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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2004
Commission file number 0-7818
INDEPENDENT BANK CORPORATION
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Michigan 38-2032782
- --------------------------------------- ---------------------------------------
(State or jurisdiction of (I.R.S. Employer Identification
Incorporation or Organization) Number)
230 West Main Street, P.O. Box 491, Ionia, Michigan 48846
- --------------------------------------------------------------------------------
(Address of principal executive offices)
(616) 527-9450
---------------
(Registrant's telephone number, including area code)
NONE
- --------------------------------------------------------------------------------
Former name, address and fiscal year, if changed since last report.
Indicate by check mark whether the registrant (1) has filed all documents
and reports required to be filed by Sections 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [X] NO [ ]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Common stock, par value $1 21,114,833
- --------------------------------------- ---------------------------------------
Class Outstanding at November 5, 2004
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
INDEX
Number(s)
---------
PART I - Financial Information
Item 1. Consolidated Statements of Financial Condition
September 30, 2004 and December 31, 2003 2
Consolidated Statements of Operations
Three- and Nine-month periods ended September 30, 2004 and 2003 3
Consolidated Statements of Cash Flows
Nine-month periods ended September 30, 2004 and 2003 4
Consolidated Statements of Shareholders' Equity
Nine-month periods ended September 30, 2004 and 2003 5
Notes to Interim Consolidated Financial Statements 6-17
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 18-37
Item 3. Quantitative and Qualitative Disclosures about Market Risk 38
Item 4. Controls and Procedures 38
PART II -Other Information
Item 2. Unregistered sales of equity securities and use of proceeds 39
Item 6. Exhibits 39
Any statements in this document that are not historical facts are
forward-looking statements as defined in the Private Securities Litigation
Reform Act of 1995. Words such as "expect," "believe," "intend," "estimate,"
"project," "may" and similar expressions are intended to identify
forward-looking statements. These forward-looking statements are predicated on
management's beliefs and assumptions based on information known to Independent
Bank Corporation's management as of the date of this document and do not purport
to speak as of any other date. Forward-looking statements may include
descriptions of plans and objectives of Independent Bank Corporation's
management for future or past operations, products or services, and forecasts of
our revenue, earnings or other measures of economic performance, including
statements of profitability, business segments and subsidiaries, and estimates
of credit quality trends. Such statements reflect the view of Independent Bank
Corporation's management as of this date with respect to future events and are
not guarantees of future performance; involve assumptions and are subject to
substantial risks and uncertainties, such as the changes in Independent Bank
Corporation's plans, objectives, expectations and intentions. Should one or more
of these risks materialize or should underlying beliefs or assumptions prove
incorrect, our actual results could differ materially from those discussed.
Factors that could cause or contribute to such differences are changes in
interest rates, changes in the accounting treatment of any particular item, the
results of regulatory examinations, changes in industries where we have a
concentration of loans, changes in the level of fee income, changes in general
economic conditions and related credit and market conditions, and the impact of
regulatory responses to any of the foregoing. Forward-looking statements speak
only as of the date they are made. Independent Bank Corporation does not
undertake to update forward-looking statements to reflect facts, circumstances,
assumptions or events that occur after the date the forward-looking statements
are made. For any forward-looking statements made in this document, Independent
Bank Corporation claims the protection of the safe harbor for forward-looking
statements contained in the Private Securities Litigation Reform Act of 1995.
Part I
Item 1.
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Financial Condition
September 30, December 31,
2004 2003
----------------------------
(unaudited)
----------------------------
(in thousands)
Assets
Cash and due from banks $ 77,578 $ 61,741
Securities available for sale 491,790 453,996
Federal Home Loan Bank stock, at cost 17,139 13,895
Loans held for sale 37,869 32,642
Loans
Commercial 897,884 603,558
Real estate mortgage 797,474 681,602
Installment 270,471 234,562
Finance receivables 225,322 147,671
----------- -----------
Total Loans 2,191,151 1,667,393
Allowance for loan losses (25,541) (16,836)
----------- -----------
Net Loans 2,165,610 1,650,557
Property and equipment, net 55,035 43,979
Bank owned life insurance 37,969 36,850
Goodwill 44,922 16,696
Other intangibles 14,259 7,523
Accrued income and other assets 47,508 43,135
----------- -----------
Total Assets $ 2,989,679 $ 2,361,014
=========== ===========
Liabilities and Shareholders' Equity
Deposits
Non-interest bearing $ 278,264 $ 192,733
Savings and NOW 867,385 700,541
Time 1,067,302 809,532
----------- -----------
Total Deposits 2,212,951 1,702,806
Federal funds purchased 85,855 53,885
Other borrowings 321,219 331,819
Subordinated debentures 64,197 52,165
Financed premiums payable 40,625 26,340
Accrued expenses and other liabilities 42,518 31,783
----------- -----------
Total Liabilities 2,767,365 2,198,798
----------- -----------
Shareholders' Equity
Preferred stock, no par value -- 200,000 shares authorized; none
outstanding
Common stock, $1.00 par value -- 30,000,000 shares authorized;
issued and outstanding: 21,112,651 shares at September 30, 2004
and 19,521,137 shares at December 31, 2003 21,113 19,521
Capital surplus 157,454 119,401
Retained earnings 34,573 16,953
Accumulated other comprehensive income 9,174 6,341
----------- -----------
Total Shareholders' Equity 222,314 162,216
----------- -----------
Total Liabilities and Shareholders' Equity $ 2,989,679 $ 2,361,014
=========== ===========
See notes to interim consolidated financial statements
2
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
------- -------- -------- ---------
(unaudited) (unaudited)
------------------ --------------------
(in thousands, except per share amounts)
Interest Income
Interest and fees on loans $37,531 $ 30,945 $ 99,978 $ 88,050
Securities available for sale
Taxable 3,275 2,727 9,366 8,575
Tax-exempt 2,460 2,134 6,935 5,982
Other investments 203 165 537 442
------- -------- -------- ---------
Total Interest Income 43,469 35,971 116,816 103,049
------- -------- -------- ---------
Interest Expense
Deposits 7,855 6,769 20,075 21,370
Other borrowings 4,158 3,943 12,162 12,146
------- -------- -------- ---------
Total Interest Expense 12,013 10,712 32,237 33,516
------- -------- -------- ---------
Net Interest Income 31,456 25,259 84,579 69,533
Provision for credit losses 2,456 569 3,966 2,279
------- -------- -------- ---------
Net Interest Income After Provision for Loan Losses 29,000 24,690 80,613 67,254
------- -------- -------- ---------
Non-interest Income
Service charges on deposit accounts 4,620 3,855 12,519 10,803
Net gains (losses) on asset sales
Real estate mortgage loans 1,381 5,652 4,603 14,001
Securities 1,561 (1,314) 2,056 (755)
Title insurance fees 496 983 1,579 2,633
Manufactured home loan origination fees 314 535 923 1,282
Real estate mortgage loan servicing 77 201 1,158 (1,196)
Other income 2,385 1,902 6,701 5,872
------- -------- -------- ---------
Total Non-interest Income 10,834 11,814 29,539 32,640
------- -------- -------- ---------
Non-interest Expense
Compensation and employee benefits 12,603 11,241 35,556 31,677
Occupancy, net 1,981 1,611 5,618 4,835
Furniture and fixtures 1,608 1,381 4,473 4,125
Other expenses 9,329 8,061 26,759 20,359
------- -------- -------- ---------
Total Non-interest Expense 25,521 22,294 72,406 60,996
------- -------- -------- ---------
Income Before Income Tax Expense 14,313 14,210 37,746 38,898
Income tax expense 3,995 3,890 10,002 10,630
------- -------- -------- ---------
Net Income $10,318 $ 10,320 $ 27,744 $ 28,268
======= ======== ======== =========
Net Income Per Share
Basic $ .49 $ .53 $ 1.37 $ 1.44
Diluted .48 .51 1.34 1.41
Dividends Per Common Share
Declared $ .17 $ .16 $ .49 $ .43
Paid .16 .16 .48 .43
See notes to interim consolidated financial statements
3
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Nine months ended
September 30,
2004 2003
--------- ---------
(unaudited)
----------------------
(in thousands)
Net Income $ 27,744 $ 28,268
--------- ---------
Adjustments to Reconcile Net Income
to Net Cash from Operating Activities
Proceeds from sales of loans held for sale 291,809 785,755
Disbursements for loans held for sale (292,433) (711,957)
Provision for credit losses 3,966 2,279
Depreciation and amortization of premiums and accretion of
discounts on securities and loans 7,426 5,585
Net gains on sales of real estate mortgage loans (4,603) (14,001)
Net (gains) losses on sales of securities (2,056) 755
Write-off of uncompleted software 977
Amortization of deferred loan fees (538) (566)
Increase in financed premiums payable 14,285 1,778
Increase in accrued income and other assets (1,162) (2,961)
Increase (decrease) in accrued expenses and other liabilities 9,337 (1,721)
--------- ---------
27,008 64,946
--------- ---------
Net Cash from Operating Activities 54,752 93,214
--------- ---------
Cash Flow used in Investing Activities
Proceeds from the sale of securities available for sale 46,025 13,247
Proceeds from the maturity of securities available for sale 14,102 18,123
Principal payments received on securities available for sale 37,009 82,777
Purchases of securities available for sale (87,084) (186,684)
Principal payments on portfolio loans purchased 2,244 6,079
Portfolio loans originated, net of principal payments (221,676) (141,051)
Purchase of common securities (3,036)
Acquisition of businesses, less cash received 12,905
Capital expenditures (8,510) (5,158)
--------- ---------
Net Cash used in Investing Activities (204,985) (215,703)
--------- ---------
Cash Flow from Financing Activities
Net increase in deposits 186,934 103,755
Net increase (decrease) in short-term borrowings 40,927 (15,669)
Proceeds from Federal Home Loan Bank advances 347,100 525,250
Payments of Federal Home Loan Bank advances (401,010) (510,077)
Dividends paid (9,098) (7,915)
Proceeds from issuance of subordinated debentures 48,712
Redemption of subordinated debentures (17,250)
Proceeds from issuance of common stock 3,219 2,089
Repurchase of common stock (2,002) (12,504)
--------- ---------
Net Cash from Financing Activities 166,070 116,391
--------- ---------
Net Increase (Decrease) in Cash and Cash Equivalents 15,837 (6,098)
Cash and Cash Equivalents at Beginning of Period 61,741 60,731
--------- ---------
Cash and Cash Equivalents at End of Period $ 77,578 $ 54,633
========= =========
Cash paid during the period for
Interest $ 31,282 $ 34,219
Income taxes 2,399 8,518
Transfer of loans to other real estate 2,044 3,108
See notes to interim consolidated financial statements
4
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Nine months ended
September 30,
2004 2003
--------- ---------
(unaudited)
----------------------
(in thousands)
Balance at beginning of period $ 162,216 $ 138,047
Net income 27,744 28,268
Cash dividends declared (10,124) (8,228)
Issuance of common stock 41,647 7,835
Repurchase of common stock (2,002) (12,504)
Net change in accumulated other comprehensive
income, net of related tax effect (note 4) 2,833 1,231
--------- ---------
Balance at end of period $ 222,314 $ 154,649
========= =========
See notes to interim consolidated financial statements.
5
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. In our opinion, the accompanying unaudited consolidated financial statements
contain all the adjustments necessary to present fairly our consolidated
financial condition as of September 30, 2004 and December 31, 2003, and the
results of operations for the three and nine-month periods ended September 30,
2004 and 2003. Certain reclassifications have been made in the prior year
financial statements to conform to the current year presentation. Our critical
accounting policies include accounting for the allowance for loan losses, the
valuation of derivative financial instruments, the valuation of originated
mortgage servicing rights, the valuation of deferred tax assets and the
valuation of goodwill. Refer to our 2003 Annual Report on Form 10-K for a
disclosure of our accounting policies.
2. Our assessment of the allowance for loan losses is based on an evaluation of
the loan portfolio, recent loss experience, current economic conditions and
other pertinent factors. Loans on non-accrual status, past due more than 90
days, or restructured amounted to $16.1 million at September 30, 2004, and $12.7
million at December 31, 2003. (See Management's Discussion and Analysis of
Financial Condition and Results of Operations).
3. The provision for income taxes represents federal and state income tax
expense calculated using annualized rates on taxable income generated during the
respective periods.
4. Comprehensive income for the three- and nine-month periods ended September 30
follows:
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
-------- -------- ------- --------
(in thousands)
Net income $ 10,318 $ 10,320 $27,744 $ 28,268
Net change in unrealized gain on securities
available for sale, net of related tax effect 6,868 (4,378) 878 (385)
Net change in unrealized gain/loss on derivative
instruments, net of related tax effect (956) 2,049 1,955 1,616
-------- -------- ------- --------
Comprehensive income $ 16,230 $ 7,991 $30,577 $ 29,499
======== ======== ======= ========
The net change in unrealized gain on securities available for sale reflect net
gains and losses reclassified into earnings as follows:
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------ ------- ------ -----
(in thousands)
Gain (loss) reclassified into earnings $1,561 $(1,314) $2,056 $(755)
Federal income tax expense as a
result of the reclassification of these
amounts from comprehensive income 547 (460) 720 (264)
5. Our reportable segments are based upon legal entities. We have five
reportable segments: Independent Bank ("IB"), Independent Bank West Michigan
("IBWM"), Independent Bank South Michigan ("IBSM"), Independent Bank East
Michigan ("IBEM") and Mepco Insurance Premium Financing, Inc. ("Mepco"). We
evaluate performance based principally on net income of the respective
reportable segments.
6
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
A summary of selected financial information for our reportable segments for the
three-month and nine-month periods ended September 30, follows:
As of or for the three months ended September 30,
IB IBWM IBSM IBEM Mepco Other(1) Elimination Total
------------ ---------- ---------- --------- ---------- ---------- ----------- -----------
(in thousands)
2004
Total assets $ 1,170,262 $ 491,898 $ 406,970 $ 666,284 $ 245,734 $ 306,586 $ 298,055 $ 2,989,679
Interest income 16,674 7,186 5,272 8,853 5,514 17 47 43,469
Net interest income 11,880 5,663 3,677 7,044 4,585 (1,393) 31,456
Provision for credit losses 1,122 114 90 1,088 42 2,456
Income (loss) before
income tax 5,955 3,737 2,338 2,323 2,419 (2,310) 149 14,313
Net income (loss) 4,398 2,653 1,730 1,777 1,473 (1,564) 149 10,318
2003
Total assets $ 1,009,718 $ 468,382 $ 338,096 $ 354,268 $ 140,693 $ 214,264 $ 209,659 $ 2,315,762
Interest income 15,050 7,417 4,560 5,007 3,956 1 20 35,971
Net interest income 10,457 5,536 3,097 3,563 3,602 (996) 25,259
Provision for credit losses 224 219 192 (136) 70 569
Income (loss) before
income tax 6,098 4,610 1,774 1,896 1,193 (1,037) 324 14,210
Net income (loss) 4,499 3,213 1,348 1,492 725 (633) 324 10,320
As of or for the nine months ended September 30,
IB IBWM IBSM IBEM Mepco Other(1) Elimination Total
------------ ---------- ---------- --------- ---------- ---------- ----------- -----------
(in thousands)
2004
Total assets $ 1,170,262 $ 491,898 $ 406,970 $ 666,284 $ 245,734 $ 306,586 $ 298,055 $ 2,989,679
Interest income 46,278 21,013 15,050 19,803 14,686 42 56 116,816
Net interest income 32,903 16,698 10,512 15,408 12,613 (3,555) 84,579
Provision for credit losses 1,834 326 336 1,288 182 3,966
Income (loss) before
income tax 17,588 11,407 6,328 5,366 2,467 (4,907) 503 37,746
Net income (loss) 13,052 8,087 4,687 4,238 1,472 (3,289) 503 27,744
2003
Total assets $ 1,009,718 $ 468,382 $ 338,096 $ 354,268 $ 140,693 $ 214,264 $ 209,659 $ 2,315,762
Interest income 45,696 21,431 13,722 14,997 7,246 22 65 103,049
Net interest income 30,207 15,734 9,177 10,589 6,622 (2,796) 69,533
Provision for credit losses 934 864 (148) 514 115 2,279
Income (loss) before
income tax 18,112 11,622 5,891 4,717 2,339 (2,944) 839 38,898
Net income (loss) 13,321 8,125 4,360 3,885 1,423 (2,007) 839 28,268
(1) Includes items relating to the Registrant and certain insignificant
operations.
7
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
6. A reconciliation of basic and diluted earnings per share for the three-month
and the nine-month periods ended September 30 follows:
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------- ------- ------- -------
(in thousands, except per share amounts)
Net income $10,318 $10,320 $27,744 $28,268
======= ======= ======= =======
Average shares outstanding (Basic) 21,089 19,548 20,230 19,621
Effect of dilutive securities:
Stock options 381 469 392 405
Stock units for deferred compensation plan for
Non-employee directors 45 46 47 46
------- ------- ------- -------
Average shares outstanding (Diluted) 21,515 20,063 20,669 20,072
======= ======= ======= =======
Net income per share
Basic $ .49 $ .53 $ 1.37 $ 1.44
Diluted .48 .51 1.34 1.41
7. Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities," ("SFAS #133") which was
subsequently amended by SFAS #138, requires companies to record derivatives on
the balance sheet as assets and liabilities measured at their fair value. The
accounting for increases and decreases in the value of derivatives depends upon
the use of derivatives and whether the derivatives qualify for hedge accounting.
Our derivative financial instruments according to the type of hedge in which
they are designated under SFAS #133 follows:
September 30, 2004
Average
Notional Maturity Fair
Amount (years) Value
-------- -------- -----
(dollars in thousands)
Fair Value Hedge - pay variable interest-rate swap agreements $173,159 3.2 $ 4
======== === ========
Cash Flow Hedge - pay fixed interest-rate swap agreements $387,000 1.4 $ (1,172)
======== === ========
No hedge designation
Pay fixed interest-rate swap agreements $ 15,000 1.1 $ 34
Pay variable interest-rate swap agreements 35,000 0.3 (51)
Rate-lock real estate mortgage loan commitments 26,000 0.1 155
Mandatory commitments to sell real estate mortgage loans 64,000 0.1 23
-------- --- --------
Total $140,000 0.3 $ 161
======== === ========
We have established management objectives and strategies that include
interest-rate risk parameters for maximum fluctuations in net interest income
and market value of portfolio equity. We monitor our interest rate risk position
via simulation modeling reports (See "Asset/liability management"). The goal of
our asset/liability management efforts is to maintain profitable financial
leverage within established risk parameters.
8
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
We use variable rate and short-term fixed-rate (less than 12 months) debt
obligations to fund a portion of our balance sheet, which exposes us to
variability in interest rates. To meet our objectives, we may periodically enter
into derivative financial instruments to mitigate exposure to fluctuations in
cash flows resulting from changes in interest rates ("Cash Flow Hedges"). Cash
Flow Hedges currently include certain pay-fixed interest-rate swaps.
Pay-fixed interest-rate swaps convert the variable-rate cash flows on debt
obligations to fixed-rates. Under interest-rate collars, we will receive cash if
interest rates rise above a predetermined level while we will make cash payments
if interest rates fall below a predetermined level. As a result, we effectively
have variable rate debt with an established maximum and minimum rate.
We record the fair value of Cash Flow Hedges in accrued expenses and other
liabilities. On an ongoing basis, we adjust our balance sheet to reflect the
then current fair value of Cash Flow Hedges. The related gains or losses are
reported in other comprehensive income and are subsequently reclassified into
earnings, as a yield adjustment in the same period in which the related interest
on the hedged items (primarily variable-rate debt obligations) affect earnings.
It is anticipated that approximately $1.1 million, net of tax, of unrealized
losses on Cash Flow Hedges at September 30, 2004 will be reclassified to
earnings over the next twelve months. To the extent that the Cash Flow Hedges
are not effective, the ineffective portion of the Cash Flow Hedges are
immediately recognized as interest expense. The maximum term of any Cash Flow
Hedge at September 30, 2004 is 4.8 years.
We also use long-term, fixed-rate brokered CDs to fund a portion of our balance
sheet. These instruments expose us to variability in fair value due to changes
in interest rates. To meet our objectives, we may enter into derivative
financial instruments to mitigate exposure to fluctuations in fair values of
such fixed-rate debt instruments ("Fair Value Hedges"). Fair Value Hedges
currently include pay-variable interest rate swaps.
Also, we record Fair Value Hedges at fair value in accrued expenses and other
liabilities. The hedged items (primarily fixed-rate debt obligations) are also
recorded at fair value through the statement of operations, which offsets the
adjustment to Fair Value Hedges. On an ongoing basis, we will adjust our balance
sheet to reflect the then current fair value of both the Fair Value Hedges and
the respective hedged items. To the extent that the change in value of the Fair
Value Hedges do not offset the change in the value of the hedged items, the
ineffective portion is immediately recognized as interest expense.
Certain derivative financial instruments are not designated as hedges. The fair
value of these derivative financial instruments have been recorded on our
balance sheet and are adjusted on an ongoing basis to reflect their then current
fair value. The changes in the fair value of derivative financial instruments
not designated as hedges, are recognized currently as interest expense.
In the ordinary course of business, we enter into rate-lock real estate mortgage
loan commitments with customers ("Rate Lock Commitments"). These commitments
expose us to interest rate risk. We also enter into mandatory commitments to
sell real estate mortgage loans ("Mandatory Commitments") to hedge price
fluctuations of mortgage loans held for sale and Rate Lock Commitments.
Mandatory Commitments help protect our loan sale profit margin from fluctuations
in interest rates. The changes in the fair value of Rate Lock Commitments and
Mandatory Commitments are recognized currently as part of gains on the sale of
real estate mortgage loans. We utilize an outside third party to assist us in
our valuation of Mandatory Commitments and Rate Lock Commitments. Interest
expense and net gains on the sale of real estate mortgage loans, as well as net
income may be more volatile as a result of derivative instruments, which are not
designated as hedges.
9
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The impact of SFAS #133 on net income and other comprehensive income for the
three-month and nine-month periods ended September 30, 2004 and 2003 is as
follows:
Other
Comprehensive
Net Income Income Total
---------- ------------- -------
(in thousands)
Change in fair value during the three-
month period ended September 30, 2004
Interest-rate swap agreements
not designated as hedges $ (20) $ (20)
Rate Lock Commitments (217) (217)
Mandatory Commitments 438 438
Ineffectiveness of cash flow hedges 11 11
Cash flow hedges $(2,757) (2,757)
Reclassification adjustment 1,287 1,287
----- ------- -------
Total 212 (1,470) (1,258)
Income tax 74 (514) (440)
----- ------- -------
Net $ 138 $ (956) $ (818)
===== ======= =======
Other
Comprehensive
Net Income Income Total
---------- ------------- -------
(in thousands)
Change in fair value during the nine-
month period ended September 30, 2004
Interest-rate swap agreements
not designated as hedges $ 66 $ 66
Rate Lock Commitments (39) (39)
Mandatory Commitments 163 163
Ineffectiveness of cash flow hedges 13 13
Cash flow hedges $(1,011) (1,011)
Reclassification adjustment 4,019 4,019
----- ------- -------
Total 203 3,008 3,211
Income tax 71 1,053 1,124
----- ------- -------
Net $ 132 $ 1,955 $ 2,087
===== ======= =======
10
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Other
Comprehensive
Net Income Income Total
---------- ------------- -------
(in thousands)
Change in fair value during the three-
month period ended September 30, 2003
Interest-rate swap agreements
not designated as hedges $ (1) $ (1)
Rate Lock Commitments (341) (341)
Mandatory Commitments (1,052) (1,052)
Ineffectiveness of cash flow hedges 2 2
Cash flow hedges $ 1,446 1,446
Reclassification adjustment 1,711 1,711
------- ------- -------
Total (1,392) 3,157 1,765
Income tax (487) 1,108 621
------- ------- -------
Net $ (905) $ 2,049 $ 1,144
======= ======= =======
Other
Comprehensive
Net Income Income Total
---------- ------------- -------
(in thousands)
Change in fair value during the nine-
month period ended September 30, 2003
Interest-rate swap agreements
not designated as hedges $ (1) $ (1)
Rate Lock Commitments 151 151
Mandatory Commitments 446 446
Ineffectiveness of cash flow hedges (17) (17)
Cash flow hedges (28) $(2,839) (2,867)
Reclassification adjustment 5,329 5,329
------- ------- -------
Total 551 2,490 3,041
Income tax 193 874 1,067
------- ------- -------
Net $ 358 $ 1,616 $ 1,974
======= ======= =======
11
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
8. Statement of Financial Accounting Standards No. 141, "Business Combinations,"
("SFAS #141") and Statement of Financial Accounting Standards No. 142, "Goodwill
and Other Intangible Assets," ("SFAS #142") effects how organizations account
for business combinations and for the goodwill and intangible assets that arise
from those combinations or are acquired otherwise.
Intangible assets, net of amortization, were comprised of the following at
September 30, 2004 and December 31, 2003:
September 30, 2004 December 31, 2003
----------------------- ----------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Amount Amortization
-------- ------------ ------ ------------
(dollars in thousands)
Amortized intangible assets
Core deposit $20,543 $ 9,169 $13,386 $8,067
Customer relationship 2,604 1,088 2,604 589
Covenant not to compete 1,520 151 220 31
------- ------- ------- ------
Total $24,667 $10,408 $16,210 $8,687
======= ======= ======= ======
Unamortized intangible assets -
Goodwill $44,922 $16,696
======= =======
Based on our review of goodwill recorded on the Statement of Financial
Condition, no impairment existed as of September 30, 2004.
Amortization of intangibles, has been estimated through 2009 and thereafter in
the following table, and does not take into consideration any potential future
acquisitions or branch purchases.
(dollars in thousands)
Three months ended December 31, 2004 $ 756
Year ending December 31:
2005 2,774
2006 2,572
2007 2,382
2008 2,061
2009 and thereafter 3,714
----------
Total $ 14,259
==========
12
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Changes in the carrying amount of goodwill and amortizing intangibles by
reporting segment for the nine months ended September 30, 2004 were as follows:
IB IBWM IBSM IBEM Mepco Other(1) Total
---------- -------- ---------- -------- ---------- ---------- -----------
(dollars in thousands)
Goodwill
Balance, December 31, 2003 $ 6,754 $ 32 $ 180 $ 9,397 $ 333 $ 16,696
Goodwill adjustment during period 2,967(2) 23,017(3) 2,195(4) 47(3) 28,226
---------- -------- ---------- --------- ---------- ---------- -----------
Balance, September 30, 2004 $ 9,721 $ 32 $ 23,197 $ 11,592 $ 380 $ 44,922
========== ======== ========== ========= ========== ========== ===========
Core Deposit Intangible, net
Balance, December 31, 2003 $ 584 $ 95 $ 594 $ 3,973 $ 73 $ 5,319
Acquired during year 2,240(2) 4,919(3) 7,159
Amortization (160) (19) (107) (806) (12) (1,104)
---------- -------- ---------- --------- ---------- ---------- -----------
Balance, September 30, 2004 $ 2,664 $ 76 $ 487 $ 8,086 $ 61 $ 11,374
========== ======== ========== ========= ========== ========== ===========
Customer Relationship Intangible, net
Balance, December 31, 2003 $ 2,015 $ 2,015
Amortization (499) (499)
---------- -------- ---------- --------- ---------- ---------- -----------
Balance, September 30, 2004 $ 1,516 $ 1,516
========== ======== ========== ========= ========== ========== ===========
Covenant not to compete, net
Balance, December 31, 2003 $ 189 $ 189
Acquired during year $ 1,300(3) 1,300
Amortization (87) (33) (120)
---------- -------- ---------- --------- ---------- ---------- -----------
Balance, September 30, 2004 $ 1,213 $ 156 $ 1,369
========== ======== ========== ========= ========== ========== ===========
(1) Includes items relating to the Registrant and certain insignificant
operations.
(2) Goodwill and intangible assets associated with the acquisition of North.
See footnote #10.
(3) Goodwill and intangible assets associated with the acquisition of Midwest.
See footnote #10.
(4) Goodwill associated with contingent consideration paid pursuant to a five
year earnout.
13
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
9. We maintain stock option plans for our non-employee directors as well as
certain of our officers and those of our Banks and their subsidiaries. Options
that were granted under these plans are exercisable not earlier than six months
after the date of grant, at a price equal to the fair market value of the common
stock on the date of grant, and expire not more than ten years after the date of
grant.
The per share weighted-average fair value of stock options was obtained using
the Black-Scholes options pricing model. The following table summarizes the
assumptions used and values obtained:
Three months ended Nine months ended
September 30, September 30,
2004(1) 2003 2004 2003
--------- --------- --------- ---------
Expected dividend yield 2.13% 2.37% 2.61%
Risk-free interest rate 4.05 4.26 4.01
Expected life (in years) 8.64 9.65 9.80
Expected volatility 32.84% 32.54% 33.27%
Per share weighted-average fair value $ 9.41 $10.57 $ 7.04
(1) No stock options were granted during the quarter ended September 30, 2004.
The following table summarizes the impact on our net income had compensation
cost included the fair value of options at the grant date:
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
--------- --------- --------- ---------
(in thousands except per share amounts)
Net income - as reported $ 10,318 $ 10,320 $ 27,744 $ 28,268
Stock based compensation expense determined under
fair value based method, net of related tax effect (610) (283) (1,738) (988)
--------- --------- --------- ---------
Pro-forma net income $ 9,708 $ 10,037 $ 26,006 $ 27,280
========= ========= ========= =========
Income per share
Basic
As reported $ .49 $ .53 $ 1.37 $ 1.44
Pro-forma .46 .51 1.29 1.39
Diluted
As reported $ .48 $ .51 $ 1.34 $ 1.41
Pro-forma .45 .50 1.26 1.36
10. On May 31, 2004, we completed our acquisition of Midwest Guaranty Bancorp
("Midwest"), Inc. with the purpose of expanding our presence in southeastern
Michigan. Midwest was a closely held bank holding company primarily doing
business as a commercial bank. As a result of the closing of this transaction,
we issued 997,700 shares of common stock and paid $16.6 million in cash to the
Midwest shareholders. 2004 results include Midwest's operations subsequent to
May 31, 2004. At the time of acquisition, Midwest had total assets of $238.0
million, total loans of $205.0 million, total deposits of $198.9 million and
total stockholders' equity of $18.7 million. We recorded purchase accounting
adjustments related to the Midwest acquisition including recording goodwill of
$23.1 million, establishing a core deposit intangible of $4.9 million, and a
covenant not to compete of $1.3 million. The core deposit intangible is being
amortized on an accelerated basis over ten years and the covenant not to compete
on a straight-line basis over five years. Included in the third quarter of 2004
was $0.2 million for amortization of the core deposit intangible and the
covenant not to compete.
14
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The following is a condensed balance sheet of Midwest at our date of acquisition
adjusted for updated information related to the fair value of assets acquired
and liabilities assumed:
(in thousands)
Cash $ 8,390
Securities 19,557
Loans, net 201,476
Property and equipment 5,674
Intangible assets 6,219
Goodwill 23,066
Other assets 1,832
--------
Total assets acquired 266,214
--------
Deposits 199,123
Short-term borrowings 12,314
Other liabilities 10,663
--------
Total liabilities assumed 222,100
--------
Net assets acquired $ 44,114
========
On July 1, 2004, we completed our acquisition of North Bancorp, Inc. ("North"),
with the purpose of expanding our presence in northern Michigan. North was a
publicly held bank holding company primarily doing business as a commercial
bank. As a result of the closing of this transaction, we issued 345,391 shares
of common stock to the North shareholders. 2004 includes the results of North's
operations beginning on July 1, 2004. At the time of acquisition, North had
total assets of $155.1 million, total loans of $103.6 million, total deposits of
$123.8 million and total stockholders' equity of $3.3 million. We recorded
purchase accounting adjustments related to the North acquisition including
recording goodwill of $3.0 million and establishing a core deposit intangible of
$2.2 million. The core deposit intangible is being amortized on an accelerated
basis over eight years. Included in the third quarter of 2004 was $0.1 million
for amortization of the core deposit intangible.
The following is a condensed balance sheet of North at our date of acquisition
adjusted for updated information related to the fair value of assets acquired
and liabilities assumed:
(in thousands)
Cash and equivalents $ 21,505
Securities 26,418
Loans, net 97,573
Property and equipment 2,318
Intangible assets 2,240
Goodwill 2,967
Other assets 9,308
--------
Total assets acquired 162,329
--------
Deposits 124,088
Short-term borrowings 22,039
Other liabilities 7,429
--------
Total liabilities assumed 153,556
--------
Net assets acquired $ 8,773
========
15
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
11. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities," ("FIN #46") which addresses consolidation by
business enterprises of variable interest entities. This Interpretation applies
immediately to variable interest entities created after January 31, 2003 and to
variable interest entities in which an enterprise obtains an interest after that
date. For enterprises with variable interest entities created before February 1,
2003, this Interpretation applies no later than the beginning of the first
interim or annual reporting period ending after December 15, 2003. However,
certain disclosure requirements were effective for all financial statements
issued after January 31, 2003. The adoption of this Interpretation did not have
a material impact on our financial condition or results of operations.
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003),
"Consolidation of Variable Interest Entities," ("FIN 46R"), which addresses how
a business enterprise should evaluate whether it has a controlling financial
interest in an entity through means other than voting rights and accordingly
should consolidate the entity. FIN 46R replaces FIN 46 discussed in the previous
paragraph. Under the general transition provisions of FIN 46R all public
entities are required to fully implement FIN 46R no later than the end of the
first reporting period ending after March 15, 2004. The adoption of FIN 46R
during the quarter ended March 31, 2004 did not have a material impact on our
financial condition or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standards No.
149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," ("SFAS #149") which amends SFAS #133 to clarify the definition of a
derivative and expand the nature of exemptions from SFAS #133. SFAS #149 also
clarifies the application of hedge accounting when using certain instruments and
the application of SFAS #133 to embedded derivative instruments. SFAS #149 also
modifies the cash flow presentation of derivative instruments that contain
financing elements. This Statement is effective for contracts entered into or
modified after June 30, 2003, with early adoption encouraged. Adoption of this
Statement did not have a material impact on our financial condition or results
of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No.
150, "Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity," ("SFAS #150") which requires issuers of financial
instruments to classify as liabilities certain freestanding financial
instruments that embody obligations for the issuer. SFAS #150 was effective for
all freestanding financial instruments entered into or modified after May 31,
2003 and was otherwise effective at the beginning of the first interim period
beginning after June 15, 2003. On October 29, 2003, the FASB voted to defer for
an indefinite period the application of the guidance in SFAS #150, to
non-controlling interests that are classified as equity in the financial
statements of a subsidiary but would be classified as a liability on the
parent's financial statements. The adoption of the sections of this Statement
that have not been deferred did not have a significant impact on our financial
condition or results of operations. The section noted above that has been
deferred indefinitely is not expected to have a material impact on our financial
condition or results of operations.
In March 2004, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin No. 105, "Application of Accounting Principles to Loan
Commitments," ("SAB #105") which provides guidance about the measurement of loan
commitments required to be accounted for as derivative instruments and
recognized at fair value under SFAS #133. SAB #105 also requires companies to
disclose their accounting policy for those loan commitments including methods
and assumptions used to estimate fair value and associated hedging strategies.
SAB #105 is effective for all loan commitments accounted for as derivatives that
are entered into after March 31, 2004. Our current policies are consistent with
the guidance issued in SAB #105.
16
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
In December 2003, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 03-03, "Accounting for Certain
Loans or Debt Securities Acquired in a Transfer". This SOP addresses accounting
for differences between contractual cash flows and cash flows expected to be
collected from an investor's initial investment in loans or debt securities
(loans) acquired in a transfer if those differences are attributable, at least
in part, to credit quality. It includes loans acquired in purchase business
combinations. This SOP does not apply to loans originated by us and is effective
for loans acquired in fiscal years beginning after December 15, 2004. This SOP
is not expected to have a material impact on our financial condition or results
of operations.
In 2003, the Emerging Issues Task Force ("EITF") issued Issue No. 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." The recognition and measurement guidance in EITF 03-1 should be
applied in other-than-temporary impairment evaluations performed in reporting
periods beginning after June 15, 2004. Disclosures were effective in annual
financial statements for fiscal years ending after December 15, 2003, for
investments accounted for under FASB Statement of Financial Accounting Standards
No. 115, "Accounting in Certain Investments in Debt and Equity Securities, and
No. 124, Accounting for Certain Investments Held by Not-for-Profit
Organizations". The disclosure requirements for all other investments are
effective in annual financial statements for fiscal years ending after June 15,
2004. Comparative information for periods prior to initial application is not
required. On September 15, 2004, the FASB staff proposed two FASB Staff
Positions ("FSP"). The first, proposed FSP EITF Issue 03-1-a, "Implementation
Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, `The
Meaning of Other-Than-Temporary Impairment and its Application to Certain
Investments,'" would provide guidance for the application of paragraph 16 of
EITF 03-1 to debt securities that are impaired because of interest rate and/or
sector spread increases. The second, proposed FSP EITF Issue 03-1-b, "Effective
Date of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments,'"
would delay the effective date of EITF 03-1 for debt securities that are
impaired because of interest rate and/or sector spread increases. Other
investments within the scope of EITF 03-1 remain subject to its recognition and
measurement provisions for interim and annual periods beginning after June 15,
2004. The disclosure provisions of EITF 03-1 also would not be affected by the
two proposed FSPs.
12. The results of operations for the three- and nine-month periods ended
September 30, 2004, are not necessarily indicative of the results to be expected
for the full year.
17
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following section presents additional information that may be necessary to
assess our financial condition and results of operations. This section should be
read in conjunction with our consolidated financial statements contained
elsewhere in this report as well as our 2003 Annual Report on Form 10-K.
FINANCIAL CONDITION
SUMMARY Our total assets increased $628.7 million during the first nine months
of 2004 due primarily to our acquisitions of Midwest Guaranty Bancorp, Inc.
("Midwest") and North Bancorp, Inc. ("North") (See note #10 to interim
consolidated financial statements) as well as loan growth. Loans, excluding
loans held for sale ("Portfolio Loans"), totaled $2.191 billion at September 30,
2004, an increase of $523.8 million from December 31, 2003. This was primarily
due to the Midwest and North acquisitions, which added approximately $308.6
million of loans at the time of acquisition, as well as growth in commercial
loans, real estate mortgage loans and finance receivables. (See "Portfolio loans
and asset quality.")
Deposits totaled $2.213 billion at September 30, 2004, compared to $1.703
billion at December 31, 2003. The $510.1 million increase in total deposits
during the first nine months of 2004 principally reflects the Midwest and North
acquisitions (which added $322.7 million in total deposits at the dates of
acquisition), as well as increases in demand deposits, savings and NOW accounts
and an increase in brokered certificates of deposit ("Brokered CDs"). Other
borrowings totaled $321.2 million at September 30, 2004, a decrease of $10.6
million from December 31, 2003 due primarily to a reduction in Federal Home Loan
Bank ("FHLB") advances that were generally replaced with Brokered CD's.
SECURITIES We maintain diversified securities portfolios, which include
obligations of the U.S. Treasury and government-sponsored agencies as well as
securities issued by states and political subdivisions, corporate securities,
mortgage-backed securities and asset-backed securities. We also invest in
capital securities, which include preferred stocks and trust preferred
securities. We regularly evaluate asset/liability management needs and attempt
to maintain a portfolio structure that provides sufficient liquidity and cash
flow. We believe that the unrealized losses on securities available for sale are
temporary in nature and due primarily to changes in interest rates and not as a
result of credit related issues, except for one mobile home loan asset-backed
security on which we did record an impairment charge during the third quarter of
2004 as described in greater detail below. We also believe that we have the
ability to hold securities with unrealized losses to maturity or until such time
as the unrealized losses reverse. (See "Asset/liability management.")
18
SECURITIES
Unrealized
------------------
Amortized Fair
Cost Gains Losses Value
--------- ------- ------ --------
(in thousands)
Securities available for sale
September 30, 2004 $476,503 $18,029 $2,742 $491,790
December 31, 2003 440,060 15,681 1,745 453,996
The increase in securities available for sale during the first nine months of
2004 is due primarily to the Midwest and North acquisitions as well as purchases
of new investment securities done primarily to increase our level of average
interest earning assets and our net interest income.
At September 30, 2004 and December 31, 2003 we had $25.0 million and $33.1
million, respectively, of asset-backed securities included in securities
available for sale. Approximately 83% of our asset-backed securities at
September 30, 2004 are backed by mobile home loans (compared to 86% at December
31, 2003). All of our asset-backed securities are rated as investment grade (by
the major rating agencies) except for one mobile home loan asset-backed security
with a balance of $2.8 million at September 30, 2004. During the third quarter
of 2004 we recorded an impairment charge of $0.1 million on this security due
primarily to some further credit related deterioration on the underlying mobile
home loan collateral. We continue to closely monitor this particular security as
well as our entire mobile home loan asset-backed securities portfolio. Based
upon that review we do not foresee, at the present time, any risk of loss
(related to credit issues) with respect to any of our other asset-backed
securities. Currently the Financial Accounting Standards Board is considering
certain changes or clarifications related to the assessment of other than
temporary impairment on investment securities as well as other related
accounting matters (See Footnote #11).
Sales of securities available for sale were as follows (See "Non-interest
income."):
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------- ------- ------- --------
(in thousands)
Proceeds $30,948 $ 9,914 $46,025 $ 13,247
======= ======= ======= ========
Gross gains $ 1,696 $ 221 $ 2,318 $ 780
Gross losses 135 (1,535) 262 (1,535)
------- ------- ------- --------
Net Gains (Losses) $ 1,561 $(1,314) $ 2,056 $ (755)
======= ======= ======= ========
PORTFOLIO LOANS AND ASSET QUALITY We believe that our decentralized loan
origination structure provides important advantages in serving the credit needs
of our principal lending markets. In addition to the communities served by our
bank branch networks, principal lending markets include nearby communities and
metropolitan areas. Subject to established underwriting criteria, we also
participate in commercial lending transactions with certain non-affiliated banks
and may also purchase real estate mortgage loans (including home equity loans)
from third-party originators.
19
Our April 2003 acquisition of Mepco Insurance Premium Financing, Inc. ("Mepco")
added the financing of insurance premiums and extended automobile warranties to
our lending activities. These are new lines of business for us and expose us to
new risks. Mepco conducts its lending activities across the United States. Mepco
generally does not evaluate the creditworthiness of the individual borrower but
instead primarily relies on the loan collateral (the unearned insurance premium
or automobile warranty contract) in the event of default. As a result, we have
established and monitor insurance carrier concentration limits in order to
manage our collateral exposure. The insurance carrier concentration limits are
primarily based on the insurance company's AM Best rating and statutory surplus
level. Mepco also has established procedures for loan servicing and collections,
including the timely cancellation of the insurance policy or automobile warranty
contract in order to protect our collateral position in the event of default.
Mepco also has established procedures to attempt to prevent and detect fraud
since the loan origination activities and initial borrower contact is entirely
done through unrelated third parties (primarily insurance agents and automobile
warranty administrators, direct marketers or automobile dealerships). There can
be no assurance that these risk management policies and procedures will prevent
us from the possibility of incurring significant credit or fraud related losses
in this business segment. In particular one warranty administrator that we do a
substantial amount of business with is experiencing some financial difficulties
and the level of loan delinquencies and cancellations with respect to this
particular administrator have risen significantly. The net receivables
associated with this warranty administrator are fully backed by a cash
collateral account maintained at an unrelated third party financial services
firm. We are carefully monitoring business with this particular warranty
administrator, the level of the cash collateral account and our net receivables
(loan balance) position.
Although the management and board of directors of each of our banks retain
authority and responsibility for credit decisions, we have adopted uniform
underwriting standards. Further, our loan committee structure as well as the
centralization of many commercial loan credit services functions and the loan
review process, provides requisite controls and promotes compliance with such
established underwriting standards. Such centralized functions also facilitate
compliance with consumer protection laws and regulations.
We generally retain loans that may be profitably funded within established risk
parameters. (See "Asset/liability management.") As a result, we may hold
adjustable-rate and balloon real estate mortgage loans as Portfolio Loans, while
15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure
to changes in interest rates. (See "Non-interest income.") During the first nine
months of 2004 our balance of real estate mortgage loans increased by $115.9
million (due primarily to the North acquisition and a decline in loan payoffs in
2004 because of a sharp drop in refinancing activity). Because of the relatively
low interest rate environment over the past few years, borrowers have more often
sought longer-term fixed rate mortgage loans. If borrowers continue to prefer
longer-term fixed rate mortgage loans (which we generally sell as described
above), we believe it may be difficult to appreciably grow our real estate
mortgage loan portfolio in the foreseeable future.
The $294.3 million increase in commercial loans during the nine months ended
September 30, 2004, principally reflects our acquisitions of Midwest and North,
as well as an emphasis on lending opportunities within this category of loans
and an increase in commercial lending staff. Loans secured by real estate
generally comprise the majority of new commercial loans.
20
The $225.3 million of finance receivables at September 30, 2004 are comprised
principally of loans to businesses to finance insurance premiums and loans to
individuals to finance extended automobile warranties. The finance receivables
are a result of our acquisition of Mepco. The growth in this category of loans
is primarily due to the geographic expansion of Mepco's lending activities,
particularly in the northeastern United States and the addition of sales staff
to call on insurance agencies.
Future growth of overall Portfolio Loans is dependent upon a number of
competitive and economic factors. Declines in Portfolio Loans or competition
leading to lower relative pricing on new Portfolio Loans could adversely impact
our future operating results. We continue to view loan growth consistent with
prevailing quality standards as a major short and long-term challenge.
NON-PERFORMING ASSETS
September 30, December 31,
2004 2003
------------- ------------
(dollars in thousands)
Non-accrual loans $11,542 $ 9,122
Loans 90 days or more past due and
still accruing interest 4,315 3,284
Restructured loans 239 335
------- -------
Total non-performing loans 16,096 12,741
Other real estate 3,122 3,256
------- -------
Total non-performing assets $19,218 $15,997
======= =======
As a percent of Portfolio Loans
Non-performing loans 0.73% 0.76%
Allowance for loan losses 1.17 1.01
Non-performing assets to total assets 0.64 0.68
Allowance for loan losses as a percent of
non-performing loans 159 132
The increase in the overall level of non-performing loans in the first nine
months of 2004 was primarily due to the Midwest and North acquisitions which
together added approximately $1.9 million to this balance at September 30, 2004.
The balance of the increase was primarily due to a rise in past-due real estate
mortgage loans. During the third quarter of 2004 we sold (without recourse)
approximately $11.2 million of non-performing loans and other loans of concern
acquired in the North transaction. Because of our intent and plan to dispose of
these loans, we classified them as "held for sale" and they were recorded at a
fair value equal to their sales price as part of the North purchase accounting
adjustments. As a result, no gain or loss was recorded on this sale.
We will place a loan that is 90 days or more past due on non-accrual, unless we
believe the loan is both well secured and in the process of collection. The
level of loans 90 days or more past due and still accruing interest increased by
$1.0 million between September 30, 2004 and December 31, 2003 due primarily to
the aforementioned rise in past-due real estate mortgage loans. We believe the
collection of the accrued but unpaid interest on non-performing loans
categorized as 90 days or more past due and still accruing interest is probable.
21
The ratio of net charge-offs to average loans was 0.19% on an annualized basis
in the first nine months of 2004 compared to 0.15% in the first nine months of
2003. The increase in net charge-offs is primarily due to increases in the level
of net charge-offs in both the real estate mortgage loan and consumer loan
portfolios.
Impaired loans totaled approximately $16.8 million and $13.4 million at
September 30, 2004 and 2003, respectively. At those same dates, certain impaired
loans with balances of approximately $12.6 million and $11.3 million,
respectively had specific allocations of the allowance for loan losses, which
totaled approximately $3.1 million and $1.9 million, respectively. Our average
investment in impaired loans was approximately $15.0 million and $9.3 million
for the nine-month periods ended September 30, 2004 and 2003, respectively. Cash
receipts on impaired loans on non-accrual status are generally applied to the
principal balance. Interest recognized on impaired loans during the first nine
months of 2004 was approximately $0.4 million compared to $0.3 million in the
first nine months of 2003.
ALLOWANCE FOR LOSSES ON LOANS AND UNFUNDED COMMITMENTS
Nine months ended
September 30,
2004 2003
------------------------ ----------------------
Loan Unfunded Loan Unfunded
Losses Commitments Losses Commitments
-------- ----------- ------- -----------
(in thousands)
Balance at beginning of period $ 16,836 $ 892 $15,830 $ 875
Additions (deduction)
Allowance on loans acquired 8,236 517
Provision charged to operating expense 3,078 888 2,290 (11)
Recoveries credited to allowance 923 795
Loans charged against the allowance (3,532) (2,448)
-------- ------- ------- -----
Balance at end of period $ 25,541 $ 1,780 $16,984 $ 864
======== ======= ======= =====
Net loans charged against the allowance to
average Portfolio Loans (annualized) 0.19% 0.15%
In the second quarter of 2004, we began to record the allowance for unfunded
loan commitments in "Accrued expenses and other liabilities". Previously, this
portion of the allowance was included in the allowance for loan losses and shown
as a contra-asset on the Consolidated Statements of Financial Condition. Prior
period amounts have been reclassified. The allowance for losses on unfunded
commitments is determined in a similar manner to the allowance for loan losses.
In determining the allowance and the related provision for credit losses, we
consider four principal elements: (i) specific allocations based upon probable
losses identified during the review of the loan portfolio, (ii) allocations
established for other adversely rated loans, (iii) allocations based principally
on historical loan loss experience, and (iv) additional allowances based on
subjective factors, including local and general economic business factors and
trends, portfolio concentrations and changes in the size, mix and/or the general
terms of the loan portfolios.
22
The first element reflects our estimate of probable losses based upon our
systematic review of specific loans. These estimates are based upon a number of
objective factors, such as payment history, financial condition of the borrower,
and discounted collateral exposure.
The second element reflects the application of our loan rating system. This
rating system is similar to those employed by state and federal banking
regulators. Loans that are rated below a certain predetermined classification
are assigned a loss allocation factor for each loan classification category that
is based upon a historical analysis of losses incurred. The lower the rating
assigned to a loan or category, the greater the allocation percentage that is
applied.
The third element is determined by assigning allocations based principally upon
the ten-year average of loss experience for each type of loan. Average losses
may be further adjusted based on the current delinquency rate. Loss analyses are
conducted at least annually.
The fourth element is based on factors that cannot be associated with a specific
credit or loan category and reflects our attempt to ensure that the overall
allowance for loan losses appropriately reflects a margin for the imprecision
necessarily inherent in the estimates of expected credit losses. We consider a
number of subjective factors when determining the unallocated portion, including
local and general economic business factors and trends, portfolio concentrations
and changes in the size, mix and the general terms of the loan portfolios. (See
"Provision for credit losses.")
Mepco's allowance for loan losses is determined in a similar manner as discussed
above and takes into account delinquency levels, historical net charge-offs,
unsecured exposure and other subjective factors deemed relevant to their lending
activities.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
September 30, December 31,
2004 2003
------------- ------------
(in thousands)
Specific allocations $ 3,148 $ 1,362
Other adversely rated loans 9,871 6,029
Historical loss allocations 6,122 3,137
Additional allocations based on subjective factors 6,400 6,308
------- -------
$25,541 $16,836
======= =======
DEPOSITS AND BORROWINGS Our competitive position within many of the markets
served by our bank branch networks limits the ability to materially increase
deposits without adversely impacting the weighted-average cost of core deposits.
Accordingly, we compete principally on the basis of convenience and personal
service, while employing pricing tactics that are intended to enhance the value
of core deposits.
We have implemented strategies that incorporate federal funds purchased, other
borrowings and Brokered CDs to fund a portion of our increases in interest
earning assets. The use of such alternate sources of funds supplements our core
deposits and is also an integral part of our asset/liability management efforts.
23
September 30, December 31,
2004 2003
------------------------------ --------------------------------
Average Average
Amount Maturity Rate Amount Maturity Rate
-------- ---------- ------ ---------- ---------- -----
(dollars in thousands)
Brokered CDs(1) $590,798 1.8 years 2.25% $416,566 2.3 years 2.43%
Fixed rate FHLB advances(1) 65,554 6.1 years 5.40 84,638 5.0 years 3.99
Variable rate FHLB advances(1) 95,000 0.4 years 1.91 104,150 0.4 years 1.30
Securities sold under agreements to
Repurchase(1) 149,347 0.1 years 1.66 140,969 0.3 years 1.22
Federal funds purchased 85,855 1 day 2.13 53,885 1 day 1.16
-------- --- ---- -------- --- ----
Total $986,554 1.5 years 2.32% $800,208 1.8 years 2.15%
======== === ==== ======== === ====
(1) Certain of these items have had their average maturity and rate altered
through the use of derivative instruments, including pay-fixed and pay-variable
interest rate swaps.
Other borrowings, principally advances from the Federal Home Loan Bank (the
"FHLB") and securities sold under agreements to repurchase ("Repurchase
Agreements"), totaled $321.2 million at September 30, 2004, compared to $331.8
million at December 31, 2003. The $10.6 million decrease in other borrowings
principally reflects the payoff of maturing FHLB advances from funds generated
through Brokered CD's which generally have had better pricing spreads during the
last few months when compared to similar term FHLB advances. (See "Liquidity and
capital resources.")
Derivative financial instruments are employed to manage our exposure to changes
in interest rates. (See "Asset/liability management".) At September 30, 2004, we
employed interest-rate swaps with an aggregate notional amount of $610.2
million. (See note #7 to interim consolidated financial statements.)
LIQUIDITY AND CAPITAL RESOURCES Our liquidity management involves the
measurement and monitoring of a variety of sources and uses of funds. Our
Consolidated Statements of Cash Flows categorize these sources and uses into
operating, investing and financing activities. We primarily focus on developing
access to a variety of borrowing sources to supplement our deposit gathering
activities and provide funds for growing our investment and loan portfolios.
At September 30, 2004 we had $643.5 million of time deposits that mature in one
year or less. Historically, a majority of these maturing time deposits are
renewed by our customers. Additionally, $1.146 billion of our deposits at
September 30, 2004 were in account types from which the customer could withdraw
the funds on demand. Changes in the balances of deposits that can be withdrawn
upon demand are usually predictable and the total balances of these accounts
have generally grown over time as a result of our marketing and promotional
activities. However, there can be no assurance that historical patterns of
renewing time deposits or overall growth in deposits will continue in the
future.
Effective management of capital resources is critical to our mission to create
value for our shareholders. The cost of capital is an important factor in
creating shareholder value and, accordingly, our capital structure includes
unsecured debt and trust preferred securities.
We also believe that a diversified portfolio of quality loans will provide
superior risk-adjusted returns. Accordingly, we have implemented balance sheet
management strategies that combine
24
efforts to originate Portfolio Loans with disciplined funding strategies.
Acquisitions have also been an integral component of our capital management
strategies. (See "Acquisitions.")
In March 2003 a special purpose entity, IBC Capital Finance II (the "trust")
issued $1.6 million of common securities to Independent Bank Corporation and
$50.6 million of trust preferred securities to the public. Independent Bank
Corporation issued $52.2 million of subordinated debentures to the trust in
exchange for the proceeds from the public offering. These subordinated
debentures represent the sole asset of the trust.
Prior to 2004 the trust was consolidated in our financial statements and the
common securities and subordinated debentures were eliminated in consolidation.
Under new accounting guidance, FASB Interpretation No. 46, as revised in
December 2003 ("FIN 46R"), the trust is no longer consolidated with Independent
Bank Corporation. Accordingly, we no longer report the $50.6 million of trust
preferred securities issued by the trust as liabilities, but instead report the
common securities of $1.6 million held by Independent Bank Corporation in other
assets and the $52.2 million of subordinated debentures issued by Independent
Bank Corporation in the liability section of our Consolidated Statements of
Financial Condition. Amounts reported at December 31, 2003 were reclassified to
conform to the current presentation. The effect of no longer consolidating the
trust had no impact on our operating results.
In connection with our acquisition of Midwest, we assumed all of the duties,
warranties and obligations of Midwest as the sponsor and sole holder of the
common securities of Midwest Guaranty Trust I ("MGT"). In 2002, MGT, a special
purpose entity, issued $232,000 of common securities to Midwest and $7.5 million
of trust preferred securities as part of a pooled offering. Midwest issued
$7,732,000 of subordinated debentures to the trust in exchange for the proceeds
of the offering, which debentures represent the sole asset of MGT. Both the
common securities and subordinated debentures are included in our Consolidated
Statement of Financial Condition at September 30, 2004.
In connection with our acquisition of North, we assumed all of the duties,
warranties and obligations of North as the sole general partner of Gaylord
Partners, Limited Partnership ("GPLP"), a special purpose entity. In 2002, North
contributed an aggregate of $50,500 to the capital of GPLP and GPLP issued $5.0
million of floating rate cumulative preferred securities as part of a private
placement offering. North issued $5,050,500 of subordinated debentures to GPLP
in exchange for the proceeds of the offering, which debentures represent the
sole asset of GPLP. Independent Bank purchased $750,000 of the GPLP floating
rate cumulative preferred securities during the private placement offering. This
investment security at Independent Bank and a corresponding amount of
subordinated debentures are eliminated in consolidation. The remaining
subordinated debentures as well as our capital investment in GPLP are included
in our Consolidated Statement of Financial Condition at September 30, 2004.
In May 2004, the Federal Reserve Board issued a proposed rule that would retain
trust preferred securities in the Tier 1 capital of bank holding companies.
After a three-year transition, the aggregate amount of trust preferred
securities and certain other capital elements would be limited to 25 percent of
Tier 1 capital elements, net of goodwill. The amount of trust preferred
securities and certain other elements in excess of the limit could be included
in the Tier 2 capital, subject to restrictions. Based upon our existing levels
of Tier 1 capital, trust preferred securities and goodwill, this proposed
Federal Reserve Board rule is not expected to have any significant impact on our
regulatory capital ratios.
25
To supplement our balance sheet and capital management activities, we
periodically repurchase our common stock. We purchased 82,000 shares at an
average price of $24.53 per share in the first nine months of 2004 compared to
570,000 shares at an average price of $21.94 per share during the first nine
months of 2003. The decline in share repurchases in 2004 compared to 2003 is
primarily related to our desire to preserve capital and improve our regulatory
capital ratios (and in particular our tangible capital ratio) given the impact
of the two bank acquisitions that we have completed this year on these ratios.
As of September 30, 2004 we had 668,000 shares remaining to be purchased under
share repurchase plans previously authorized by our Board of Directors.
CAPITALIZATION
September 30, December 31,
2004 2003
------------- ------------
(in thousands)
Unsecured debt $ 9,500
--------- ---------
Subordinated debentures 64,197 $ 52,165
Amount not qualifying as regulatory capital (1,847) (1,565)
--------- ---------
Amount qualifying as regulatory capital 62,350 50,600
--------- ---------
Shareholders' Equity
Preferred stock, no par value
Common stock, par value $1.00 per share 21,113 19,521
Capital surplus 157,454 119,401
Retained earnings 34,573 16,953
Accumulated other comprehensive income 9,174 6,341
--------- ---------
Total shareholders' equity 222,314 162,216
--------- ---------
Total capitalization $ 294,164 $ 212,816
========= =========
Total shareholders' equity at September 30, 2004 increased $60.1 million from
December 31, 2003, primarily due to the retention of earnings and common stock
issued for the Midwest and North acquisitions (997,700 shares and 345,391
shares, respectively) and for employee benefit plans. These increases were
partially offset by purchases of our common stock and cash dividends declared.
Shareholders' equity totaled $222.3 million, equal to 7.44% of total assets at
September 30, 2004. At December 31, 2003, shareholders' equity totaled $162.2
million, which was equal to 6.87% of total assets.
CAPITAL RATIOS
September 30, 2004 December 31, 2003
------------------ -----------------
Equity capital 7.44% 6.87%
Tier 1 leverage (tangible equity capital) 7.46 7.91
Tier 1 risk-based capital 9.74 10.55
Total risk-based capital 10.98 11.57
ASSET/LIABILITY MANAGEMENT Interest-rate risk is created by differences in the
cash flow characteristics of our assets and liabilities. Options embedded in
certain financial instruments, including caps on adjustable-rate loans as well
as borrowers' rights to prepay fixed-rate loans also create interest-rate risk.
Our asset/liability management efforts identify and evaluate opportunities to
structure the balance sheet in a manner that is consistent with our mission to
maintain profitable financial
26
leverage within established risk parameters. We evaluate various opportunities
and alternate balance-sheet strategies carefully and consider the likely impact
on our risk profile as well as the anticipated contribution to earnings. The
marginal cost of funds is a principal consideration in the implementation of our
balance-sheet management strategies, but such evaluations further consider
interest-rate and liquidity risk as well as other pertinent factors. We have
established parameters for interest-rate risk. We regularly monitor our
interest-rate risk and report quarterly to our respective banks' boards of
directors.
We employ simulation analyses to monitor each bank's interest-rate risk profile
and evaluate potential changes in each bank's net interest income and market
value of portfolio equity that result from changes in interest rates. The
purpose of these simulations is to identify sources of interest-rate risk
inherent in our balance sheets. The simulations do not anticipate any actions
that we might initiate in response to changes in interest rates and,
accordingly, the simulations do not provide a reliable forecast of anticipated
results. The simulations are predicated on immediate, permanent and parallel
shifts in interest rates and generally assume that current loan and deposit
pricing relationships remain constant. The simulations further incorporate
assumptions relating to changes in customer behavior, including changes in
prepayment rates on certain assets and liabilities.
RESULTS OF OPERATIONS
SUMMARY Net income totaled $10.3 million and $27.7 million during the three- and
nine-month periods ended September 30, 2004. Quarterly net income was relatively
unchanged comparing the third quarters of 2004 and 2003. However earnings per
share in 2004 did decline from 2003 because there were more shares outstanding
in 2004 primarily as a result of shares issued in connection with the Midwest
and North acquisitions. The decline in year to date net income from the
comparative period in 2003 is primarily a result of declines in net gains on
real estate mortgage loan sales and title insurance fees, as well as increases
in the provision for loan losses and non-interest expense, including during the
second quarter of 2004 a $2.7 million charge for an estimated liability at Mepco
as well as a $1.0 million write-off of uncompleted software (See "Non-interest
expense"). Partially offsetting these items were increases in net interest
income, service charges on deposits, securities gains and real estate mortgage
loan servicing income.
27
KEY PERFORMANCE RATIOS
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------ ------ ------ ------
Net income to
Average assets 1.39% 1.75% 1.42% 1.73%
Average equity 18.99 26.77 19.67 25.45
Earnings per common share
Basic $ 0.49 $ 0.53 $ 1.37 $ 1.44
Diluted 0.48 0.51 1.34 1.41
NET INTEREST INCOME Tax equivalent net interest income increased by 23.8% to
$32.9 million and by 21.1% to $88.7 million, respectively, during the three- and
nine-month periods in 2004 compared to 2003. These increases primarily reflect
an increase in average interest-earning assets and to a lesser degree changes in
tax equivalent net interest income as a percent of average earning assets ("Net
Yield").
We review yields on certain asset categories and our net interest margin on a
fully taxable equivalent basis. This presentation is not in accordance with
generally accepted accounting principles ("GAAP") but is customary in the
banking industry. In this non-GAAP presentation, net interest income is adjusted
to reflect tax-exempt interest income on an equivalent before-tax basis. This
measure ensures comparability of net interest income arising from both taxable
and tax-exempt sources. The adjustments to determine tax equivalent net interest
income were $1.5 million and $1.3 million for the third quarters of 2004 and
2003, respectively, and were $4.1 million and $3.7 million for the first nine
months of 2004 and 2003, respectively. These adjustments were computed using a
35% tax rate.
Average interest-earning assets totaled $2.718 billion and $2.416 billion during
the three- and nine-month periods in 2004, respectively. The increases from the
corresponding periods of 2003 principally reflect increases in securities
available for sale, commercial loans, finance receivables and the Midwest and
North acquisitions.
Net Yield decreased by 7 basis points to 4.83% during the three-month period in
2004 and increased by 6 basis points to 4.90% during the nine-month period in
2004 as compared to the like periods in 2003. The slight decline in our Net
Yield during the third quarter of 2004 compared to the like quarter of 2003 is
due primarily to our acquisition of North. North had a substantially lower Net
Yield compared to ours due to their earning asset and funding mix and higher
level of non-performing (non-accrual) loans. One of our primary objectives
related to the integration of the North acquisition is to improve the Net Yield
on their interest earning assets.
The Federal Reserve Bank ("FRB") has increased the target federal funds rate by
0.75% thus far in 2004 and it is anticipated that the FRB may continue to
gradually increase short-term interest rates. Long-term interest rates after
having generally moved up during early 2004 in anticipation of the actions of
the FRB have recently declined resulting in a flattening of the yield curve. We
attempt to mitigate the impact of changes in interest rates on our Net Yield and
tax equivalent net interest income through our asset liability management
efforts (See "Asset/Liability Management") although a flattening yield curve
over time would be expected to generally put
28
some downward pressure on our Net Yield. There can be no assurance that our
asset liability management efforts will be successful in preventing significant
fluctuations in our tax equivalent net interest income as a result of changes in
interest rates.
AVERAGE BALANCES AND TAX EQUIVALENT RATES
Three Months Ended
September 30,
2004 2003
---------------------------------- ---------------------------------
Average Average
Balance Interest Rate Balance Interest Rate
----------- ---------- ------- ----------- ---------- -----
(dollars in thousands)
Assets
Taxable loans (1) $ 2,184,861 $ 37,447 6.83% $ 1,698,405 $ 30,797 7.22%
Tax-exempt loans (1,2) 6,977 130 7.41 11,236 228 7.98
Taxable securities 284,528 3,275 4.58 246,360 2,727 4.39
Tax-exempt securities (2) 222,002 3,867 6.93 188,775 3,376 7.10
Other investments 19,573 203 4.13 13,414 165 4.88
----------- ---------- ----------- ----------
Interest Earning Assets 2,717,941 44,922 6.59 2,158,190 37,293 6.87
---------- ----------
Cash and due from banks 67,192 55,626
Other assets, net 169,230 121,333
----------- -----------
Total Assets $ 2,954,363 $ 2,335,149
=========== ===========
Liabilities
Savings and NOW $ 876,259 1,228 0.56 $ 696,523 1,070 0.61
Time deposits 1,004,803 6,627 2.62 771,731 5,699 2.93
Long-term debt 7,995 77 3.84
Other borrowings 491,978 4,081 3.30 452,372 3,943 3.46
----------- ---------- ----------- ----------
Interest Bearing Liabilities 2,381,035 12,013 2.01 1,920,626 10,712 2.21
---------- ----------
Demand deposits 279,288 204,480
Other liabilities 77,869 57,121
Shareholders' equity 216,171 152,922
----------- -----------
Total liabilities and shareholders' equity $ 2,954,363 $ 2,335,149
=========== ===========
Tax Equivalent Net Interest Income $ 32,909 $ 26,581
========== ==========
Tax Equivalent Net Interest Income
as a Percent of Earning Assets 4.83% 4.90%
==== ====
(1) All domestic
(2) Interest on tax-exempt loans and securities is presented on a fully tax
equivalent basis assuming a marginal tax rate of 35%
29
AVERAGE BALANCES AND TAX EQUIVALENT RATES
Nine Months Ended
September 30,
2004 2003
---------------------------------- ---------------------------------
Average Average
Balance Interest Rate Balance Interest Rate
----------- ---------- ------- ----------- ---------- -----
(dollars in thousands)
Assets
Taxable loans (1) $ 1,921,632 $ 99,731 6.93% $ 1,588,440 $ 87,590 7.36%
Tax-exempt loans (1,2) 6,819 381 7.46 11,674 708 8.11
Taxable securities 265,257 9,366 4.72 235,641 8,575 4.87
Tax-exempt securities (2) 206,072 10,936 7.09 174,344 9,476 7.27
Other investments 15,951 537 4.50 11,802 442 5.01
----------- ---------- ----------- ----------
Interest Earning Assets 2,415,731 120,951 6.68 2,021,901 106,791 7.06
---------- ----------
Cash and due from banks 52,889 48,897
Other assets, net 146,968 117,029
----------- -----------
Total Assets $ 2,615,588 $ 2,187,827
=========== ===========
Liabilities
Savings and NOW $ 787,986 3,195 0.54 $ 686,418 3,867 0.75
Time deposits 864,957 16,880 2.61 728,254 17,503 3.21
Long-term debt 3,560 101 3.82
Other borrowings 473,765 12,061 3.43 395,579 12,146 4.11
----------- ---------- ----------- ----------
Interest Bearing Liabilities 2,130,268 32,237 2.02 1,810,251 33,516 2.48
---------- ----------
Demand deposits 226,162 179,975
Other liabilities 70,794 49,090
Shareholders' equity 188,364 148,511
----------- -----------
Total liabilities and shareholders' equity $ 2,615,588 $ 2,187,827
=========== ===========
Tax Equivalent Net Interest Income $ 88,714 $ 73,275
========== ==========
Tax Equivalent Net Interest Income
as a Percent of Earning Assets 4.90% 4.84%
==== ====
(1) All domestic
(2) Interest on tax-exempt loans and securities is presented on a fully tax
equivalent basis assuming a marginal tax rate of 35%
PROVISION FOR CREDIT LOSSES The provision for credit losses was $2.5 million and
$0.6 million for the third quarters of 2004 and 2003, respectively. During the
nine-month periods ended September 30, 2004 and 2003, the provision was $4.0
million and $2.3 million, respectively. The provision for credit losses reflects
our assessment of the allowance for loan losses and the allowance for losses on
unfunded commitments taking into consideration factors such as loan mix, levels
of non-performing and classified loans and net charge-offs (See "Portfolio loans
and asset quality"). In particular, the increase in the provision in the third
quarter of 2004 primarily reflects changes in our assessment of the credit
quality of certain commercial loans.
NON-INTEREST INCOME Non-interest income totaled $10.8 million during the three
months ended September 30, 2004, a $1.0 million decrease from the comparable
period in 2003. This decrease was primarily due to significant declines in net
gains on the sale of real estate mortgage loans and title insurance fees that
were partially offset by increases in service charges on deposits and
30
securities gains. Non-interest income decreased to $29.5 million during the nine
months ended September 30, 2004, from $32.6 million a year earlier and the
components of this change were largely similar to the quarterly comparative
periods.
NON-INTEREST INCOME
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------- -------- ------- --------
(in thousands)
Service charges on deposit accounts $ 4,620 $ 3,855 $12,519 $ 10,803
Net gains (losses) on asset sales
Real estate mortgage loans 1,381 5,652 4,603 14,001
Securities 1,561 (1,314) 2,056 (755)
Title insurance fees 496 983 1,579 2,633
Bank owned life insurance 363 360 1,091 1,102
Manufactured home loan origination fees
and commissions 314 535 923 1,282
Mutual fund and annuity commissions 332 319 975 909
Real estate mortgage loan servicing 77 201 1,158 (1,196)
Other 1,690 1,223 4,635 3,861
------- -------- ------- --------
Total non-interest income $10,834 $ 11,814 $29,539 $ 32,640
======= ======== ======= ========
Service charges on deposit accounts increased by 19.8% to $4.6 million and by
15.9% to $12.5 million during the three- and nine-month periods ended September
30, 2004, respectively, from the comparable periods in 2003. The increase in
service charges principally relate to growth in checking accounts as a result of
deposit account promotions, which include direct mail solicitations, as well as
our acquisitions of Midwest and North.
Our mortgage lending activities have a substantial impact on total non-interest
income. Net gains on the sale of real estate mortgage loans decreased by $4.3
million during the three months ended September 30, 2004 from the same period in
2003 and decreased by $9.4 million on a year to date comparative basis. The
decreases in real estate mortgage loan origination volume, loans sold and gains
on such sales are primarily due to a significant decline in mortgage loan
refinance activity in 2004 compared to 2003. Also during the three- and
nine-month periods ended September 30, 2004 gains on the sale of real estate
mortgage loans increased by approximately $0.1 million in both periods as a
result of recording changes in the fair value of certain derivative instruments
pursuant to SFAS #133 (compared to a decrease of $0.5 million and an increase of
$0.4 million for the three- and nine-month periods ended September 30, 2003,
respectively). The SFAS #133 adjustments to gains on the sale of real estate
mortgage loans primarily represent timing differences that reverse when the
applicable commitments to sell real estate mortgage loans in the secondary
market are fulfilled.
31
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
-------- --------- -------- --------
(in thousands)
Real estate mortgage loans originated $163,707 $ 344,999 $522,702 $970,210
Real estate mortgage loans sold 80,576 299,502 287,206 771,754
Real estate mortgage loans sold with servicing
rights released 14,070 12,802 38,315 43,517
Net gains on the sale of real estate mortgage loans 1,381 5,652 4,603 14,001
Net gains as a percent of real estate mortgage
loans sold ("Loan Sale Margin") 1.71% 1.89% 1.60% 1.81%
SFAS #133 adjustments included in the Loan
Sale Margin 0.13% (0.16)% 0.02% 0.05%
The volume of loans sold is dependent upon our ability to originate real estate
mortgage loans as well as the demand for fixed-rate obligations and other loans
that we cannot profitably fund within established interest-rate risk parameters.
(See "Portfolio loans and asset quality.") Net gains on real estate mortgage
loans are also dependent upon economic and competitive factors as well as our
ability to effectively manage exposure to changes in interest rates and thus can
often be a volatile part of our overall revenues.
When taking into account the impact of the SFAS #133 adjustments, net gains as a
percentage of real estate mortgage loans sold (our "loan sales margin") were
lower in 2004 compared to 2003. The lower loan sales margin in 2004 reflects a
more competitive pricing environment as mortgage lenders are competing for a
much smaller volume due to the steep drop in mortgage loan refinance volume as
compared to 2003.
Securities gains totaled $1.6 million in the third quarter of 2004 compared to
securities losses of $1.3 million in the third quarter of 2003. The securities
gains in the third quarter of 2004 are comprised of a $0.5 million gain on the
sale of a trust preferred security that had been previously written off through
impairment charges and the balance of the gains were due to a sale of a
corporate debt security and a pooled trust preferred security. Included in the
third quarter 2003 securities losses is an impairment charge of $0.75 million
which represented the write-off of the remainder of a $1.5 million trust
preferred security that was purchased in 1999. The remainder of securities
losses (net) in the third quarter of 2003 was composed of losses on municipal
securities ($0.8 million) with the sales proceeds being reinvested in higher
yield securities, partially offset by $0.2 million in securities gains primarily
from the sale or call of some trust preferred securities.
The declines in title insurance fees in 2004 compared to 2003 primarily reflect
the changes in our mortgage loan origination volume.
Manufactured home loan origination fees and commissions have continued to
decline in 2004 compared to 2003. This industry has faced a challenging
environment as several buyers of this type of loan have exited the market or
materially altered the guidelines under which they will purchase such loans. In
addition, generally low interest rates for mortgage loans have made traditional
housing more affordable and reduced the demand for manufactured homes. Finally,
regulatory changes have reduced the opportunity to generate revenues on the sale
of insurance
32
related to this type of lending. As a result, the lower level of revenue
recorded in the first nine months of 2004 from this activity is likely to be
fairly reflective of ensuing quarters, at least in the short-term.
Real estate mortgage loan servicing generated income of $0.1 million and $1.2
million in the third quarter and first nine months of 2004 respectively,
compared to income of $0.2 million and an expense of $1.2 million in the
corresponding periods of 2003, respectively. These variations are primarily due
to changes in the impairment reserve on and the amortization of capitalized
mortgage loan servicing rights.
Activity related to capitalized mortgage loan servicing rights is as follows:
CAPITALIZED REAL ESTATE MORTGAGE LOAN SERVICING RIGHTS
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
-------- ------- -------- -------
(in thousands)
Balance at beginning of period $ 10,154 $ 5,565 $ 8,873 $ 4,455
Servicing rights acquired 1,138 1,138
Originated servicing rights capitalized 643 2,647 2,443 6,632
Amortization (376) (1,163) (1,457) (3,303)
(Increase)/decrease in impairment reserve (436) 641 126 (94)
-------- ------- -------- -------
Balance at end of period $ 11,123 $ 7,690 $ 11,123 $ 7,690
-------- ------- -------- -------
Impairment reserve at end of period $ 596 $ 1,189 $ 596 $ 1,189
======== ======= ======== =======
The declines in originated mortgage loan servicing rights capitalized are due to
the lower level of real estate mortgage loan sales in the third quarter and
first nine months of 2004 compared to 2003. The amortization of capitalized
mortgage loan servicing rights declined in 2004 compared to 2003 due to a lower
level of mortgage loan prepayment activity. The impairment reserve on
capitalized mortgage loan servicing rights totaled $0.6 million at September 30,
2004, compared to $0.7 million and $1.2 million at December 31, 2003, and
September 30, 2003, respectively. The changes in the impairment reserve reflect
the valuation of capitalized mortgage loan servicing rights at each quarter end.
At September 30, 2004, the Company was servicing approximately $1.3 billion in
real estate mortgage loans for others on which servicing rights have been
capitalized. This servicing portfolio had a weighted average coupon rate of
approximately 5.85% and a weighted average service fee of 26.0 basis points.
NON-INTEREST EXPENSE Non-interest expense increased by $3.2 million to $25.5
million and by $11.4 million to $72.4 million during the three- and nine-month
periods ended September 30, 2004, respectively, compared to the like periods in
2003.
33
NON-INTEREST EXPENSE
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
------- ------- ------- -------
(in thousands)
Salaries $ 8,816 $ 7,183 $24,207 $20,446
Performance-based compensation
and benefits 1,452 1,670 4,216 4,560
Other benefits 2,335 2,388 7,133 6,671
------- ------- ------- -------
Compensation and employee
benefits 12,603 11,241 35,556 31,677
Occupancy, net 1,981 1,611 5,618 4,835
Furniture and fixtures 1,608 1,381 4,473 4,125
Data processing 1,169 1,025 3,332 2,921
Advertising 1,274 1,151 2,879 2,894
Mepco claims expense 2,700
Loan and collection 1,035 824 2,659 2,655
Communications 917 738 2,582 2,134
Legal and professional 1,155 584 1,995 1,415
Amortization of intangible assets 746 492 1,723 1,226
Supplies 461 461 1,561 1,420
Write-off of uncompleted software 977
Loss on prepayments of borrowings 983 983
Other 2,572 1,803 6,351 4,711
------- ------- ------- -------
Total non-interest expense $25,521 $22,294 $72,406 $60,996
======= ======= ======= =======
The increase in third quarter non-interest expense was partially due to merger
related expenses of $0.3 million, intangible amortization relating to the North
and Midwest acquisitions of $0.3 million and Sarbanes-Oxley 404 implementation
costs of $0.1 million. In addition to the discussion below, a majority of the
remainder of the increase in non-interest expense is primarily due to operating
costs related to the addition of staff and branch offices from the Midwest and
North acquisitions and increases in compensation and employee benefits. The
increase in compensation and employee benefits expense is primarily attributable
to merit pay increases that were effective January 1, 2004, staffing level
increases associated with the expansion and growth of the organization and an
increase in health care insurance costs. Third quarter 2003 non-interest
expenses included a loss of $1.0 million on the prepayment of certain FHLB
advances which were replaced with new borrowings at lower rates. The variations
in the year to date comparative periods are largely reflective of the quarterly
comparative changes as discussed above.
We incurred costs of approximately $0.6 million in the third quarter of 2004 in
connection with the previously disclosed (Form 10-Q for the quarter ended June
30, 2004) investigation of certain aspects of our operations conducted through
Mepco. That investigation is principally focused on Mepco's operations prior to
the date of our acquisition of Mepco in April 2003. An escrow agreement with the
former owners of Mepco was entered into on September 30, 2004 pursuant to which
the former owners of Mepco deposited Independent Bank Corporation common stock
with a market value at September 30, 2004 of approximately $2.5 million with a
third-party escrow agent. As a result of this escrow agreement, as well as the
$2.7 million accrual that we recorded
34
in the second quarter of 2004, we do not expect that future liabilities, if any,
resulting from this investigation will be material. Although the investigation
is ongoing, it has been completed to a stage where we believe all significant
issues (including any potential liabilities) have been identified. We are
currently working to determine a final liability, if any, to third parties, and
this process is expected to take several more months. The terms of the agreement
under which we acquired Mepco, obligates the former shareholders of Mepco to
indemnify Independent Bank Corporation for existing and resulting damages and
liabilities from pre-acquisition activities at Mepco. Accordingly, to the extent
that we actually incur any damages or liabilities resulting from these
pre-acquisition activities, we believe that we have reasonable grounds to claim
and collect full reimbursement. However, there can be no assurance that we will
successfully prevail with respect to any of these potential claims.
INCOME TAX EXPENSE Our effective income tax rate was reasonably comparable in
2004 to the like periods in 2003. The primary reason for the difference between
our statutory and effective income tax rates results from tax exempt interest
income.
ACQUISITIONS
On April 15, 2003, we completed the acquisition of Mepco Insurance Premium
Financing, Inc. Mepco is a 40-year old Chicago-based company that specializes in
financing insurance premiums for businesses and extended automobile warranties
for consumers.
On May 31, 2004, we completed the acquisition of Midwest. We issued 997,700
shares of common stock and paid $16.6 million in cash to the Midwest
shareholders. 2004 includes the results of Midwest's operations subsequent to
May 31, 2004. At the time of acquisition, Midwest had total assets of $238.0
million, total loans of $205.0 million, total deposits of $198.9 million and
total stockholders' equity of $18.7 million. We recorded purchase accounting
adjustments related to the Midwest acquisition including recording goodwill of
$23.1 million, establishing a core deposit intangible of $4.9 million, and a
covenant not to compete of $1.3 million.
On July 1, 2004, we completed the acquisition of North. We issued 345,391 shares
of common stock to the North shareholders. 2004 includes the results of North's
operations beginning on July 1, 2004. At the time of acquisition, North had
total assets of $155.1 million, total loans of $103.6 million, total deposits of
$123.8 million and total stockholders' equity of $3.3 million. We recorded
purchase accounting adjustments related to the North acquisition including
recording goodwill of $3.0 million and establishing a core deposit intangible of
$2.2 million.
CRITICAL ACCOUNTING POLICIES
Our accounting and reporting policies are in accordance with accounting
principles generally accepted within the United States of America and conform to
general practices within the banking industry. Accounting and reporting policies
for the allowance for loan losses, real estate mortgage servicing rights,
derivative financial instruments, income taxes and goodwill are deemed critical
since they involve the use of estimates and require significant management
judgments. Application of assumptions different than those that we have used
could result in material changes in our financial position or results of
operations.
35
Our methodology for determining the allowance and related provision for credit
losses is described above in "Financial Condition - Portfolio Loans and asset
quality." In particular, this area of accounting requires a significant amount
of judgment because a multitude of factors can influence the ultimate collection
of a loan or other type of credit. It is extremely difficult to precisely
measure the amount of losses that are probable in our loan portfolio. We use a
rigorous process to attempt to accurately quantify the necessary allowance and
related provision for credit losses, but there can be no assurance that our
modeling process will successfully identify all of the losses that are probable
in our loan portfolio and unfunded commitments. As a result, we could record
future provisions for credit losses that may be significantly different than the
levels that we have recorded in the most recent quarter.
At September 30, 2004 we had approximately $11.1 million of real estate mortgage
loan servicing rights capitalized on our balance sheet. There are several
critical assumptions involved in establishing the value of this asset including
estimated future prepayment speeds on the underlying real estate mortgage loans,
the interest rate used to discount the net cash flows from the real estate
mortgage loan servicing, the estimated amount of ancillary income that will be
received in the future (such as late fees) and the estimated cost to service the
real estate mortgage loans. We utilize an outside third party (with expertise in
the valuation of real estate mortgage loan servicing rights) to assist us in our
valuation process. We believe the assumptions that we utilize in our valuation
are reasonable based upon accepted industry practices for valuing mortgage
servicing rights and represent neither the most conservative or aggressive
assumptions.
We use a variety of derivative instruments to manage our interest rate risk.
These derivative instruments include interest rate swaps, collars, floors and
caps and mandatory forward commitments to sell real estate mortgage loans. Under
SFAS #133 the accounting for increases or decreases in the value of derivatives
depends upon the use of the derivatives and whether the derivatives qualify for
hedge accounting. In particular, we use pay fixed interest-rate swaps to convert
the variable rate cash flows on short-term or variable rate debt obligations to
fixed rates. At September 30, 2004 we had approximately $387.0 million in fixed
pay interest rate swaps being accounted for as cash flow hedges, thus permitting
us to report the related unrealized gains or losses in the fair market value of
these derivatives in other comprehensive income and subsequently reclassify such
gains or losses into earnings as yield adjustments in the same period in which
the related interest on the hedged item (primarily short-term or variable rate
debt obligations) affect earnings. The fair market value of our fixed pay
interest-rate swaps being accounted for as cash flow hedges is approximately
negative $1.2 million at September 30, 2004.
Our accounting for income taxes involves the valuation of deferred tax assets
and liabilities primarily associated with differences in the timing of the
recognition of revenues and expenses for financial reporting and tax purposes.
At December 31, 2003 we had recorded a net deferred tax asset of $9.0 million,
which included a net operating loss carryforward of $7.2 million. We have
recorded no valuation allowance on our net deferred tax asset because we believe
that the tax benefits associated with this asset will more likely than not, be
realized. However, changes in tax laws, changes in tax rates and our future
level of earnings can adversely impact the ultimate realization of our net
deferred tax asset.
At September 30, 2004 we had recorded $44.9 million of goodwill. Under SFAS
#142, amortization of goodwill ceased, and instead this asset must be
periodically tested for impairment. Our goodwill primarily arose from our 2004
acquisitions of Midwest and North, our 2003 acquisition of Mepco and the past
acquisitions of other banks and a mobile home loan origination company. We test
our goodwill for impairment utilizing the methodology
36
and guidelines established in SFAS #142. This methodology involves assumptions
regarding the valuation of the business segments that contain the acquired
entities. We believe that the assumptions we utilize are reasonable and as a
general matter, even utilizing more conservative assumptions on valuation, would
not presently result in any impairment in the amount of goodwill that we have
recorded. However, we may incur impairment charges related to our goodwill in
the future due to changes in business prospects or other matters that could
affect our valuation assumption.
37
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No material changes in the market risk faced by the Registrant have occurred
since December 31, 2003.
Item 4.
CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As required by Rule 13a-15
under the Securities Exchange Act of 1934, as of the end of the period covered
by this report, the Company carried out an evaluation of the effectiveness of
our disclosure controls and procedures. This evaluation was carried out under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer. Based upon that evaluation,
our Chief Executive Officer and Chief Financial Officer concluded that as of
September 30, 2004, our disclosure controls and procedures were adequate and
effective to ensure that material information relating to the Company and its
consolidated subsidiaries would be made known to them by others within those
entities in connection with the filing of its quarterly report on 10-Q for the
period ended September 30, 2004. Other than as discussed in the third paragraph
of this Item 4, there have been no changes in our internal control over
financial reporting that have materially affected, or reasonably likely to
materially affect, our internal control over financial reporting.
Disclosure controls and procedures are designed to ensure that information
required to be disclosed in our reports filed or submitted under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission's rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed in our
reports filed under the Exchange Act is accumulated and communicated to
management, including our Chief Executive Office and Chief Financial Officer as
appropriate, to allow timely decisions regarding required disclosure.
In April 2003, we acquired Mepco Insurance Premium Financing, Inc. ("Mepco") a
Chicago-based Company that specializes in financing insurance premiums for
businesses and extended automobile warranties for consumers. As discussed in
item 2 above, we have identified and reviewed certain business practices
relating to Mepco's handling of certain overpayments on premium finance loans
resulting from payoffs and cancellations. As a result of that review we have
made changes to strengthen internal controls related to the manner in which
overpayments on premium finance loans are handled, and we intend to continue to
refine the process and have additional corrective actions in place by the end of
the fourth quarter of 2004.
38
Part II
Item 2. Unregistered sales of equity securities and use of proceeds
The following table shows certain information relating to purchases of
common stock for the three-months ended September 30, 2004 pursuant to our
share repurchase plan:
Remaining
Total Number of Number of
Shares Purchased Shares
as Part of a Authorized for
Total Number of Average Price Publicly Purchase Under
Period Shares Purchased(1) Paid Per Share Announced Plan(2) the Plan
- -------------- ------------------- -------------- ----------------- --------------
July 2004 280 $25.58
August 2004
September 2004 944 27.00
----- ------ -------
Total 1,224 $26.68 668,400
===== ====== =======
(1)Represents shares purchased to fund our Deferred Compensation and Stock
Purchase Plan for Non-employee Directors.
(2)Our current stock repurchase plan, announced December 4, 2003,
authorizes the purchase up to 750,000 shares of our common stock. The repurchase
plan expires on December 31, 2004.
Item 6. Exhibits
The following exhibits (listed by number corresponding to the Exhibit
Table as Item 601 in Regulation S-K) are filed with this report:
11. Computation of Earnings Per Share.
31.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
31.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
39
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.
Date November 8, 2004 By /s/ Robert N. Shuster
----------------------------------------
Robert N. Shuster, Principal Financial
Officer
Date November 8, 2004 By /s/ James J. Twarozynski
----------------------------------------
James J. Twarozynski, Principal
Accounting Officer
40
Exhibit Index
Exhibit No. Description
The following exhibits (listed by number corresponding to the Exhibit Table
as Item 601 in Regulation S-K) are filed with this report:
11. Computation of Earnings Per Share.
31.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. 1350).
31.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. 1350).
32.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. 1350).
32.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 (18 U.S.C. 1350).
41