgage-related securities.

 

8. Shareholders' Equity

 

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory actions and possible additional discretionary actions by regulators, that, if undertaken, could have a direct material effect on the Bank’s and the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

 

Quantitative measures established by federal regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total capital and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to adjusted assets (as all of these terms are defined in the applicable regulations). Management believes, as of September 30, 2014, that the Bank met or exceeded all capital adequacy requirements to which it is subject. The Company is not aware of any conditions or events which would change the Bank’s status from “well capitalized.”

 

23
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

8. Shareholders' Equity (continued)

 

The following table presents the Bank’s actual and required regulatory capital amounts and ratios as of the dates indicated:

 

   Actual   Required
For Capital
Adequacy Purposes
   To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
As of September 30, 2014:                              
Total capital  $282,446    18.26%  $123,753    8.00%  $154,691    10.00%
(to risk-weighted assets)                              
Tier 1 capital   263,070    17.01    61,877    4.00    92,815    6.00 
(to risk-weighted assets)                              
Tier 1 capital   263,070    11.39    92,423    4.00    115,529    5.00 
(to adjusted total assets)                              
                               
As of December 31, 2013:                              
Total capital  $272,074    17.82%  $122,159    8.00%  $152,698    10.00%
(to risk-weighted assets)                              
Tier 1 capital   252,931    16.56    61,079    4.00    91,619    6.00 
(to risk-weighted assets)                              
Tier 1 capital   252,931    10.89    92,943    4.00    116,179    5.00 
(to adjusted total assets)                              

 

9. Earnings Per Share

 

The following table summarizes the computation of basic and diluted earnings per share for the periods indicated:

 

   Three Months Ended
September 30
   Nine Months Ended
September 30
 
   2014   2013   2014   2013 
Basic earnings per share:                    
Net income  $4,409   $2,908   $10,831   $8,102 
Weighted average shares outstanding   46,249,884    46,210,424    46,249,884    46,202,886 
Vested restricted stock for period   43,220    28,930    39,014    23,811 
Basic shares outstanding   46,293,104    46,239,354    46,288,898    46,226,697 
Basic earnings per share  $0.09   $0.06   $0.23   $0.17 
                     
Diluted earnings per share:                    
Net income  $4,409   $2,908   $10,831   $8,102 
Weighted average shares outstanding used in basic earnings per share   46,293,104    46,239,354    46,288,898    46,226,697 
Net dilutive effect of:                    
Stock option shares   242,215    213,622    242,227    141,333 
Unvested restricted stock   27,867    35,525    29,026    27,850 
Diluted shares outstanding   46,563,186    46,488,501    46,560,151    46,395,880 
Diluted earnings per share  $0.09   $0.06   $0.23   $0.17 

 

24
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

9. Earnings Per Share (continued)

 

The Company had stock options for 458,000 and 1,778,000 shares outstanding as of September 30, 2014 and 2013, respectively, that were not included in the computation of diluted earnings per share because they were anti-dilutive. These shares had weighted average exercise prices of $7.70 and $10.53 per share as of those dates, respectively.

 

 

10. Employee Benefit Plans

 

The Company has a discretionary, defined contribution savings plan (the “Savings Plan”). The Savings Plan is qualified under Sections 401 and 401(k) of the Internal Revenue Code and provides employees meeting certain minimum age and service requirements the ability to make contributions to the Savings Plan on a pretax basis. The Company then matches a percentage of the employee’s contributions. Matching contributions made by the Company were $141 and $47 during the three months ended September 30, 2014 and 2013, respectively, and $481 and $145 during the nine months ended September 30, 2014 and 2013, respectively.

 

The Company also has a defined benefit pension plan covering employees meeting certain minimum age and service requirements and a non-qualified supplemental pension plan for certain qualifying employees. The supplemental pension plan is funded through a "rabbi trust" arrangement. The benefits are generally based on years of service and the employee’s average annual compensation for five consecutive calendar years in the last ten calendar years that produces the highest average. The Company’s funding policy for the qualified plan is to contribute annually the amount necessary to satisfy the requirements of the Employee Retirement Income Security Act of 1974.

 

Effective January 1, 2013, the Company closed the qualified defined benefit pension plan to employees that were not eligible to participate in the plan as of that date, as well as any employees hired after that date. In addition, effective for service performed after March 1, 2013, the Company reduced certain benefits paid under the qualified and supplemental plans related to any employee service performed after that date. Finally, effective January 1, 2014, the Company froze the benefits of participants in the qualified defined benefit pension plan that had less than 20 years of service. This change also resulted in the future benefits under the Company’s supplemental defined benefit pension plan being effectively frozen.

 

The following table summarizes the qualified plan’s net periodic benefit cost for the periods indicated:

 

   Three Months Ended
September 30
   Nine Months Ended
September 30
 
   2014   2013   2014   2013 
Service cost  $224   $770   $672   $2,310 
Interest cost   667    575    2,001    1,725 
Expected return on plan assets   (722)   (824)   (2,166)   (2,472)
Amortization of net loss from earlier periods   165    433    495    1,299 
Net periodic benefit cost  $334   $954   $1,002   $2,862 

 

The net periodic benefit cost for the Company’s supplemental plan was $115 and $232 for the three months ended September 30, 2014 and 2013, respectively, and $345 and $696 for the nine months ended September 30, 2014 and 2013, respectively. The amounts in 2014 consisted of interest cost of $113, and amortization of net loss from earlier periods of $2 for the three month period, and interest cost of $339, and amortization of net loss from earlier periods of $6 for the nine-month period. The amounts in 2013 consisted of service cost of $40, interest cost of $97, and amortization of net loss from earlier periods of $95 for the three month period, and service cost of $120, interest cost of $291, and amortization of net loss from earlier periods of $285 for the nine-month period. The Company does not expect to make a contribution to the qualified or supplemental plans in 2014. This determination was based on a number of factors, including the results of actuarial valuation reports as of January 1, 2014.

 

25
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

11. Stock-Based Benefit Plans

 

In 2004 the Company’s shareholders approved the 2004 Stock Incentive Plan (the “2004 Plan”). Options granted under the 2004 Plan vested over five years and had expiration terms of ten years. The 2004 Plan also provided for restricted stock awards that also vested over five years. The 2004 Plan terminated on February 1, 2014, in accordance with the terms of the plan. Options awarded under the 2004 Plan will remain outstanding until exercised, forfeited, or expired.

 

In May 2014 the Company’s shareholders approved the 2014 Stock Incentive Compensation Plan (the “2014 Plan”), which provides for the award of stock options, stock appreciation rights, restricted stock, restricted stock units, and performance shares. Awards under the 2014 Plan vest over a period of three or more years and, if applicable, have a maximum term of ten years. The number of shares of common stock of the Company that may be issued under the 2014 Plan is limited to 3,000,000 options and/or shares. As of September 30, 2014, 2,939,500 options and/or shares remain eligible for award under the 2014 Plan.

 

Restricted stock grants are amortized to compensation expense as the Company’s employees and directors become vested in the granted shares. The amount amortized to expense was $96 and $54 for the three months ended September 30, 2014 and 2013, respectively, and $279 and $187 for the nine months ended as of the same date. Outstanding non-vested restricted stock grants had a fair value of $1,408 and an unamortized cost of $1,239 at September 30, 2014. The cost of these shares is expected to be recognized over a weighted-average period of 1.83 years.

 

Stock option grants are amortized to compensation expense as the Company’s employees and directors become vested in the options. The amount amortized to expense was $101 and $74 for the three months ended September 30, 2014 and 2013, respectively, and $74 and $228 for the nine months ended as of the same dates, respectively. As of September 30, 2014, there was $1,115 in total unrecognized stock option compensation expense related to non-vested options. This cost is expected to be recognized over a weighted-average period of 1.63 years.

 

The following table summarizes the activity in the Company’s stock options during the periods indicated:

 

   Nine Months Ended September 30 
   2014   2013 
   Stock
Options
   Weighted
Average
Exercise
Price
   Stock
Options
   Weighted
Average
Exercise
Price
 
Outstanding at beginning of period   2,955,000   $8.0742    2,671,000   $8.4711 
Granted   276,000    6.9653    352,000    4.9439 
Exercised           (12,000)   4.6418 
Forfeited   (60,000)   11.9737    (43,800)   8.9014 
Expired   (1,536,000)   10.6730         
Outstanding at end of period   1,635,000   $5.3025    2,967,000   $8.0620 

 

26
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

11. Stock-Based Benefit Plans (continued)

 

The following table provides additional information regarding the Company’s outstanding options as of September 30, 2014.

 

   Remaining   Non-Vested Options   Vested Options 
   Contractual
Life
   Stock
Options
   Intrinsic
Value
   Stock
Options
   Intrinsic
Value
 
Exercise price:                         
$11.160   3.6            32,000     
$12.025   3.9            50,000     
$7.226   5.6    10,000        40,000     
$4.740   6.2    28,000   $47    42,000   $70 
$5.050   6.3    136,000    185    217,000    295 
$4.300   6.5    10,000    21    15,000    32 
$3.720   6.8    7,000    28    10,500    19 
$3.390   7.3    232,500    702    167,000    504 
$3.800   7.5    6,000    16    4,000    10 
$4.820   8.3    232,800    370    69,200    110 
$5.360   8.6    16,000    17    4,000    4 
$5.700   8.7    16,000    11    4,000    3 
$6.340   8.8    8,000    1    2,000     
$7.170   9.3    221,000        7,500     
$6.010   9.6    7,500    3         
$5.850   9.6    20,000    11         
$6.100   9.9    20,000    6         
Total   .    970,800   $1,418    664,200   $1,047 
Weighted-average remaining contractual life           8.0 years         6.5 years      
Weighted-average exercise price       $5.140        $5.527      

 

There were no options exercised during the nine months ended September 30, 2014. The intrinsic value of options exercised during the nine months ended September 30, 2013, was $14. The weighted average grant date fair value of non-vested options at September 30, 2014, was $1.44 per share. During the nine months ended September 30, 2014, options for 276,000 shares were granted, options for 273,700 shares became vested, non-vested options for 60,000 shares were forfeited, and vested options for 1,536,000 shares expired.

 

The Company uses the Black-Scholes option-pricing model to estimate the fair value of granted options. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. However, the Company's stock options have characteristics significantly different from traded options and changes in the subjective input assumptions can materially affect the fair value estimate. Option valuation models such as Black-Scholes require the input of highly subjective assumptions including the expected stock price volatility, which is computed using ten years of actual price activity in the Company’s stock. The Company uses historical data of employee behavior as a basis to estimate the expected life of the options, as well as forfeitures due to employee terminations. The Company also uses its actual dividend yield at the time of the grant, as well as actual U.S. Treasury yields in effect at the time of the grant to estimate the risk-free rate. The following weighted-average assumptions were used to value 276,000 options granted during the nine-month period ended September 30, 2014: risk free rate of 2.37%, dividend yield of 1.82%, expected stock volatility of 32%, and expected term to exercise of 7.5 years. These options had a weighted-average value of $2.25 per option using these assumptions. The following weighted-average assumptions were used to value 352,000 options granted during the nine-month period ended September 30, 2013: risk free rate of 1.28%, dividend yield of 1.67%, expected stock volatility of 30%, and expected term to exercise of 7.5 years. These options had a weighted-average value of $1.35 per option using these assumptions.

 

27
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

12. Derivatives and Other Financial Instruments

 

Off-balance sheet financial instruments or obligations whose contract amounts represent credit and/or interest rate are summarized in the following table as of the dates indicated:

 

   September 30   December 31 
   2014   2013 
Unused commercial lines of credit  $89,985   $104,734 
Commercial loans   10,210    1,535 
Standby letters of credit   4,953    3,350 
Real estate loan commitments:          
Fixed rate   41,963    29,158 
Adjustable rate   207,452    141,604 
Unused consumer lines of credit   167,974    168,645 

 

The Company sells substantially all of its long-term, fixed-rate, one- to four-family loan originations in the secondary market. The Company uses derivative instruments to manage interest rate risk associated with these activities. Specifically, the Company enters into interest rate lock commitments (“IRLCs”) with borrowers, which are considered to be derivative instruments. The Company manages its exposure to interest rate risk in IRLCs (as well as interest rate risk in its loans held-for-sale) by entering into forward commitments to sell loans to the Federal National Mortgage Association (“Fannie Mae”) or the FHLB of Chicago. Commitments to sell loans expose the Company to interest rate risk if market rates of interest decrease during the commitment period. Such forward commitments are considered to be derivative instruments. These derivatives are not designated as accounting hedges as specified in GAAP. As such, changes in the fair value of the derivative instruments are recognized currently through earnings. As of September 30, 2014, and December 31, 2013, net unrealized gains of $150 and $93, respectively, were recognized in net gain on loan sales activities on these derivative instruments. These amounts were exclusive of net unrealized gains of $96 and $16 on loans held-for-sale as of those dates, respectively, which were also included in net gain on loan sales activities.

 

The Company enters into interest rate swap arrangements to manage the interest rate risk exposure associated with specific commercial loan relationships at the time such loans are originated. These interest rate swaps, as well as the embedded derivatives associated with certain of its commercial loan relationships, are derivative financial instruments under GAAP. None of these derivative financial instruments are designated by the Company as accounting hedges as specified in GAAP. As such, the fair market value of the interest rate swaps and embedded derivatives are carried on the Company’s balance sheet as derivative assets or liabilities, as the case may be, and periodic changes in fair market value of such financial instruments are recorded through periodic earnings in other non-interest income. As of September 30, 2014, and December 31, 2013, unrealized gains of $630 and $32, respectively, were recognized in other non-interest income on these derivative instruments as well as unrealized losses of $630 and $32, for the same periods, respectively, on these derivative instruments.

 

28
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

12. Derivatives and Other Financial Instruments (continued)

 

The following table summarizes the Company’s derivative assets and liabilities as of the dates indicated:

 

   September 30, 2014   December 31, 2013 
   Notional
Amount
   Fair Value   Notional
Amount
   Fair Value 
Interest rate lock commitments  $9,941   $174   $4,361   $60 
Forward commitments to sell loans   10,763    (24)   4,085    33 
Embedded derivatives on commercial loans   24,035    417    4,983    32 
Receive-fixed interest rate swaps   10,930    213         
Pay-fixed interest rate swaps   34,965    (630)   4,983    (32)
Net unrealized gains       $150        $93 

 

The unrealized gains shown in the above table were included as a component of other assets as of the dates indicated. The unrealized losses were included in other liabilities as of the dates indicated.

 

13. Fair Value Measurements

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. The Company primarily applies the market approach for recurring value measurements and endeavors to utilize the best available information. Accordingly, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The Company is able to classify fair value measurements based on the observability of those inputs. Accounting guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), the next highest priority is given to prices based on models, methodologies, and/or management judgments that rely on direct or indirect observable inputs (Level 2), and the lowest priority to prices derived from models, methodologies, and/or management judgments that rely on significant unobservable inputs (Level 3). There were no transfers of assets or liabilities between categories of the fair value hierarchy during the three months ended September 30, 2014.

 

The methods and assumptions used by the Company in estimating the fair value of its financial instruments, whether or not such fair values are recognized in the consolidated financial statements, are summarized below:

 

Cash and Cash Equivalents The carrying amounts reported in the statements of financial condition for cash and cash equivalents approximate those assets’ fair values. The Company considers the fair value of cash and cash equivalents to be Level 1 in the fair value hierarchy.

 

Mortgage-Related Securities Available-for-Sale and Held-to-Maturity Fair values for these securities are based on price estimates obtained from a third-party independent pricing service. This service utilizes pricing models that vary by asset class and incorporate available trade, bid, ask, and other market information of comparable instruments. For structured securities, such as CMOs, the pricing models include cash flow estimates that consider the impact of loan performance data, including, but not limited to, expectations relating to loan prepayments, default

rates, and loss severities. Management has reviewed the pricing methodology used by its pricing service to verify that prices are determined in accordance with the fair value guidance specified in GAAP. The Company considers the fair value of mortgage-related securities to be Level 2 in the fair value hierarchy.

 

29
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13. Fair Value Measurements (continued)

 

Loans Receivable Loans receivable are segregated by type such as one- to four-family, multi-family, and commercial real estate mortgage loans, consumer loans, and commercial business loans. The fair value of each type is calculated by discounting scheduled cash flows through the expected maturity of the loans using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan type. The estimated maturity is based on the Company’s historical experience with prepayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The Company considers the fair value of loans receivable to be Level 3 in the fair value hierarchy.

 

Mortgage Servicing Rights The Company estimates the fair market value of MSRs for those loans that are sold with servicing rights retained. For valuation purposes, the related loans are stratified into pools by product type and, within product type, by interest rates. The fair value of the MSR pools is based upon the present value of estimated future cash flows using current market assumptions for prepayments, servicing cost, and other factors. The Company considers the fair value of MSRs to be Level 3 in the fair value hierarchy.

 

The following table summarizes the significant inputs utilized by the Company to estimate the fair value of its MSRs as of September 30, 2014:

 

   Weighted-
Average
   Range 
Loan size  $121   $2-$414 
Contractual interest rate   3.78%  2.00%-7.15% 
Constant prepayment rate (“CPR”)   8.35%  5.24%-24.93% 
Remaining maturity in months   231   4-480 
Servicing fee   0.25%   
Annual servicing cost per loan (not in thousands)  $60    
Annual ancillary income per loan (not in thousands)  $30    
Discount rate   9.80%  9.75%-11.50% 

 

MSR pools with an amortized cost basis greater than fair value are carried at fair value in the Company’s financial statements. There were no pools determined to be impaired at September 30, 2014. Accordingly, the Company had no valuation allowance as of September 30, 2014, but did record a gain of $1 during the nine-month period then ended, which was equal to the change in the valuation allowance during that period. MSR pools determined to be impaired at December 31, 2013, had an amortized cost basis of $10 and a fair value of $9 as of that date. Accordingly, the Company recorded a valuation allowance of $1 as of December 31, 2013, as well as a corresponding gain of $2,395 during the twelve month period then ended, which was equal to the change in the valuation allowance during that period. The Company recorded a gain of $2,319 during the nine-month period ended September 30, 2013.

 

Federal Home Loan Bank Stock FHLB of Chicago stock is carried at cost, which is its redeemable (fair) value, since the market for this stock is restricted. The Company considers the fair value of FHLB of Chicago stock to be Level 2 in the fair value hierarchy.

 

Accrued Interest Receivable and Payable The carrying values of accrued interest receivable and payable approximate their fair value. The Company considers the fair value of accrued interest receivable and payable to be Level 2 in the fair value hierarchy.

 

Deposit Liabilities and Advance Payments by Borrowers for Taxes and Insurance Fair values for demand deposits equal book value. The Company considers the fair value of demand deposits to be Level 2 in the fair value hierarchy. Fair values for certificates of deposits are estimated using a discounted cash flow calculation that applies current market borrowing interest rates to a schedule of aggregated expected monthly maturities on deposits. The Company considers the fair value of certificates of deposit to be Level 3 in the fair value hierarchy. The advance

 

30
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13. Fair Value Measurements (continued)

 

payments by borrowers for taxes and insurance are equal to their carrying amounts at the reporting date. The Company considers the fair value of advance payment by borrowers to be Level 2 in the fair value hierarchy.

 

Borrowings The fair value of long-term borrowings is estimated using discounted cash flow calculations with the discount rates equal to interest rates currently being offered for borrowings with similar terms and maturities. The carrying value on short-term borrowings approximates fair value. The Company considers the fair value of borrowings to be Level 2 in the fair value hierarchy.

 

Derivatives and Other Financial Instruments Derivatives and other financial instruments consist of commitments to extend credit, IRLCs, forward commitments to sell loans, interest rate swaps, and embedded derivatives related to certain commercial loan relationships. Commitments to extend credit that are not IRLCs generally carry variable rates of interest. As such, the fair value of these instruments is not material. The Company considers the fair value of these instruments to be Level 2 in the fair value hierarchy. The carrying value of IRLCs, forward commitments to sell loans, interest rate swaps, and embedded derivatives is equal to their fair value. For IRLCs and forward commitments, the fair value is the difference between the current market prices for securities collateralized by similar loans and the notional amounts of the IRLCs and forward commitments. The fair value of the Company’s interest rate swaps and embedded derivatives is determined using discounted cash flow analysis on the expected cash flows of each derivative and also includes a nonperformance or credit risk component. The Company considers the fair value of IRLCs, forward commitments to sell loans, interest rate swaps, and embedded derivatives to be Level 2 in the fair value hierarchy.

 

The carrying values and fair values of the Company’s financial instruments are presented in the following table as of the indicated dates.

 

   September 30
2014
   December 31
2013
 
   Carrying
Value
   Fair
Value
   Carrying
Value
   Fair
Value
 
Cash and cash equivalents  $34,294   $34,294   $42,456   $42,456 
Mortgage related securities available-for-sale   348,046    348,046    446,596    446,596 
Mortgage related securities held-to-maturity   153,626    154,094    155,505    153,223 
Loans held-for-sale   4,678    4,678    1,798    1,798 
Loans receivable, net   1,597,280    1,621,997    1,508,996    1,508,092 
Mortgage servicing rights, net   8,045    10,415    8,737    10,479 
Federal Home Loan Bank stock   14,209    14,209    12,245    12,245 
Accrued interest receivable   5,784    5,784    5,910    5,910 
Deposit liabilities   1,685,706    1,578,545    1,762,682    1,647,540 
Borrowings   278,983    286,660    244,900    251,826 
Advance payments by borrowers   31,518    31,518    3,431    3,431 
Accrued interest payable   978    978    450    450 
Unrealized gain (loss) on derivatives and other financial instruments:   

 

 

                
   Interest rate lock commitments on loans   174    174    60    60 
   Forward commitments to sell loans   (24)   (24)   33    33 
   Embedded derivatives on commercial loans   417    417    32    32 
   Receive-fixed interest rate swaps   213    213         
   Pay-fixed interest rate swaps   (630)   (630)   (32)   (32)

 

31
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

September 30, 2014

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13. Fair Value Measurements (continued)

 

The following table segregates by fair value hierarchy (i.e., Level 1, 2, or 3) all of the Company's assets and liabilities that were accounted for at fair value on a recurring basis as of the dates indicated:

 

   At September 30, 2014 
   Level 1   Level 2   Level 3   Total 
Loans held-for-sale      $4,678       $4,678 
Mortgage-related securities available-for-sale       348,046        348,046 

 

   At December 31, 2013 
   Level 1   Level 2   Level 3   Total 
Loans held-for-sale      $1,798       $1,798 
Mortgage-related securities available-for-sale       446,596        446,596 

 

Impaired Loans For non-accrual loans greater than an established threshold and individually evaluated for impairment and all renegotiated loans, impairment is measured based on: (i) the fair value of the loan or the fair value of the collateral less estimated selling costs (collectively the “collateral value method”) or (ii) the present value of the estimated cash flows discounted at the loan’s original effective interest rate (the “discounted cash flow method”). The resulting valuation allowance, if any, is a component of the allowance for loan losses. The discounted cash flow method is a fair value measure. For the collateral value method, the Company generally obtains appraisals on a periodic basis to support the fair value of collateral underlying the loans. Appraisals are performed by independent certified and/or licensed appraisers that have been reviewed by the Company and incorporate information such as recent sales prices for comparable properties, costs of construction, and net operating income of the property or business. Selling costs are generally estimated at 10%. Appraised values may be further discounted based on management judgment regarding changes in market conditions and other factors since the time of the appraisal. A significant unobservable input in using net operating income to estimate fair value is the capitalization rate. At September 30, 2014, the range of capitalization rates utilized to determine the fair value of the underlying collateral on certain loans was 6% to 12%. The Company considers these fair values to be Level 3 in the fair value hierarchy. For those loans individually evaluated for impairment using the collateral value method, a valuation allowance of $653 was recorded for loans with a recorded investment of $47,572 at September 30, 2014. These amounts were $1,000 and $49,066 at December 31, 2013, respectively. Provision for loan losses related to these loans was $65 during the nine-month period ended September 30, 2014, and $380 during the twelve month period ended December 31, 2013. Provision for loan losses related to impaired loans at September 30, 2013, was $352 for the nine months ended September 30, 2013.

 

Foreclosed Properties Foreclosed properties acquired through, or in lieu of, loan foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. In determining fair value, the Company generally obtains appraisals to support the fair value of foreclosed properties, as described in the previous paragraph. In certain instances, the Company may also use the selling list price, less estimated costs to sell, as the fair value of foreclosed properties. In such instances, the list price is generally less than the appraised value. The Company considers these fair values to be Level 3 in the fair value hierarchy. As of September 30, 2014, $4,656 in foreclosed properties was valued at collateral value compared to $6,612 at December 31, 2013. Losses of $745 and $1,672 related to these foreclosed properties were recorded during the nine months ended September 30, 2014, and the twelve months ended December 31, 2013, respectively. Losses on foreclosed properties valued at collateral value at September 30, 2013 were $1,692 for the nine months ended September 30, 2013.

  

32
 

 

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

 

Cautionary Statement

 

This report contains or incorporates by reference various forward-looking statements concerning the Company's prospects that are based on the current expectations and beliefs of management. Forward-looking statements may contain, and are intended to be identified by, words such as “anticipate,” “believe,” “estimate,” “expect,” “objective,” “projection,” “intend,” and similar expressions; the use of verbs in the future tense and discussions of periods after the date on which this report is issued are also forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks, and uncertainties, many of which are beyond the Company's control, that could cause the Company's actual results and performance to differ materially from what is stated or expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company: general economic conditions, including volatility in credit, lending, and financial markets; weakness and declines in the real estate market, which could further affect both collateral values and loan activity; periods of relatively high unemployment or economic weakness and other factors which could affect borrowers’ ability to repay their loans; negative developments affecting particular borrowers, which could further adversely impact loan repayments and collection; legislative and regulatory initiatives and changes, including action taken, or that may be taken, in response to difficulties in financial markets and/or which could negatively affect the rights of creditors; monetary and fiscal policies of the federal government; the effects of further regulation and consolidation within the financial services industry, including substantial changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”); regulators’ strict expectations for financial institutions’ capital levels and restrictions imposed on institutions, as to payments of dividends or otherwise, to maintain or achieve those levels, including the possible effects of new regulatory capital requirements under Basel III; recent, pending, and/or potential rulemaking or other actions by the Consumer Financial Protection Bureau (“CFPB”); potential regulatory or other actions affecting the Company or the Bank; potential changes in the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), which could impact the home mortgage market; increased competition and/or disintermediation within the financial services industry; changes in tax rates, deductions and/or policies; potential further changes in Federal Deposit Insurance Corporation (“FDIC”) premiums and other governmental assessments; changes in deposit flows; changes in the cost of funds; fluctuations in general market rates of interest and/or yields or rates on competing loans, investments, and sources of funds; demand for loan or deposit products; illiquidity of financial markets and other negative developments affecting particular investment and mortgage-related securities, which could adversely impact the fair value of and/or cash flows from such securities; changes in customers’ demand for other financial services; the Company’s potential inability to carry out business plans or strategies; changes in accounting policies or guidelines; natural disasters, acts of terrorism, or developments in the war on terrorism or other global conflicts; the risk of failures in computer or other technology systems or data maintenance, or breaches of security relating to such systems; and the factors discussed in the Company’s filings with the Securities and Exchange Commission, particularly under Part I, Item 1A, “Risk Factors,” of the Company’s 2013 Annual Report on Form 10-K.

 

Results of Operations

 

Overview The Company’s net income was $4.4 million or $0.09 per diluted share and $10.8 million or $0.23 per diluted share for the three- and nine-month periods ended September 30, 2014, respectively, compared to $2.9 million or $0.06 per diluted share and $8.1 million or $0.17 per diluted share during the same periods in 2013, respectively. Net income during the three- and nine-month periods ended September 30, 2014, represented a return on assets (“ROA”) of 0.76% and 0.62%, respectively, compared to 0.50% and 0.46% in the same periods of 2013, respectively. Net income in these same periods of 2014 also represented a return on equity (“ROE”) of 6.16% and 5.08%, respectively, compared to 4.23% and 3.94% in the same periods of 2013, respectively. The improvement in net income between these periods was due primarily to higher net interest income, lower provision for loan losses, lower net losses and expenses on real estate, and lower compensation-related expenses. These developments were partially offset by lower net mortgage banking revenue, higher occupancy and equipment expense, and for the year-to-date period, a non-recurring charge in the first quarter of 2014 related to state income taxes. The following paragraphs describe these changes in greater detail, along with other matters affecting the Company’s results of operations during the three and nine months ended September 30, 2014 and 2013.

 

33
 

 

Net Interest Income The Company’s net interest income increased by $599,000 or 3.6% and by $2.8 million or 5.6% during the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. These increases were primarily attributable to a 23 basis point improvement in the Company’s net interest margin, from 3.06% during the nine months ended September 30, 2013, to 3.29% during the same period in the current year. In the quarter just ended, Company’s net interest margin improved to 3.29% compared to 3.17% in the third quarter of last year. The improvements in net interest margin were due principally to an improved earning asset mix and an improved funding mix between these periods. Specifically, Company’s average loans receivable increased by $103.1 million or 7.3% during the nine months ended September 30, 2014, compared to the same period in 2013, and its average mortgage-related securities, investment securities, and overnight investments declined by $138.7 million or 19.3% in the aggregate between these same periods. Loans receivable generally have a higher yield than securities and overnight investments.

 

With respect to Company’s funding mix, its average checking and savings deposits increased by $31.2 million or 3.4% in the aggregate during the nine months ended September 30, 2014, compared to the same period in 2013 and its average certificates of deposit declined by $156.0 million or 21.2% between these periods. Checking and savings deposits generally have a lower interest cost (or no interest cost) relative to certificates of deposits. Also contributing to the improvement in funding mix during the nine months ended September 30, 2014, was a $44.3 million or 21.3% increase in average borrowings from the Federal Home Loan Bank (“FHLB”) of Chicago during the nine months ended September 30, 2014, compared to the same period in 2013. This increase, which funded loan growth and net deposit outflows, had a marginal average interest cost during the nine months ended September 30, 2014, that was substantially lower than the average cost of certificates of deposit.

 

Also contributing to the improvement in net interest margin during the nine months ended September 30, 2014, compared to the same period in 2013 was a 40 basis point decline in the average cost of Company’s certificates of deposit. However, it should be noted that compared to the second quarter of 2014, the Company’s average cost of certificates of deposit declined by only six basis points in the third quarter. Also, in recent weeks the Company has increased the rates and lengthened maturity terms on certain of the certificates of deposits it offers customers. Accordingly, management believes that the average cost of the Company’s certificates of deposits may begin to increase modestly in the fourth quarter and that such trend could continue for the foreseeable future.

 

The favorable impact of the aforementioned developments on net interest income was partially offset by a $35.6 million or 1.7% decrease in average earning assets during the nine months ended September 30, 2014, compared to the same period in 2013. Company’s earning assets have declined in recent periods as it has used available cash flow to fund a net decrease in its liabilities, particularly its certificates of deposit, as previously described (refer to “Financial Condition—Deposit Liabilities,” below, for additional discussion).

 

As noted in a prior paragraph, the Company’s net interest margin during the third quarter of 2014 was 3.29%, which was three basis points lower than the net interest margin in its second quarter. Management believes the Company’s quarterly net interest margin could trend modestly lower in the near term due to the deposit pricing strategy mentioned in a preceding paragraph, as well as a declining yield on earning assets due principally to continued declines in the yield on the Company’s loan portfolio in the current rate environment. In addition, during the third quarter of 2014 Bank Mutual drew $30.0 million in two-year term advances from the FHLB of Chicago at a rate of 0.69%. The proceeds from this advance were used to reduce overnight borrowings from the FHLB of Chicago, which had a rate of 0.13%, but fluctuates on a daily basis and could increase in the future.

 

34
 

The following table presents certain details regarding the Company's average balance sheet and net interest income for the periods indicated. The tables present the average yield on interest-earning assets and the average cost of interest-bearing liabilities. The yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown. The average balances are derived from daily balances over the periods indicated. Interest income includes fees, which are considered adjustments to yields. Net interest spread is the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin is derived by dividing net interest income by average interest-earning assets. The Company’s tax exempt investments are insignificant, so no tax equivalent adjustments have been made.

  

   Three Months Ended September 30 
   2014   2013 
       Interest   Average       Interest   Average 
   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Rate   Balance   Paid   Rate 
   (Dollars in thousands) 
Assets:                              
Interest-earning assets:                              
Loans receivable (1)  $1,557,868   $16,588    4.26%  $1,430,966   $16,132    4.51%
Mortgage-related securities   523,208    3,043    2.33    618,619    3,597    2.33 
Investment securities (2)   14,015    35    1.00    11,663    9    0.31 
Interest-earning deposits   15,175    5    0.13    55,698    20    0.14 
Total interest-earning assets   2,110,266    19,671    3.73    2,116,946    19,758    3.73 
Non-interest-earning assets   225,272              225,999           
Total average assets  $2,335,538             $2,342,945           
                               
Liabilities and equity:                              
Interest-bearing liabilities:                              
Regular savings deposits  $223,405    14    0.03   $228,952    16    0.03 
Money market accounts   502,964    186    0.15    484,429    173    0.14 
Interest-bearing demand accounts   223,744    7    0.01    214,044    7    0.01 
Certificates of deposit   539,925    880    0.65    679,640    1,591    0.94 
Total deposit liabilities   1,490,038    1,087    0.29    1,607,065    1,787    0.44 
Advance payments by borrowers for taxes and insurance   27,423        0.00    28,562        0.00 
Borrowings   271,754    1,204    1.77    206,369    1,190    2.31 
Total interest-bearing liabilities   1,789,215    2,291    0.51    1,841,996    2,977    0.65 
Non-interest-bearing liabilities:                              
Non-interest-bearing deposits   192,573              171,045           
Other non-interest-bearing liabilities   67,382              55,229           
Total non-interest-bearing liabilities   259,955              226,274           
Total liabilities   2,049,170              2,068,270           
Total equity   286,368              274,675           
Total average liabilities and equity  $2,335,538             $2,342,945           
Net interest income and net interest rate spread       $17,380    3.22%       $16,781    3.08%
Net interest margin             3.29%             3.17%
Average interest-earning assets to average interest-bearing liabilities   1.18X             1.15X          

  

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in loans receivable.
(2)The carrying value and earnings on stock in the FHLB of Chicago is included in investment securities.

 

35
 

 

   Nine Months Ended September 30 
   2014   2013 
       Interest   Average       Interest   Average 
   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Rate   Balance   Paid   Rate 
   (Dollars in thousands) 
Assets:                              
Interest-earning assets:                              
Loans receivable (1)  $1,522,958   $49,399    4.32%  $1,419,887   $48,314    4.54%
Mortgage-related securities   553,612    9,642    2.32    631,392    11,062    2.34 
Investment securities (2)   13,439    90    0.89    12,336    32    0.35 
Interest-earning deposits   12,966    11    0.11    74,958    86    0.15 
Total interest-earning assets   2,102,975    59,142    3.75    2,138,573    59,494    3.71 
Non-interest-earning assets   227,419              229,367           
Total average assets  $2,330,394             $2,367,940           
                               
Liabilities and equity:                              
Interest-bearing liabilities:                              
Regular savings deposits   223,145    41    0.02    226,697    48    0.03 
Money market accounts   500,780    547    0.15    474,359    518    0.15 
Interest-bearing demand accounts   229,370    21    0.01    221,011    24    0.01 
Certificates of deposit   578,688    3,066    0.71    734,664    6,135    1.11 
Total deposit liabilities   1,531,983    3,675    0.32    1,656,731    6,725    0.54 
Advance payments by borrowers for taxes and insurance   18,091    1    0.01    19,512    1    0.01 
Borrowings   252,335    3,536    1.87    208,066    3,613    2.32 
Total interest-bearing liabilities   1,802,409    7,212    0.53    1,884,309    10,339    0.73 
Non-interest-bearing liabilities:                              
Non-interest-bearing deposits   177,212              103,393           
Other non-interest-bearing liabilities   66,335              106,283           
Total non-interest-bearing liabilities   243,547              209,676           
Total liabilities   2,045,956              2,093,985           
Total equity   284,438              273,955           
Total average liabilities and equity  $2,330,394             $2,367,940           
Net interest income and net interest rate spread       $51,930    3.22%       $49,155    2.98%
Net interest margin             3.29%             3.06%
Average interest-earning assets to average interest-bearing liabilities   1.17X             1.13X          

  

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in loans receivable.
(2)The carrying value and earnings on stock in the FHLB of Chicago is included in investment securities.

 

36
 

 

The following tables present the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to the change attributable to change in volume (change in volume multiplied by prior rate), the change attributable to change in rate (change in rate multiplied by prior volume), and the net change. The change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate.

 

   Three Months Ended September 30, 2014,
Compared to September 30, 2013
 
   Increase (Decrease) 
   Volume   Rate   Net 
   (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $1,380   $(924)  $456 
Mortgage-related securities   (554)       (554)
Investment securities   2    24    26 
Interest-earning deposits   (13)   (2)   (15)
Total interest-earning assets   815    (902)   (87)
Interest-bearing liabilities:               
Savings accounts   (2)       (2)
Money market accounts   6    7    13 
Interest-bearing demand accounts            
Certificates of deposit   (288)   (423)   (711)
Total deposit liabilities   (284)   (416)   (700)
Advance payments by borrowers for taxes and insurance            
Borrowings   327    (313)   14 
Total interest-bearing liabilities   43    (729)   (686)
Net change in net interest income  $772   $(173)  $599 

 

   Nine Months Ended September 30, 2014,
Compared to September 30, 2013
 
   Increase (Decrease) 
   Volume   Rate   Net 
   (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $3,496   $(2,411)  $1,085 
Mortgage-related securities   (1,326)   (94)   (1,420)
Investment securities   3    55    58 
Interest-earning deposits   (56)   (19)   (75)
Total interest-earning assets   2,117    (2,469)   (352)
Interest-bearing liabilities:               
Savings accounts   10    (17)   (7)
Money market accounts   30    (1)   29 
Interest-bearing demand accounts   1    (4)   (3)
Certificates of deposit   (1,125)   (1,944)   (3,069)
Total deposit liabilities   (1,084)   (1,966)   (3,050)
Advance payments by borrowers for taxes and insurance            
Borrowings   692    (769)   (77)
Total interest-bearing liabilities   (392)   (2,735)   (3,127)
Net change in net interest income  $2,509   $266   $2,775 

 

37
 

 

Provision for Loan Losses The Company’s provision for loan losses was $98,000 in the third quarter of 2014 compared to $707,000 in the same quarter last year. The provision for the nine months ended September 30, 2014, was $432,000 compared to $3.3 million in the same period last year. The decline in the provision for loan loss during these periods was due principally to an improvement in the general credit quality of the Company’s loan portfolio, as evidenced by a continued decrease in non-performing loans, as well as a decrease in the overall level of Bank Mutual’s classified loans, as described later in this report. These improvements resulted in a decline in the portion of the Company’s allowance for loan loss that is determined primarily by internal risk ratings and the level of loans within each rating. General economic, employment, and real estate conditions continue to improve modestly in the Company’s markets. However, there can be no assurances that these trends will continue or that classified loans and/or non-performing loans will continue to trend lower in future periods. Furthermore, there can be no assurances that the Company’s provision for loan losses will not vary considerably from period to period. For additional discussion related to the Company’s non-performing loans, non-performing assets, classified assets, and allowance for loan losses, refer to “Financial Condition—Asset Quality,” below.

 

Non-Interest Income Total non-interest income decreased by $50,000 or 0.8% and $4.0 million or 19.1% during the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013, respectively. Significant reasons for the changes in the components of non-interest income are discussed in the following paragraphs.

 

Deposit-related fees and charges declined by $56,000 or 1.8% and $160,000 or 1.8% during the three- and nine-month periods ended September 30, 2014, respectively, compared to the same periods in the previous year. Deposit-related fees and charges consist of overdraft fees, ATM and debit card fees, merchant processing fees, account services charges, and other revenue items related to services performed by the Company for its retail and commercial deposit customers. In previous periods, the Company had reported ATM and debit card fees, merchant processing fees, and certain other items as a component of other income (for additional discussion refer to “Note 1. Basis of Presentation” in the Company’s Unaudited Condensed Consolidated Financial Statements included in “Item 1. Financial Statements”). Management attributes the decrease in deposit-related fees and charges during the 2014 periods to changes in deposit customer spending behavior in recent periods which have resulted in lower revenue from overdraft charges and from check printing commissions. These developments were partially offset by increased revenue from a debit card reward program that the Company implemented in 2013, as well as increased revenue from treasury management and merchant card processing services that the Company offers to commercial depositors.

 

Brokerage and insurance commissions were $534,000 during the third quarter of 2014, which was $124,000 or 18.8% lower than the same period in the previous year. On a year-to-date basis, this source of revenue was $1.9 million in 2014, which was a $416,000 or 17.9% decline from the same period in 2013. This revenue item consists of commissions earned on sales of tax-deferred annuities, mutual funds, and certain other securities, as well as personal and business insurance products. These decreases were primarily due to a decline in customer demand for tax-deferred annuities in recent periods.

 

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Mortgage banking revenue, net, was $810,000 and $2.2 million during the three and nine-month periods ended September 30, 2014, respectively. This compared to $769,000 and $6.2 million during the same periods in 2013, respectively. The following table presents the components of mortgage banking revenue, net, for the periods indicated (in prior periods these components had been presented as separate line items in the consolidated statements of income):

 

   Three Months Ended
September 30
   Nine Months Ended
September 30
 
   2014   2013   2014   2013 
   (Dollars in thousands) 
Gross servicing fees  $690   $727   $2,109   $2,164 
Mortgage servicing rights amortization   (453)   (542)   (1,332)   (2,335)
Mortgage servicing rights valuation recovery       90    1    2,319 
Loan servicing revenue, net   237    275    778    2,148 
Gain on sale of loan activity, net   573    494    1,454    4,036 
Mortgage banking, net  $810   $769   $2,232   $6,185 

 

In prior periods the above components of mortgage banking revenue, net, had been presented as separate line items in the consolidated statement of income (for additional discussion refer to “Note 1. Basis of Presentation” in the Company’s Unaudited Condensed Consolidated Financial Statements included in “Item 1. Financial Statements”).

 

Loan servicing revenue, net, was $237,000 in the third quarter of 2014 compared to $275,000 in the same period in 2013. On a year-to-date basis, this revenue item was $778,000 in 2014 compared to $2.1 million in 2013. Gross loan servicing fees have declined in the 2014 periods compared to the same periods in 2013 due to an overall decline in loans serviced for third-party investors. As of September 30, 2014, the Company serviced $1.1 billion in loans for third-party investors compared to $1.2 billion one year ago. The change in the valuation allowance that the Company maintains against its mortgage servicing rights (“MSRs”) is recorded as a recovery or loss, as the case may be, in the period in which the change occurs. Higher market interest rates for residential loans beginning in early 2013 and continuing into 2014 resulted in lower future prepayment expectations on the loans underlying the Company’s MSRs, which resulted in a recovery of substantially all of the related valuation allowance in 2013. Higher rates also resulted in substantially lower MSR amortization in the 2014 periods compared to the same periods in 2013 due to a lower level of actual loan prepayments. As of September 30, 2014, the Company’s MSRs had a net book value of $8.0 million compared to $8.9 million one year earlier.

 

The valuation of MSRs, as well as the periodic amortization of MSRs, is significantly influenced by the level of market interest rates and loan prepayments. In periods prior to 2014 the amortization of MSRs exceeded the fee revenue that was collected from servicing the related mortgage loans. Amortization of MSRs was elevated in those periods because of a low interest rate environment, which resulted in increased loan prepayment activity and faster amortization of the related MSRs. Market interest rates for residential mortgage loans have increased and prepayment expectations decreased in recent periods. As such, the Company could record reduced levels of MSR amortization expense and has recovered all or a portion of previously established allowance on MSRs. In contrast, if market interest rates decrease and/or actual or expected loan prepayment expectations increase in future periods, amortization expense is likely to increase because of higher levels of loan prepayment activity. In addition, the Company could potentially record charges to earnings related to increases in the valuation allowance on its MSRs.

 

Gain on loan sales activities, net, was $573,000 and $1.5 million during the three- and nine-month periods ended September 30, 2014, respectively, compared to $794,000 and $4.0 million in the same periods last year, respectively. The Company typically sells most of the fixed-rate, one- to four-family mortgage loans that it originates. During the nine months ended September 30, 2014, sales of these loans were $54.5 million, which was $176.2 million or 76.4% lower than the same period in 2013. Higher market interest rates for mortgage loans during 2013 and continuing into 2014 have resulted in lower originations and sales of fixed-rate, one- to four-family loans in recent periods. Management expects this trend to continue in the near term.

 

39
 

 

 

Income from bank-owned life insurance (“BOLI”) was $1.1 million during the three months ended September 30, 2014, compared to $817,000 during the same period in 2013. On a year-to-date basis, income from BOLI was $2.2 million in 2014 compared to $2.0 million in the same period of 2013. These increases were caused by higher payouts associated with excess death benefits, which can vary considerably from period to period. Excess death benefits were $632,000 and $751,000 during the three and nine months ended September 30, 2014, respectively, compared to $407,000 and $639,000 during the same periods in 2013, respectively. Income from BOLI is also not subject to income taxes.

 

During the third quarter of 2014 the Company recorded $102,000 in gain on the sale of $17.6 million in mortgage-related securities that management felt no longer met its yield objectives for the portfolio. The Company did not sell any securities in 2013.

 

Other non-interest income was $434,000 during the third quarter of 2014 compared to $433,000 during the same quarter in 2013. During the nine-month period, other non-interest income was $1.3 million in 2014 compared to $1.0 million in the same period last year. The increase between the year-to-date periods was due primarily to increased fee revenue from interest rate swaps related to certain commercial lending relationships. In 2013 the Company began to mitigate the interest rate risk associated with these types of lending relationships by executing interest rate swaps, the accounting for which resulted in the recognition of a certain amount of fee revenue at the time the swap contracts were executed. Management expects that this source of revenue will vary from period to period depending on borrower preference for the types of lending relationships that generate the need for the interest rate swaps.

 

Non-Interest Expense Total non-interest expense decreased by $1.1 million or 6.4% and $3.6 million or 6.6% during the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013, respectively. Significant reasons for the changes in the components of non-interest expense are discussed in the following paragraphs.

 

Compensation-related expenses decreased by $410,000 or 3.8% and $2.5 million or 7.5% during the three- and nine-month periods ended September 30, 2014, respectively, compared to the same period in 2013. These decreases were due primarily to lower costs related to the Company’s defined benefit pension plan, the benefits of which were frozen for most participants effective December 31, 2013. Also contributing to the decrease in this plan’s costs was an increase in the discount rate used to determine the present value of the pension obligation. Compensation-related expenses was also lower in the 2014 periods because of a change in the manner in which employees earn vacation and other paid time off benefits beginning in 2014. Management anticipates that this change, which is non-recurring, will reduce full-year compensation expense in 2014 by approximately $1.3 million compared to 2013.

 

The favorable developments described in the preceding paragraph were partially offset by an increase in employer contributions to the Company’s defined contribution savings plan. This increase was intended to partially offset the effects of the changes that were made to the defined benefit pension plan, as previously described. Also offsetting the favorable developments described in the preceding paragraph was the impact of normal annual merit increases granted to most employees in the first quarter of 2014.

 

Occupancy and equipment expenses increased by $244,000 or 8.3% during the three months ended September 30, 2014, compared to the same period in the prior year. Year-to-date, occupancy and equipment expenses increased by $670,000 or 7.6% in 2014 compared to the same nine-month period in 2013. Most of these increases were caused by increased maintenance and repair costs in the 2014 periods relative to the 2013 periods. Also contributing to the year-to-date increase were higher snow removal costs and utility expenses earlier in 2014 due to harsh winter conditions compared to the prior year.

 

40
 

 

Federal deposit insurance premiums were $367,000 during the third quarter 2014, which was $71,000 or 16.2% lower than the same period in 2013. On a year-to-date basis, these premiums were $1.1 million in 2014, which was $369,000 or 24.9% lower than the same period in 2013. These decreases were caused by continued improvements in the Company’s financial condition and operating results that, under the FDIC’s risk-based premium assessment system, have resulted in lower insurance assessment rates. Also contributing to the decreases were lower levels of average total assets in during the 2014 periods compared to the same periods in 2013. The FDIC uses average total assets as the assessment base for determining the insurance premium.

 

Advertising and marketing-related expenses declined modestly during the third quarter of 2014 compared to the same quarter in the previous year. Year-to-date, advertising and marketing expenses declined by $94,000 or 6.6% in 2014 compared to the same nine month period in the prior year. At this time management expects advertising and marketing-related expenses for the full year of 2014 could be about 5% higher than they were in 2013. However, this will depend on future management decisions and there can be no assurances.

 

Net losses and expenses on foreclosed real estate were $44,000 and $1.0 million during the three and nine months ended September 30, 2014, respectively, compared to $716,000 and $2.3 million during the same period of last year. In general, the Company has experienced lower losses and expenses on foreclosed real estate in recent periods due to lower levels of foreclosed properties.

 

Income Tax Expense Income tax expense was $2.3 million and $1.5 million during the three months ended September 30, 2014 and 2013, respectively, and was $6.7 million and $4.2 million during the nine months ended as of the same dates, respectively. The Company’s effective tax rate (“ETR”) during the third quarter of 2014 was 34.1%, which was the same rate during the third quarter of 2013. The 2014 year-to-date period includes a non-recurring charge of $518,000 (net of federal income tax benefit) that was related to a payment by the Company to the Wisconsin Department of Revenue (the “Department”) to settle a tax matter that has been previously disclosed. Excluding this non-recurring charge, as well as the related federal tax benefit, the Company’s ETRs during the first nine months of 2014 and 2013 were 35.3% and 34.1%, respectively. The Company’s ETR will vary from period to period depending primarily on the impact of non-taxable revenue items, such as tax-exempt interest income and earnings from BOLI. The Company’s ETR will generally be higher in periods in which these non-taxable revenue items comprise a smaller portion of pre-tax income.

 

Financial Condition

 

Overview The Company’s total assets decreased by $20.2 million or 0.9% during the nine months ended September 30, 2014. During this period the Company’s mortgage-related securities available-for-sale declined by $98.6 million due primarily to the receipt of periodic principal repayments, as well as the sale of certain securities, as previously described. In addition, other borrowings, which consist of advances from the FHLB of Chicago, increased by $34.1 million during the period and advance payments from borrowers for taxes and insurance increased by $28.1 million, the latter due primarily to seasonal trends. Cash flows from these sources funded an $88.3 million increase in the Company’s loans receivable and a $77.0 million decrease in its deposit liabilities. The Company’s total shareholders’ equity increased from $281.0 million at December 31, 2013, to $287.5 million at September 30, 2014.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of mortgage-related securities available-for-sale declined by $98.6 million or 22.1% during the nine months ended September 30, 2014. This decrease was principally due to periodic principal repayments on the securities. Also contributing, however, was the sale of $17.6 million in certain securities, as previously described. The Company did not purchase any available-for-sale securities during the nine months ended September 30, 2014.

 

41
 

 

Changes in the fair value of the Company’s mortgage-related securities available-for-sale are recorded through accumulated other comprehensive loss (net of deferred income taxes), which is a component of shareholders’ equity. The fair value adjustment on the Company’s mortgage-related securities available-for-sale was a net unrealized gain of $6.9 million at September 30, 2014, compared to a net unrealized gain of $7.1 million at December 31, 2013.

 

The Company maintains an investment in private-label CMOs that were all rated “triple-A” by various credit rating agencies at the time of their purchase. However, all of the securities in the portfolio have since been downgraded. As of September 30, 2014, and December 31, 2013, the carrying value of the Company’s investment in private-label CMOs was $31.7 million and $38.7 million, respectively. The net unrealized gain on the securities as of such dates was $748,000 and $580,000, respectively. As of September 30, 2014, $25.0 million of the Company’s private-label CMOs were rated less than investment grade by at least one credit rating agency. These securities had a net unrealized gain of $684,000 as of that date. As of December 31, 2013, $28.8 million of the Company’s private-label CMOs were rated less than investment grade and had a net unrealized gain of $502,000.

 

As of September 30, 2014, management determined that none of the Company’s private-label CMOs were other-than-temporarily impaired. The Company does not intend to sell these securities and it is unlikely it would be required to sell them before the recovery of their amortized cost. However, collection is subject to numerous factors outside of the Company’s control and a future determination of OTTI could result in significant losses being recorded through earnings in future periods.

 

Mortgage-Related Securities Held-to-Maturity The Company maintains a portfolio of mortgage-related securities held-to-maturity that consists of securities issued and guaranteed by Fannie Mae and backed by multi-family residential loans. The Company has classified these securities as held-to-maturity because it has the ability and intent to hold these securities until they mature. The Company did not purchase any held-to-maturity securities during the nine months ended September 30, 2014.

 

Loans Held-for-Sale The Company’s policy is to sell substantially all of its fixed-rate, one- to four-family mortgage loan originations in the secondary market. Loans held-for-sale were $4.7 million and $1.8 million at September 30, 2014, and December 31, 2013, respectively. Management believes that originations and sales of fixed-rate, one- to four-family mortgage loans will continue to be relatively low in the near term, for reasons noted previously in this report.

 

Loans Receivable The Company’s loans receivable increased by $88.3 million or 5.9% during the nine months ended September 30, 2014. During the nine months ended September 30, 2014, commercial and industrial loans increased by $46.4 million or 27.8% as a result of increased originations and credit line utilization by borrowers and multi-family real estate loans increased by $37.6 million or 14.1% on sustained demand from borrowers in this market segment. In addition, one- to four-family loans increased by $10.6 million or 2.4% despite a lower level of originations during the nine months ended September 30, 2014, compared to the same period in 2013. This development was caused by higher market interest rates, as previously noted, which significantly reduced the amount of prepayment activity in the one- to four-family loan portfolio in recent periods. Finally, construction loans, net of the undisbursed portion, increased by $26.7 million or 21.7% during the nine months ended September 30, 2014. Construction loans consist principally of loans secured by multi-family, commercial, and residential properties, and to a very small degree, developed and undeveloped land. In contrast to these increases, the Company’s portfolio of commercial real estate loans declined by $26.7 million or 9.6% during the nine months ended September 30, 2014, due to low borrower demand and aggressive competition for these types of loans in recent periods. The Company’s portfolios of home equity and consumer loans have also declined in recent periods for similar reasons. Growth in the Company’s total loans is subject to economic, market, and competitive factors outside of its control and there can be no assurances that expected loan growth will continue or that total loans will not decrease in future periods.

 

42
 

 

The following table sets forth the Company’s commercial and retail loans that were originated for portfolio during the periods indicated:

 

   Nine Months Ended
September 30
 
   2014   2013 
  (Dollars in thousands) 
Commercial loans:    
    Commercial and industrial  $51,439   $45,350 
    Commercial real estate   21,776    33,620 
    Multi-family real estate   79,055    34,574 
    Construction and development   111,548    133,930 
        Total commercial loans   263,818    247,474 
Retail loans:          
    One- to four-family first mortgages (1)   50,803    71,227 
    Home equity   26,248    43,067 
    Other consumer   1,046    2,899 
        Total retail loans   78,097    117,193 
        Total loan originations  $341,915   $364,667 

 

(1)Excludes $57.3 million and $222.7 million in loans originated for sale during the nine months ended September 30, 2014 and 2013, respectively.

 

Mortgage Servicing Rights The carrying value of the Company’s MSRs was $8.0 million at September 30, 2014, and $8.7 million at December 31, 2013, net of valuation allowances of zero and $1,400 as of such dates, respectively. As of September 30, 2014, the Company serviced $1.1 billion in loans for third-party investors compared to a similar amount at December 31, 2013. Refer to “Results of Operations—Non-Interest Income,” above, for additional discussion related to the Company’s MSRs.

 

Other Assets As of September 30, 2014, and December 31, 2013, the Company’s net deferred tax asset, which is included as a component of other assets, was $21.4 million and $27.4 million, respectively. Management evaluates this asset on an on-going basis to determine if a valuation allowance is required. Management determined that no valuation allowance was required as of these dates. The evaluation of the net deferred tax asset requires significant management judgment based on positive and negative evidence. Such evidence includes the Company’s recent trends in earnings, expectations for the Company’s future earnings, the duration of federal and state net operating loss carryforward periods, and other factors. There can be no assurance that future events, such as adverse operating results, court decisions, regulatory actions or interpretations, changes in tax rates and laws, or changes in positions of federal and state taxing authorities will not differ from management’s current assessments. The impact of these matters could be significant to the consolidated financial conditions, results of operations, and capital of the Company.

 

The Company’s foreclosed properties and repossessed assets, which are included as a component of other assets, were $5.2 million and $6.7 million at September 30, 2014, and December 31, 2013, respectively. Management expects foreclosed properties and repossessed assets to trend modestly lower in the near term. However, there can be no assurances that foreclosed properties and repossessed assets will not fluctuate significantly from period to period.

 

Deposit Liabilities The Company’s deposit liabilities decreased by $77.0 million or 4.4% during the nine months ended September 30, 2014. Certificates of deposit declined by $105.6 million or 16.7% during the period while transaction deposits, consisting of checking, savings, and money market accounts, increased by $28.6 million or 2.5%. The Company continues to closely manage the rates it offers on certificates of deposit to control its overall liquidity position, which has resulted in a decline in certificates of deposit in recent periods. However, as noted earlier in this report, in recent weeks the Company has increased the rates and lengthened maturity terms on certain of the certificates of deposits it offers customers. Accordingly, management believes that the average cost of the Company’s certificates of deposits may begin to increase modestly in the fourth quarter and that such trend could continue for the foreseeable future.

 

43
 

 

The Company’s transaction deposits have increased in recent periods in response to management’s efforts to increase sales of such products and related services to commercial businesses, as well as efforts to focus its retail sales efforts on such products and related services. Also contributing to the increase in transaction deposits in recent periods, however, was customer reaction to the low interest rate environment for deposit products. Management believes that this environment has encouraged some customers to switch to transaction deposits in an effort to retain flexibility in the event interest rates increase in the future. If interest rates increase in the future, customer preference may shift from transaction deposits back to certificates of deposit, which typically have a higher interest cost to the Company. This development could increase the Company’s cost of funds in the future, which could have an adverse impact on its net interest margin.

 

Borrowings Borrowings, which consist of advances from the FHLB of Chicago, increased by $34.1 million or 13.9% during the nine months ended September 30, 2014. This increase was due to an increase in overnight and term borrowings from the FHLB of Chicago, which partially funded growth in the Company’s loans receivable during the period, as well as the decrease in its deposit liabilities. During the third quarter the Company drew a $30.0 million two-year term advance from the FHLB of Chicago. The proceeds from this advance, which has annual rate of 0.69%, were used to reduce the level of overnight borrowings from the FHLB of Chicago. The Company’s term advances from the FHLB of Chicago are subject to significant prepayment penalties if repaid by the Company prior to their stated maturity. Management believes that additional funds are available to be borrowed from the FHLB of Chicago or other sources in the future to fund maturing term advances, loan originations, security purchases, and other corporate purposes, if needed or desirable. However, there can be no assurances of the future availability of borrowings or any particular level of future borrowings.

 

Advance Payments by Borrowers for Taxes and Insurance Advance payments by borrowers for taxes and insurance (i.e., escrow deposits) were $31.5 million at September 30, 2014, compared to $3.4 million at December 31, 2013. Escrow deposits typically increase during the course of the calendar year until real estate tax obligations are paid, generally in December of each year or January of the following year.

 

Shareholders' Equity The Company’s shareholders’ equity increased from $281.0 million at December 31, 2013, to $287.5 million at September 30, 2014. This increase was due primarily to net income during the period, partially offset by the payment of cash dividends during the period. The book value of the Company’s common stock was $6.17 per share at September 30, 2014, compared to $6.05 per share at December 31, 2013.

 

On November 3, 2014, the Company’s board of directors declared a $0.04 per share dividend payable on November 28, 2014, to shareholders of record on November 14, 2014. For additional discussion relating to the Company’s ability to pay dividends refer to “Liquidity and Capital Resources—Capital Resources,” below.

 

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Asset Quality The following table summarizes non-performing loans and assets as of the dates indicated:

 

   At September 30   At December 31 
   2014   2013 
  (Dollars in thousands) 
Non-accrual commercial loans:    
     Commercial and industrial  $213   $284 
     Commercial real estate   2,487    4,401 
     Multi-family real estate   1,413    1,783 
     Construction and development   605    728 
        Total commercial loans   4,718    7,196 
Non-accrual retail loans:          
     One- to four-family first mortgages   3,727    4,556 
     Home equity   486    676 
     Other consumer   47    104 
        Total non-accrual retail loans   4,260    5,336 
        Total non-accrual loans   8,978    12,532 
Accruing loans delinquent 90 days or more (1)   406    443 
    Total non-performing loans   9,384    12,975 
Foreclosed real estate and repossessed assets   5,243    6,736 
    Total non-performing assets  $14,627   $19,711 
           
Non-performing loans to total loans   0.59%   0.86%
Non-performing assets to total assets   0.63%   0.84%
Interest income that would have been recognized
if non-accrual loans had been current (2)
  $375   $1,265 
Interest income on non-accrual loans included in
interest income (2)
  $233   $658 

 

(1)Consists of student loans that are guaranteed under programs sponsored by the U.S. government.

(2) Amounts shown are for the nine months ended September 30, 2014, and the twelve months ended December 31, 2013, respectively.

 

The Company’s non-performing loans were $9.4 million or 0.59% of loans receivable as of September 30, 2014, compared to $13.0 million or 0.86% of loans receivable as of December 31, 2013. Non-performing assets, which includes non-performing loans, were $14.6 million or 0.63% of total assets and $19.7 million or 0.84% of total assets as of these same dates, respectively. Non-performing assets are classified as “substandard” in accordance with the Company’s internal risk rating policy. In addition to non-performing assets, at September 30, 2014, management was closely monitoring $36.8 million in additional loans that were classified as “special mention” and $38.2 million in additional loans that were classified as “substandard” in accordance with the Company’s internal risk rating policy. These amounts compared to $52.7 million and $36.1 million, respectively, as of December 31, 2013. As of September 30, 2014, most of the additional loans that were classified as “special mention” or “substandard” were secured by commercial real estate, multi-family real estate, land, and certain commercial business assets. The decrease in loans classified as “special mention” was due primarily to the downgrade of certain loans to “substandard” earlier in 2014. Management does not believe any of these particular loans were impaired as of September 30, 2014, although there can be no assurances that the loans will not become impaired in future periods. The impact of these downgrades on total loans classified as “substandard” was offset in part by a number of other “substandard” loans that paid-off during the period or were upgraded due to the improved financial condition and operating results of the borrowers.

 

Trends in the credit quality of the Company’s loan portfolio are subject to many factors that are outside of the Company’s control, such as economic and market conditions. As such, there can be no assurances that there will not be significant fluctuations in the Company’s non-performing assets and/or classified loans in future periods or that there will not be significant variability in the Company’s provision for loan losses from period to period.

 

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A summary of the Company’s allowance for loan losses is shown below for the periods indicated:

 

   Nine Months Ended
September 30
 
   2014   2013 
   (Dollars in thousands) 
Balance at beginning of period  $23,565   $21,577 
Provision for loan losses   432    3,329 
Charge-offs:          
Commercial and industrial   (59)   (199)
Commercial real estate   (561)   (493)
Multi-family real estate   (241)   (536)
Construction and development   (34)   (148)
One- to four-family first mortgages   (798)   (934)
Home equity   (73)   (822)
Other consumer   (326)   (286)
Total charge-offs   (2,092)   (3,418)
Recoveries:          
Commercial and industrial   61    5 
Commercial real estate   160    633 
Multi-family real estate        
Construction and development   142    77 
One- to four-family first mortgages   225    475 
Home equity   23    65 
Other consumer   24    27 
Total recoveries   635    1,282 
Net charge-offs   (1,457)   (2,136)
          Balance at end of period  $22,540   $22,770 

 

   September 30   December 31 
   2014   2013 
Allowance for loan losses to total loans   1.41%   1.56%
Allowance for loan losses to non-performing loans   240.20%   181.62%
Net charge-offs to average loans (1)   0.13%   0.18%

 

(1)The rate for the nine months ended September 30, 2014, is annualized.

 

The Company’s allowance for loan losses was $22.5 million or 1.41% of total loans at September 30, 2014, compared to $23.6 million or 1.56% of total loans at December 31, 2013. As a percent of non-performing loans, the Company’s allowance for loan losses was 240.2% at September 30, 2014, compared to 181.6% at December 31, 2013. Management believes the allowance for loan losses at September 30, 2014, was adequate to cover probable and estimable losses in the Company’s loan portfolio as of that date. However, future increases to the allowance may be necessary and results of operations could be adversely affected if future conditions differ from the assumptions used by management to determine the allowance for loan losses as of the end of the period.

 

Management is responsible for the timely and periodic determination of the amount of the allowance required. Future provisions for loan losses will continue to be based upon management’s assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions, and other relevant factors. To the best of management’s knowledge, all known and inherent losses have been provided for in the allowance for loan losses.

 

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Refer to “Operating Results—Provision for Loan Losses,” above, for additional discussion.

 

Liquidity and Capital Resources

 

Liquidity The term "liquidity" refers to the Company’s ability to generate cash flow to fund loan originations, loan purchases, deposit withdrawals, and operating expenses. The Company’s primary sources of funds are deposit liabilities, scheduled payments, prepayments, and maturities of loans and mortgage-related securities, sales of one- to four-family loans in the secondary market, borrowings from the FHLB of Chicago, and cash flow provided by the Company’s operations. From time-to-time the Company may also sell securities classified as available-for-sale. Historically, these sources of funds have been adequate to maintain liquidity, with the Company borrowing correspondingly more in periods in which its operations generate less cash.

 

Scheduled payments and maturities of loans and mortgage-related securities are relatively predictable sources of funds. However, cash flows from customer deposits, calls of investment securities (if any), and prepayments of loans and mortgage-related securities are strongly influenced by interest rates, general and local economic conditions, and competition in the marketplace. These factors increase the variability of cash flows from these sources of funds.

 

The Company is committed to maintaining a strong liquidity position; therefore, management monitors the Company’s liquidity position on a daily basis. Based upon historical experience and available sources of liquidity, management anticipates that the Company will have sufficient funds to meet current funding commitments. For additional discussion refer to “Financial Condition,” above, and “Qualitative and Quantitative Disclosures about Market Risk” in Part I, Item 3, below.

 

Capital Resources The Company’s ratio of shareholders’ equity to total assets was 12.35% at September 30, 2014, compared to 11.97% at December 31, 2013. The increase in this ratio was due in part to the Company’s net income, less the dividends it paid during the period. Also contributing was a decline in the Company’s total assets during the period, as noted in earlier paragraphs.

 

At September 30, 2014, the Bank exceeded each of the applicable regulatory capital requirements (refer to Note 8, “Shareholders’ Equity,” of the Unaudited Condensed Consolidated Financial Statements, above). In order to be classified as "well-capitalized" by the FDIC, the Bank is required to have Tier 1 (leverage) capital to total adjusted assets of at least 5.0% and total risk-based capital to risk-weighted assets of at least 10.0%. At September 30, 2014, the Bank had a Tier 1 capital ratio of 11.39% and a total risk-based capital ratio of 18.26%.

 

The payment of dividends or the repurchase of common stock by the Company is highly dependent on the ability of the Bank to pay dividends or otherwise distribute capital to the Company. Such payments are also subject to any requirements imposed by law or regulations and to the application and interpretation thereof by the OCC and FRB. The Company cannot provide any assurances that dividends will continue to be paid, the amount of any such dividends, or whether the Company will choose to or be able to repurchase its common stock in future periods.

 

In 2013 the FRB and the OCC published final regulatory capital rules under Basel III. These new rules will become effective on January 1, 2015, although certain aspects of the new rules will phase in over the following four years. At this time management does not expect these new rules to have a significant impact on the activities of the Bank, its financial condition, or its results of operations, although there can be no assurances. In addition, the Dodd-Frank Act imposed specific capital requirements on savings and loan holding companies such as the Company that are effective as of the same date. At this time management does not expect this new capital requirement to have a significant impact on the Company. However, these developments, as well as other requirements that could be imposed by regulators, could impact the ability of the Company and/or the Bank to pay dividends or, in the case of the Company, repurchase its common stock.

 

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Contractual Obligations, Commitments, Off-Balance Sheet Arrangements, and Contingencies

 

Contractual Obligations The following table presents, as of September 30, 2014, significant fixed and determinable contractual obligations to third parties by payment date (excluding interest payments due in the future on deposits and borrowed funds):

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Deposits with no stated maturity  $1,157,438               $1,157,438 
Certificates of deposits   425,513   $74,780   $27,975        528,268 
Borrowed funds   68,450    91,222    59,318   $59,993    278,983 
Operating leases   970    1,243    828    2,236    5,277 
Purchase obligations   2,400    4,800    4,800        12,000 
Deferred retirement plans and deferred compensation plans   996    1,563    1,618    5,410    9,587 

 

The Company’s operating lease obligations represent short- and long-term lease and rental payments for facilities, certain software and data processing equipment, and other equipment. Purchase obligations represent obligations under agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The purchase obligation amounts presented above primarily relate to certain contractual payments for services provided for information technology.

 

The Company also has obligations under its deferred retirement plan for executives and directors as described in Note 10, “Employee Benefit Plans,” to the Unaudited Condensed Consolidated Financial Statements, above.

 

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Commitments to Extend Credit The following table details the amounts and expected maturities of approved commitments as of September 30, 2014:

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Commercial lines of credit  $89,985               $89,985 
Commercial loans   10,061   $53   $96        10,210 
Standby letters of credit   4,908    45            4,953 
Multi-family and commercial real estate loans   224,238                224,238 
Residential real estate loans   25,176                25,176 
Revolving home equity and credit card lines   167,974                167,974 
Net commitments to sell mortgage loans   10,763                10,763 

 

Commitments to extend credit, including loan commitments, standby letters of credit, unused lines of credit and commercial letters of credit do not necessarily represent future cash requirements, since these commitments often expire without being drawn upon.

 

Off-Balance Sheet Arrangements At September 30, 2014, the Company had forward commitments to sell one- to four-family mortgage loans of $10.8 million to Fannie Mae. As described in Note 12, “Financial Instruments with Off-Balance Sheet Risk,” to the Company’s Unaudited Condensed Consolidated Financial Statements, the Company uses forward commitments to sell loans to mitigate interest rate risk on one- to four-family IRLCs and loans held-for-sale.

 

Contingent Liabilities The Company did not have a material exposure to contingent liabilities as of September 30, 2014.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Gap Analysis

 

Repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring a financial institution's interest rate sensitivity “gap.” An asset or liability is said to be “interest rate sensitive” within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period.

 

A gap is considered positive when the amount of interest-earning assets maturing or repricing within a specific time period exceeds the amount of interest-bearing liabilities maturing or repricing within that specific time period. A gap is considered negative when the amount of interest-bearing liabilities maturing or repricing within a specific time period exceeds the amount of interest-earning assets maturing or repricing within the same period. During a period of rising interest rates, a financial institution with a negative gap position would be expected, absent the effects of other factors, to experience a greater increase in the costs of its liabilities relative to the yields of its assets and thus a decrease in the institution's net interest income. An institution with a positive gap position would be expected, absent the effect of other factors, to experience the opposite result. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to reduce net interest income.

 

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The following table presents the amounts of the Company’s interest-earning assets and interest-bearing liabilities outstanding at September 30, 2014, which management anticipates to reprice or mature in each of the future time periods shown. The information presented in the following table is based on the following assumptions:

 

·Loans—based upon contractual maturities, repricing date, if applicable, scheduled repayments of principal, and projected prepayments of principal based upon the Company’s historical experience or anticipated prepayments. Actual cash flows may differ substantially from these assumptions.

 

·Mortgage-related securities—based upon known repricing dates (if applicable) and an independent outside source for determining estimated prepayment speeds. Actual cash flows may differ substantially from these assumptions.

 

·Deposit liabilities—based upon contractual maturities and the Company’s historical decay rates. Actual cash flows may differ substantially from these assumptions.

 

·Borrowings—based upon final maturity.

 

   September 30, 2014 
   Within   Three to   More than   More than         
   Three   Twelve   1 Year to   3 Years -   Over 5     
   Months   Months   3 Years   5 Years   Years   Total 
   (Dollars in thousands) 
Loans receivable:                              
Commercial loans:                              
     Fixed  $29,770   $94,125   $154,229   $105,273   $16,902   $400,299 
     Adjustable   312,299    55,912    93,728    36,181        498,120 
Retail loans:                              
     Fixed   19,400    37,415    75,864    50,160    101,691    284,530 
     Adjustable   108,562    149,331    83,698    41,228    50,809    433,628 
Interest-earning deposits   7,286                    7,286 
Mortgage-related securities:                              
Fixed   30,184    76,469    136,670    144,121    85,258    472,702 
Adjustable   22,104                    22,104 
Other interest-earning assets   14,209                    14,209 
Total interest-earning assets   543,814    413,252    544,189    376,963    254,660    2,132,878 
                               
Deposit liabilities:                              
     Non-interest-bearing demand accounts   1,068    3,167    8,170    7,787    158,206    178,398 
Interest-bearing demand accounts   1,409    4,175    10,773    10,268    208,612    235,237 
Savings accounts   1,465    4,334    11,133    10,541    195,616    223,089 
Money market accounts   520,714                    520,714 
Certificates of deposit   158,622    280,660    61,008    27,978        528,268 
Advance payments by borrowers  for taxes and insurance   31,518                    31,518 
Borrowings   45,314    24,414    93,875    60,643    54,737    278,983 
     Total non-interest- and interest-bearing liabilities   760,110    316750    184,959    117,217    617,171    1,996,207 
Interest rate sensitivity gap  $(216,296)  $96,502   $359,230   $259,746   $(362,511)  $136,671 
Cumulative interest rate sensitivity gap  $(216,296)  $(119,794)  $239,436   $499,182   $136,671      
Cumulative interest rate sensitivity gap as a percent of total assets   (9.29)%   (5.15)%   10.29%   21.45%   5.87%     
Cumulative interest-earning assets as a percentage of non-interest- and interest-bearing liabilities   71.54%   88.88%   118.98%   136.20%   106.85%     

 

Based on the above gap analysis, at September 30, 2014, the Company’s interest-bearing liabilities maturing or repricing within one year exceeded its interest-earning assets maturing or repricing within the same period. Based on this information, over the course of the next year the Company’s net interest income could be adversely impacted by an increase in market interest rates. Alternatively, the Company’s net interest income could be favorably impacted by a decline in market interest rates. However, it should be noted that the Company’s future net interest income is affected by more than just future market interest rates. Net interest income is also affected by absolute and relative levels of earning assets and interest-bearing liabilities, the level of non-performing loans and other investments, and by other factors outlined in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Cautionary Statement,” as well as Part I, Item 1A, “Risk Factors,” of the Company’s 2013 Annual Report on Form 10-K.

 

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In addition to not anticipating all of the factors that could impact future net interest income, gap analysis has certain shortcomings. For example, although certain assets and liabilities may mature or reprice in similar periods, the interest rates on such react by different degrees to changes in market interest rates, especially in instances where changes in rates are limited by contractual caps or floors or instances where rates are influenced by competitive forces. Interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. For example, it is the Company’s past experience that rate changes on most of its deposit liabilities generally lag changes in market interest rates. Certain assets, such as adjustable-rate loans, have features which limit changes in interest rates on a short term basis and over the life of the loan. If interest rates change, prepayment, and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of borrowers to make payments on their adjustable-rate loans may decrease if interest rates increase. Because of these shortcomings, management of the Company believes that gap analysis is a better indicator of the relative change in the Company’s interest rate risk exposure from period to period than it is an indicator of the direction or amount of future change in net interest income.

 

Present Value of Equity

 

In addition to the gap analysis table, management also uses simulation models to monitor interest rate risk. The models report the present value of equity (“PVE”) in different interest rate environments, assuming an instantaneous and permanent interest rate shock to all interest rate sensitive assets and liabilities. The PVE is the difference between the present value of expected cash flows of interest rate sensitive assets and liabilities. The changes in market value of assets and liabilities due to changes in interest rates reflect the interest rate sensitivity of those assets and liabilities as their values are derived from the characteristics of the asset or liability (i.e., fixed rate, adjustable rate, caps, and floors) relative to the current interest rate environment. For example, in a rising interest rate environment, the fair market value of a fixed-rate asset will decline whereas the fair market value of an adjustable-rate asset, depending on its repricing characteristics, may not decline. Increases in the market value of assets will increase the PVE whereas decreases in market value of assets will decrease the PVE. Conversely, increases in the market value of liabilities will decrease the PVE whereas decreases in the market value of liabilities will increase the PVE.

 

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The following table presents the estimated PVE over a range of interest rate change scenarios at September 30, 2014. The present value ratio shown in the table is the PVE as a percent of the present value of total assets in each of the different rate environments. For purposes of this table, management has made assumptions such as prepayment rates and decay rates similar to those used for the gap analysis table.

  

               Present Value of Equity 
               as a Percent of 
Change in  Present Value of Equity   Present Value of Assets 
Interest Rates  Dollar   Dollar   Percent   Present Value   Percent 
(Basis Points)  Amount   Change   Change   Ratio   Change 
   (Dollars in thousands)           
+400  $297,634   $(118,464)   (28.5)%   13.74%   (22.2)%
+300   324,715    (91,383)   (22.0)   14.68    (16.8)
+200   354,562    (61,536)   (14.8)   15.71    (11.1)
+100   384,531    (31,567)   (7.6)   16.68    (5.5)
0   416,098            17.66     
-100   422,765    6,667    1.6    17.50    (0.9)

 

Based on the above analysis, the Company’s PVE could be adversely affected by an increase in interest rates. The decline in the PVE as a result of an increase in rates is attributable to the combined effects of a decline in the present value of the Company’s earning assets (which is further impacted by an extension in duration in rising rate environments due to slower prepayments on loan and mortgage-related securities and reduced likelihood of calls on certain investment securities), partially offset by a decline in the present value of deposit liabilities and FHLB of Chicago advances. Alternatively, it should be noted the Company’s PVE could be favorably impacted by a decrease in interest rates. However, it should be noted that the Company’s PVE is impacted by more than changes in market interest rates. Future PVE is also affected by management’s decisions relating to reinvestment of future cash flows, decisions relating to funding sources, and by other factors outlined in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Cautionary Statement,” above, as well as Part I, Item 1A, “Risk Factors,” of the Company’s 2013 Annual Report on Form 10-K.

 

As is the case with gap analysis, PVE analysis also has certain shortcomings. PVE modeling requires management to make assumptions about future changes in market interest rates that are unlikely to occur, such as immediate, sustained, and parallel (or equal) changes in all market rates across all maturity terms. PVE modeling also requires that management make assumptions which may not reflect the manner in which actual yields and costs respond to changes in market interest rates. For example, it is the Company’s past experience that rate changes on most of its deposit liabilities generally lag changes in market interest rates. In addition, management makes assumptions regarding the changes in prepayment speeds of mortgage loans and securities. Prepayments will accelerate in a falling rate environment and the reverse will occur in a rising rate environment. Management also assumes that decay rates on transaction deposits will accelerate in a rising rate environment and the reverse in a falling rate environment. The model assumes that the Company will take no action in response to the changes in interest rates, when in practice rate changes on most deposit liabilities lag behind market changes and/or may be limited by competition. In addition, prepayment estimates and other assumptions within the model are subjective in nature, involve uncertainties, and therefore cannot be determined with precision. Accordingly, although the PVE model may provide an estimate of the Company’s interest rate risk at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in interest rates on the Company’s PVE. Because of these shortcomings, management of the Company believes that PVE analysis is a better indicator of the relative change in the Company’s interest rate risk exposure from period to period than it is an indicator of the direction or amount of future change in net interest income.

 

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Item 4. Controls and Procedures

 

Disclosure Controls and Procedures

 

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures, as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

 

Internal Control Over Financial Reporting

 

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II

 

Item 1A. Risk Factors

Refer to “Risk Factors” in Part I, Item 1A, of the Company’s 2013 Annual Report on Form 10-K. Refer also to "Management’s Discussion and Analysis of Financial Condition and Results of Operations—Cautionary Statement" in Part I, Item 2, above.

  

Item 6. Exhibits

 

Refer to Exhibit Index, which follows the signature page hereof.

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SIGNATURES

 

Pursuant to the requirements 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.

 

  BANK MUTUAL CORPORATION
  (Registrant)
   
Date: November 4, 2014   /s/ David A. Baumgarten
  David A. Baumgarten
  President and Chief Executive Officer

 

Date: November 4, 2014 /s/ Michael W. Dosland
  Michael W. Dosland
  Senior Vice President and
  Chief Financial Officer

 

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EXHIBIT INDEX

 

BANK MUTUAL CORPORATION

 

Form 10-Q for Quarter Ended September 30, 2014

 

Exhibit No.   Description   Incorporated Herein
by Reference To
  Filed Herewith
             
31.1  

Sarbanes-Oxley Act Section 302 Certification signed by the Chairman and Chief Executive Officer of Bank Mutual Corporation

 

      X
31.2  

Sarbanes-Oxley Act Section 302 Certification signed by the Senior Vice President and Chief Financial Officer of Bank Mutual Corporation

 

      X
32.1  

Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Executive Officer of Bank Mutual Corporation

 

      X
32.2   Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Financial Officer of Bank Mutual Corporation       X

 

101   The following materials are provided from Bank Mutual Corporation’s Quarterly Report on Form 10-Q for the period ended September 30, 2014, formatted in Extensible Business Reporting Language (“XBRL”):  (i) the Unaudited Condensed Consolidated Statements of Financial Condition, (ii) Unaudited Condensed Consolidated Statements of Income, (iii) Unaudited Condensed Statements of Comprehensive Income (iv) Unaudited Condensed Consolidated Statements of Equity, (v) Unaudited Condensed Consolidated Statements of Cash Flow, and (vi) Notes to Unaudited Condensed Consolidated Financial Statements.

 

101.INS   XBRL Instance Document       X
             
101.SCH   XBRL Taxonomy Extension Schema Document       X
             
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document       X
             
101.LAB   XBRL Extension Labels Linkbase Document       X

 

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101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document       X
             
101.DEF   XBRL Taxonomy Extension Definition Linkbase Document       X

 

57