UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
| [X] |
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934. For the fiscal year ended: December 31, 2002 |
OR
| [ ] |
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to |
Commission File Number: 0-11244
GERMAN AMERICAN BANCORP
(Exact name of registrant as specified in its charter)
| INDIANA | 35-1547518 |
|
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
|
711 Main Street, Jasper, Indiana 47546 (Address of Principal Executive Offices and Zip Code) | |
Registrant's telephone number, including area code: (812) 482-1314
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, No Par Value
Preferred Stock Purchase Rights
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [
] NO
[ X ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES [ X ] NO [ ]
The aggregate market value of the registrant’s common shares held by non-affiliates of the registrant, computed by reference to the price at which the common shares were last sold, as of June 28, 2002 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $174,608,000.
As of March 1, 2003, there were outstanding 11,460,469 common shares, no par value, of the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement of German American Bancorp for the Annual Meeting of its Shareholders to be held April 24, 2003, to the extent stated herein, are incorporated by reference into Part III.
GERMAN AMERICAN BANCORP
ANNUAL REPORT ON FORM 10-K
For Fiscal Year Ended December 31, 2002
Table of Contents
PART I
| Item 1. | Business | 3 |
| Item 2. | Properties | 6 |
| Item 3. | Legal Proceedings | 6 |
| Item 4. | Submission of Matters to a Vote of Security Holders | 6 |
PART II
| Item 5. | Market for Registrant's Common Equity and Related Stockholder Matters | 7 |
| Item 6. | Selected Financial Data | 8 |
| Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 9-24 |
| Item 7A. | Quantitative and Qualitative Disclosures About Market Risk | 25 |
| Item 8. | Financial Statements and Supplementary Data | 26-53 |
| Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure | 54 |
PART III
| Item 10. | Directors and Executive Officers of the Registrant. | 54 |
| Item 11. | Executive Compensation | 54 |
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 54 |
| Item 13. | Certain Relationships and Related Transactions | 55 |
| Item 14. | Controls and Procedures | 55 |
PART IV
| Item 15. | Exhibits, Financial Statement Schedules and Reports on Form 8-K | 56 |
| SIGNATURES | 57 | ||
| CERTIFICATIONS | 58-59 | ||
| INDEX OF EXHIBITS | 60-61 | ||
– 2 –
PART I
Item 1. Business.
General
German American Bancorp (“the Company”) is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s National Market System under the symbol GABC. The Company operates five affiliated community banks with 26 retail banking offices in the eight contiguous Southwestern Indiana counties of Daviess, Dubois, Gibson, Knox, Martin, Perry, Pike, Spencer and a business lending center in Evansville, Indiana. The Company also operates a trust, brokerage and financial planning subsidiary which operates from the banking offices of the bank subsidiaries, and two insurance agencies with four insurance agency offices throughout its market area. The Company’s lines of business include retail and commercial banking, mortgage banking, comprehensive financial planning, full service brokerage and trust administration, title insurance, and a full range of personal and corporate insurance products. Financial and other information by segment is included in “Note 16 – Segment Information” of the “Notes to the Consolidated Financial Statements” included in Item 8 of this Report and is incorporated into this Item 1 by reference. Substantially all of the Company’s revenues are derived from customers located in, and substantially all of its assets are located in the United States.
The Company’s principal operating subsidiaries are described in the following table:
|
Name The German American Bank First American Bank First Title Insurance Company First State Bank, Southwest Indiana Peoples Bank Citizens State Bank The Doty Agency, Inc. German American Financial Advisors & Trust Company |
Type of Business Commercial Bank Commercial Bank Title Insurance Agency Commercial Bank Commercial Bank Commercial Bank Multi-Line Insurance Agency Trust, Brokerage, Financial Planning |
Principal Office Location Jasper, IN Vincennes, IN Vincennes, IN Tell City, IN Washington, IN Petersburg, IN Petersburg, IN Jasper, IN |
Recent Development: Self Tender Offer
The Company on February 7, 2003, commenced a tender offer for up to 1,000,000 of its common shares, at $20 per share, net to the seller. The Company has reserved the right to purchase up to an additional 225,000 shares if they are tendered pursuant to the offer, but it is not obligated to do so. The offer is scheduled to expire at 5:00 pm CST on March 14, 2003, unless the Company elects to extend the offer. The complete terms and conditions of the offer are filed as exhibits to a Tender Offer Statement on Schedule TO that was filed by the Company on February 7, 2003, as amended, which is available free of charge by accessing the Securities and Exchange Commission site on the World Wide Web, www.sec.gov.
Assuming the Company purchases the maximum of 1,000,000 shares that it is obligated to purchase pursuant to the offer at a purchase price of $20.00 per share, the Company expects the maximum aggregate cost of such purchase to be approximately $20,288,000, including estimated fees and expenses of approximately $288,000. If as many as 1,225,000 shares are tendered under the offer and the Company elects to purchase all of the additional 225,000 shares, the Company expects the maximum aggregate cost to be approximately $24,806,000, including estimated fees and expenses of approximately $306,000.
– 3 –
The Company intends to fund approximately $15,000,000 of its potential obligation to purchase shares pursuant to the offer and to pay related fees and expenses by applying cash and investments currently held by the parent company. If the Company requires more than $15,000,000 in order to purchase shares validly tendered under the offer and pay related fees and expenses, the Company expects to finance the additional funds requirements by drawing against a revolving line of credit that it proposes to establish with Bank One, N.A., Chicago, Illinois (“Bank One”). Bank One has issued a commitment letter to the Company to establish a $10,000,000 revolving line of credit for the purpose of funding stock repurchases and parent company working capital needs, with a proposed maturity date for the repayment of principal and all accrued unpaid interest of two years from the date of establishment. Bank One has orally indicated a willingness to increase the amount of its revolving line of credit to an amount greater than $10,000,000, but not more than $15,000,000, and the Company may request a line of credit greater than $10,000,000 in the event that the self tender offer is oversubscribed and the Company elects to purchase more than the 1,000,000 shares that it is obligated to purchase. In accordance with Bank One’s commitment letter, interest on the unpaid balance of the loan is expected to be payable quarterly at a rate of 90-day LIBOR plus 125 basis points and there is expected to be a commitment fee on the unused balance of 15 basis points per annum. Establishment of the credit facility is subject to the execution and delivery of a mutually acceptable loan agreement, which is expected to include usual and customary covenants, including an agreement by the Company not to incur other debt without Bank One’s consent, an agreement that the Company will not pledge to others its investments in its subsidiaries, and an agreement to maintain its capital and the capital of its subsidiaries at “well capitalized” levels as that term is defined by bank regulatory agencies.
Competition
The industries in which the Company operates are highly competitive. The Company’s subsidiary banks compete for commercial and retail banking business within its core banking segment not only with financial institutions that have offices in the same counties but also with financial institutions that compete from other locations in Southwest Indiana and elsewhere. The Company’s subsidiaries compete with commercial banks, savings and loan associations, savings banks, credit unions, production credit associations, federal land banks, finance companies, credit card companies, personal loan companies, investment brokerage firms, insurance agencies, insurance companies, lease finance companies, money market funds, mortgage companies and other non-depository financial intermediaries. Many of these banks and other organizations have substantially greater resources than the Corporation.
Employees
At March 1, 2003 the Company and its subsidiaries employed approximately 392 full-time equivalent employees. There are no collective bargaining agreements, and employee relations are considered to be good.
Regulation and Supervision
The Company is subject to the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is required to file with the Board of Governors of the Federal Reserve System (“FRB”) annual reports and such additional information as the FRB may require. The FRB may also make examinations or inspections of the Company. Under FRB policy, the Company is expected to act as a source of financial strength to its bank subsidiaries and to commit resources to support them even in circumstances where the Company might not do so absent such an FRB policy.
The Company’s five subsidiary banks are under the supervision of and subject to examination by the Indiana Department of Financial Institutions (“DFI”), and the Federal Deposit Insurance Corporation (“FDIC”). Regulation and examination by banking regulatory agencies are primarily for the benefit of depositors rather than shareholders.
With certain exceptions, the BHC Act prohibits a bank holding company from engaging in (or acquiring direct or indirect control of more than 5 percent of the voting shares of any company engaged in) nonbanking activities. One of the principal exceptions to this prohibition is for activities deemed by the FRB to be “closely related to banking.” Under current regulations, bank holding companies and their subsidiaries are permitted to engage in such banking-related business ventures as consumer finance; equipment leasing; credit life insurance; computer service bureau and software operations; mortgage banking; and securities brokerage.
Under the BHC Act, certain well-managed and well-capitalized bank holding companies may elect to be treated as a “financial holding company” and, as a result, be permitted to engage in a broader range of activities that are “financial in nature” and in activities that are determined to be incidental or complementary to activities that are financial in nature. These activities include underwriting, dealing in and making a market in securities; insurance underwriting and agency activities; and merchant banking. Banks may also engage through financial subsidiaries in certain of the activities permitted for financial holding companies, subject to certain conditions. The Company has not elected to become a financial holding company and none of its subsidiary banks have elected to form financial subsidiaries.
The Company’s banks and their subsidiaries may generally engage in activities that are permissible activities for state chartered banks under Indiana banking law, without regard to the limitations that might apply to such activities under the BHC Act if the Company were to engage directly in such activities.
– 4 –
Indiana law and the BHC Act restrict certain types of expansion by the Company and its bank subsidiaries. The Company and its subsidiaries may be required to apply for prior approval from (or give prior notice and an opportunity for review to) the FRB, the DFI, and/or other bank regulatory or other regulatory agencies, as a condition to the acquisition or establishment of new offices, or the acquisition (by merger or consolidation, purchase or otherwise) of the stock, business or properties of other banks or other companies.
The earnings of commercial banks and their holding companies are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. In particular, the FRB regulates money and credit conditions and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. Government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for time and savings deposits. FRB monetary policies have had a significant effect on the operating results of commercial banks in the past and this is expected to continue in the future. The general effect, if any, of such policies upon the future business and earnings of the Company cannot accurately be predicted.
The Company and its bank subsidiaries are required by law to maintain minimum levels of capital. These required capital levels are expressed in terms of capital ratios, known as the leverage ratio and the capital to risk-based assets ratios. The Company significantly exceeds the minimum required capital levels for each measure of capital adequacy. See Note 9 to the Company’s consolidated financial statements that are presented in Item 8 of this report, which Note 9 is incorporated herein by reference.
Also, federal regulations define five categories of financial institutions for purposes of implementing prompt corrective action and supervisory enforcement requirements of the Federal Deposit Insurance Corporation Improvements Act of 1991. The category to which the most highly capitalized institutions are assigned is termed “Well-Capitalized.” Institutions falling into this category must have a total risk-based capital ratio (the ratio of total capital to risk-weighted assets) of at least 10%, a Tier 1 risk-based capital ratio (the ratio of Tier 1, or “core”, capital to risk-weighted assets) of at least 6%, a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 5%, and must not be subject to any written agreement, order or directive from its regulator relative to meeting and maintaining a specific capital level. On December 31, 2002, the Company had a total risk-based capital ratio of 15.86%, a Tier 1 risk-based capital ratio of 14.64% (based on Tier 1 capital of $99,698,000 and total risk-weighted assets of $680,914,000), and a leverage ratio of 9.91%. The Company meets all of the requirements of the “Well Capitalized” category and, accordingly, the Company does not expect these regulations to significantly impact operations.
Although the Company’s equity capital will be reduced to the extent that the Company purchases shares and pays expenses and costs pursuant to its pending self tender offer, the Company expects that it will continue to remain “Well Capitalized” and that it will continue to significantly exceed the minimum required capital levels for each measure of capital adequacy, even if the Company elects to purchase the maximum (1,225,000) shares that it is permitted to buy without amending the offer.
The Company is a corporation separate and distinct from its bank and other subsidiaries. Most of the Company’s revenues will be received by it in the form of dividends or interest paid by its bank subsidiaries. These subsidiaries are subject to statutory restrictions on its ability to pay dividends. The FRB possesses enforcement powers over bank holding companies and their non-bank subsidiaries that enable it to prevent or remedy actions that in its view may represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability in appropriate cases to proscribe the payment of dividends by banks and bank holding companies. The FDIC and DFI possess similar enforcement powers over the respective bank subsidiaries of the Company for which they have supervision. The “prompt corrective action” provisions of federal banking law impose further restrictions on the payment of dividends by insured banks which fail to meet specified capital levels and, in some cases, their parent bank holding companies.
Internet Address; Internet Availability of SEC Reports.
The Company's Internet address is www.germanamericanbancorp.com.
Effective March 10, 2003, the Company commenced making available, free of charge through its Internet website its annual report on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after those reports are filed.
– 5 –
Forward-Looking Statements
The Company from time to time in its oral and written communications makes statements relating to its expectations regarding the future. These types of statements are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward looking statements can include statements about adequacy of allowance for loan losses and the quality of the Company’s loans and other assets; simulations of changes in interest rates; litigation results; dividend policy; estimated cost savings, plans and objectives for future operations; and expectations about the Company’s financial and business performance and other business matters as well as economic and market conditions and trends. They often can be identified by the use of words like “expect,” “may,” “will,” “would,” “could,” “should,” “intend,” “project,” “estimate,” “believe” or “anticipate,” or similar expressions.
The Company may include forward-looking statements in filings with the Securities and Exchange Commission (“SEC”), such as this Form 10-K, in other written materials, and in oral statements made by senior management to analysts, investors, representatives of the media, and others. It is intended that these forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the forward-looking statement is made. Readers are cautioned that, by their nature, forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that are expressed or implied by any forward-looking statement. The discussion in Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” lists some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statements. Other risks, uncertainties, and factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statement include the effects of changes in competitive conditions; acquisitions of other businesses by the Company and costs of integrations of such acquired businesses; the introduction, withdrawal, success and timing of business initiatives and strategies; changes in customer borrowing, repayment, investment and deposit practices; changes in fiscal, monetary and tax policies; changes in interest rates and financial and capital markets; changes in general economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; the impact, extent and timing of technological changes; capital management activities; actions of the Federal Reserve Board and legislative and regulatory actions and reforms; and the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends. Investors should consider these risks, uncertainties, and other factors in addition to those mentioned by the Company in its other SEC filings from time to time when considering any forward-looking statement.
Item 2. Properties.
The Company conducts its operations from the main office building of German American Bank at 711 Main Street, Jasper, Indiana. The main office building contains approximately 23,600 square feet of office space. The Company’s subsidiaries conduct their operations from 30 other locations in Southwest Indiana.
Item 3. Legal Proceedings.
There are no material pending legal proceedings, other than routine litigation incidental to the business of the Company’s subsidiaries, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted during the fourth quarter of 2002 to a vote of security holders, by solicitation of proxies or otherwise.
– 6 –
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
German American Bancorp’s stock is traded on NASDAQ’s National Market System under the symbol GABC. The quarterly high and low closing prices for the Company’s common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the table below. All per share data are retroactively restated for all stock dividends.
2002 2001
---- ----
Cash Cash
High Low Dividend High Low Dividend
---- --- -------- ---- --- --------
Fourth Quarter $18.00 $15.26 $0.133 $17.62 $14.01 $0.127
Third Quarter $17.71 $15.42 $0.133 $17.24 $13.65 $0.127
Second Quarter $17.62 $15.24 $0.133 $14.60 $10.93 $0.127
First Quarter $16.43 $15.05 $0.133 $14.60 $11.00 $0.127
$0.532 $0.508
====== ======
The Common Stock was held of record by approximately 3,300 shareholders at March 1, 2003.
Cash dividends paid to the Company’s shareholders are primarily funded from dividends received by the Company from its subsidiaries. The Company presently intends to follow its historical policy as to the amount, timing and frequency of the payment of cash and stock dividends. The declaration and payment of future dividends, however, will depend upon the earnings and financial condition of the Company and its subsidiaries, general economic conditions, compliance with regulatory requirements, and other factors.
| Transfer Agent: |
UMB Bank, N.A. Securities Transfer Division P.O. Box 410064 Kansas City, MO 64141-0064 Contact: Shareholder Relations (800) 884-4225 |
|
Shareholder Information and Corporate Office: |
Terri A. Eckerle German American Bancorp P. O. Box 810 Jasper, Indiana 47547-0810 (812) 482-1314 (800) 482-1314 |
– 7 –
Item 6. Selected Financial Data.
The following selected data should be read in conjunction with the consolidated financial statements and related notes that are included in Item 8 of this report, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is included in Item 7 of this report (Dollars in thousands except per share data).
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Summary of Operations:
Interest Income........................ $ 60,494 $ 71,069 $ 79,319 $ 72,135 $ 69,188
Interest Expense....................... 28,558 38,917 45,646 37,744 36,315
----------- ----------- ----------- ----------- ------------
Net Interest Income................ 31,936 32,152 33,673 34,391 32,873
Provision for Loan Losses.............. 1,115 660 2,231 1,749 1,344
----------- ----------- ----------- ----------- ------------
Net Interest Income after Provision
For Loan Losses.................... 30,821 31,492 31,442 32,642 31,529
Non-interest Income.................... 9,509 9,772 2,543(1) 6,385 5,249
Non-interest Expense.................. 28,901 29,308 28,238 26,357 23,751
----------- ----------- ----------- ----------- ------------
Income before Income Taxes............ 11,429 11,956 5,747 12,670 13,027
Income Tax Expense.................... 1,987 2,763 459 3,316 3,805
----------- ----------- ----------- ----------- ------------
Net Income............................ $ 9,442 $ 9,193 $ 5,288 $ 9,354 $ 9,222
=========== =========== =========== =========== ============
======================================================================================================================
Year-end Balances:
Total Assets.......................... $ 957,005 $ 1,015,111 $ 1,079,808 $ 1,056,641 $ 952,930
Total Loans, Net of Unearned Income... 610,741 657,166 709,744(1) 741,609 639,816
Total Deposits........................ 707,194 726,874 735,570 751,428 714,779
Total Long-term Debt................... 121,687 156,726 182,370 126,902 124,381
Total Shareholders' Equity............ 104,519 102,209 97,260 93,685 97,153
======================================================================================================================
Average Balances:
Total Assets.......................... $ 1,000,167 $ 1,014,917 $ 1,070,093 $ 999,761 $ 919,750
Total Loans, Net of Unearned Income... 644,990 704,562 766,533(1) 691,250 628,254
Total Deposits........................ 718,763 718,160 749,235 743,153 700,400
Total Shareholders' Equity............ 103,301 100,232 95,788 97,855 94,323
======================================================================================================================
Per Share Data (2):
Net Income............................. $ 0.82 $0.79 $0.46 $0.80 $ 0.79
Cash Dividends(3)...................... 0.53 0.51 0.47 0.42 0.37
Book Value at Year-end................. 9.12 8.82 8.41 8.12 8.34
======================================================================================================================
Other Data at Year-end:
Number of Shareholders................. 3,299 3,314 3,208 3,192 3,202
Number of Employees.................... 390 422 405 416 388
Weighted Average Number of Shares (2).. 11,486,776 11,572,927 11,554,395 11,701,166 11,711,966
======================================================================================================================
Selected Performance Ratios:
Return on Assets....................... 0.94% 0.91% 0.49% 0.94% 1.00%
Return on Equity....................... 9.14% 9.17% 5.52% 9.56% 9.78%
Equity to Assets....................... 10.92% 10.07% 9.01% 8.87% 10.20%
Dividend Payout........................ 64.99% 63.98% 98.54% 50.04% 36.09%
Net Charge-offs to Average Loans....... 0.19% 0.22% 0.27% 0.23% 0.27%
Allowance for Loan Losses to Loans..... 1.36% 1.27% 1.31% 1.23% 1.34%
Net Interest Margin.................... 3.68% 3.62% 3.57% 3.87% 4.02%
| (1) |
In 2000, the Company reclassified $69.8 million of sub-prime, out-of-market
residential mortgage loans as held-for-sale. The difference between book value
and market value resulted in a $5.2 million allowance for market loss on loans
held-for-sale. |
| (2) |
Share and Per Share Data has been retroactively adjusted to give effect for
stock dividends and excludes the dilutive effect of stock options. |
| (3) |
Cash Dividends represent historical dividends declared per share without
retroactive restatement for business combination transactions accounted for
under the pooling of interests method of accounting. |
If, and to the extent that, the Company purchases after March 14, 2003, a material number of the 1,000,000 (or more) shares that it may purchase pursuant to its pending self tender offer, the Company’s financial condition and its future results of operations, capital resources and liquidity will be materially affected. For a discussion of the pending tender offer, the Company’s source of funds and possible borrowing plans in connection with such purchase, and the possible financial effects of the purchase of shares pursuant to the offer (including possible effects on certain of the per share data and performance ratios that are presented in the above table), see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Expected Effects of Purchase of Shares Pursuant to Tender Offer.” Readers are cautioned that the data set forth is not intended to be indicative of the Company’s future financial condition and results of operations, capital resources or liquidity, and that the uncertainties relating to the pending self tender offer should be considered in connection with evaluating any trends that may be indicated by that data.
– 8 –
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
FORWARD-LOOKING STATEMENTS
This Item contains statements relating to future results of the Company and its future financial conditions, capital resources and liquidity that are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Readers are cautioned that actual future experiences or conditions may differ materially from those expressed or implied therein as a result of certain risks and uncertainties, including those risks and uncertainties expressed in this Item 7 and those risks and uncertainties that are described in Item 1 of this report, “Business,” under the caption “Forward-Looking Statements,” which is incorporated herein by reference.
INTRODUCTION AND OVERVIEW
German American Bancorp (“the Company”) is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s National Market System under the symbol GABC. The Company operates five affiliated community banks with 26 retail banking offices in the eight contiguous Southwestern Indiana counties of Daviess, Dubois, Gibson, Knox, Martin, Perry, Pike, and Spencer and a business lending center in Evansville, Indiana. The Company also operates a trust, brokerage and financial planning subsidiary which operates from the banking offices of the bank subsidiaries, and two insurance agencies with four insurance agency offices throughout its market area. The Company’s lines of business include retail and commercial banking, mortgage banking, comprehensive financial planning, full service brokerage and trust administration, title insurance, and a full range of personal and corporate insurance products.
The information in this Management’s Discussion and Analysis is presented as an analysis of the major components of the Company’s operations for the years 2000 through 2002 and its financial condition as of December 31, 2002 and 2001. This information should be read in conjunction with the accompanying consolidated financial statements and footnotes contained elsewhere in this report, and with the description of business included in Item 1 of this Report, in particular the description in such Item 1 of the pending self tender offer that is included under the subheading “Recent Development: Self Tender Offer.” Financial and other information by segment is included in Note 16 – Segment Information of the Notes to the Consolidated Financial Statements included in Item 8 of this Report and is incorporated into this Item 7 by reference.
MERGERS AND ACQUISITIONS
There were no significant banking merger and acquisition transactions completed during 2002 or 2001. In October 2000, the Company completed a merger with Holland Bancorp, Inc. Holland Bancorp was merged with and into the Company, with the simultaneous merger of Holland’s sole bank subsidiary, The Holland National Bank, into the Company’s subsidiary, The German American Bank. The Holland National Bank operated four banking offices in Dubois County, Indiana. This merger was accounted for as a pooling of interests and prior period financial information has been restated accordingly.
There have been several insurance acquisition transactions during the periods 2000 through 2002. These transactions are detailed in Note 18 – Business Combinations of the Notes to the Consolidated Financial Statements included in this Report.
RESULTS OF OPERATIONS
NET INCOME
In 2002, the Company earned net income of $9,442,000 or $0.82 per share. Earnings for 2002 increased by approximately 3% from the $9,193,000 or $0.79 per share reported for 2001. The Company’s 2002 earnings increase was generated primarily by the Company’s core banking segment. German American’s mortgage banking operations were adversely affected during the fourth quarter 2001 and throughout 2002 due to the impact of historic low levels of interest rates on the valuation of mortgage servicing rights and net interest income. The mortgage banking segment experienced net losses of $963,000 during 2002 compared to nearly break-even results in 2001 of $28,000 net income.
– 9 –
In 2001, earnings increased by $3,905,000, or 74%, from the $5,288,000, or $0.46 per share reported for 2000. Significantly contributing to the increase in earnings was $3,152,000 of after-tax charges recorded in 2000 related to a balance sheet restructuring which occurred late in the fourth quarter of 2000 as described below. The increase in 2001 net income was largely fueled by increases in insurance revenues and mortgage banking revenues and a decrease in provision for loan losses. The increase in the non-interest revenue sources helped to mitigate a decline of $1.5 million, or 5% in net interest income.
Late in the fourth quarter of 2000, the Company initiated a repositioning of its balance sheet within the mortgage banking component of the Company’s operations. Approximately $69.8 million of sub-prime, out-of–market mortgage loans were reclassified as held-for-sale in December 2000. The sale of these loans was completed in February 2001.
For a discussion of the expected effect on the Company’s net income, and net income per share, that may result in the event that the Company purchases a material number of shares of its common stock pursuant to its pending self tender offer, see “Expected Effects of Purchase of Shares Pursuant to Tender Offer,” below, in this Item 7.
NET INTEREST INCOME
Net interest income is the Company’s single largest source of earnings, and represents the difference between interest and fees realized on earning assets, less interest paid on deposits and borrowed funds. Several factors contribute to the determination of net interest income and net interest margin, including the volume and mix of earning assets, interest rates, and income taxes. Many factors affecting net interest income are subject to control by management policies and actions. Factors beyond the control of management include the general level of credit and deposit demand, Federal Reserve Board monetary policy, and changes in tax laws.
Net interest income declined modestly during 2002 by $216,000 or 1% (an increase of $5,000 on a tax equivalent basis) compared with 2001. Net interest margin is tax-equivalent net interest income expressed as a percentage of average earning assets. For 2002 the net interest margin improved to 3.68% compared with 3.62% for 2001.
The improvement in net interest margin in 2002 was primarily attributable to the historically low interest rate environment that enabled the Company to significantly lower its cost of funds. The maturity of higher costing borrowed funds coupled with an increase in transaction deposits (savings, money market, and demand deposit accounts) were the most significant factors in the lower cost of funds. An overall decline in interest earning assets primarily due to a lower level of residential mortgage loans and the effects of the low interest rate environment on loan and security yields tempered the effects of the lower cost of funds during 2002.
The Company’s net interest income has been negatively impacted by the Company’s mortgage banking segment. The mortgage banking segment’s net interest income declined by $1.9 million during 2002 compared with 2001. The decline resulted from the sale of sub-prime residential real estate loans in 2001 combined with the prepayment of a significant amount of the segment’s portfolio loans and the continued sale of a majority of the Company’s residential real estate production to the secondary market. In contrast, the core banking segment’s net interest income increased $1.8 million during 2002, primarily due to the decrease in the cost of funds discussed above.
The Company has re-invested some assets that resulted from the decline in loans in its mortgage banking segment in shorter-term investment securities. The Company expects to apply the proceeds from the sale or redemption of approximately $27 million of these investment securities to retire certain FHLB advances. In the aggregate, the mortgage banking segment has approximately $58 million of FHLB advances that mature in 2003, 2004, and 2005. The interest rates payable by the Company on these long-term FHLB advances have been higher than the yields that have been earned by the Company on the shorter-term investments that have been internally matched to the repayment of those advances, resulting in a “negative interest spread” on this portion of the mortgage banking segment’s balance sheet and a consequent negative impact on the segment’s net interest income. See Note 8 for a discussion of the cost of FHLB advances. A portion of these shorter-term investments were used in December 2002 to retire $26 million of FHLB advances that matured in December 2002 or were scheduled to mature in January 2003. This $26 million portion of the segment’s balance sheet carried an approximately 4% negative interest spread during a significant period of 2002.
During 2001, net interest income declined $1,521,000 or 5% ($1,364,000 or 4% on a tax equivalent basis) compared with 2000. The net interest margin for 2001 improved modestly from the 3.57% in 2000. The decline in the Company’s net interest income during 2001 was largely attributable to a decline in the overall level of interest earning assets and an increase in federal funds sold and other short-term investments. The decline in interest earning assets was attributable to the call of investment securities during the first half of 2001, refinance activity in the residential real estate loan portfolio, and the aforementioned sale of sub-prime residential real estate loans.
Average loans outstanding (including loans held-for-sale) declined $59.6 million during 2002 compared with 2001. The decline in loans is attributable primarily to a significant reduction in the Company’s residential mortgage loan portfolio. This reduction is attributable to the refinance activity in the residential loan industry that has been fueled by the historically low interest rate environment and the Company’s continued sale of a majority of residential loan production to the secondary market. Residential loans declined $92.2 million during 2002. Mitigating the decline in residential loans has been growth in the commercial loan portfolio of $45.6 million during 2002.
– 10 –
Average loans outstanding (including loans held-for-sale) declined $62.0 million during 2001 compared with 2000. The sale of sub-prime residential mortgage loans previously discussed was a significant factor in the reduced level of average loans outstanding. Also contributing to the decline in average loans outstanding during 2001 has been the sale of a majority of the Company’s residential loan production to the secondary market.
The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years. For tax-equivalent adjustments, an effective tax rate of 34% was used for all years presented (1).
Average Balance Sheet
(Tax-equivalent basis / dollars in thousands)
Twelve Months Ended Twelve Months Ended Twelve Months Ended
December 31, 2002 December 31, 2001 December 31, 2000
Principal Income/ Yield/ Principal Income/ Yield/ Principal Income/ Yield/
Balance Expense Rate Balance Expense Rate Balance Expense Rate
------- ------- ---- ------- ------- ---- ------- ------- ----
ASSETS
Federal Funds Sold and Other
Short-term Investments..... $ 45,531 $ 754 1.66% $ 63,197 $ 2,093 3.31% $ 8,843 $ 496 5.61%
Securities:
Taxable.................... 155,784 7,144 4.59% 106,756 6,868 6.43% 160,653 11,195 6.97%
Non-taxable................ 87,380 6,248 7.15% 74,568 5,550 7.44% 66,345 5,230 7.88%
Total Loans and Leases (2).... 644,990 48,654 7.54% 704,562 58,643 8.32% 766,533 64,326 8.39%
---------- ------- ---------- ------- ---------- -------
TOTAL INTEREST
EARNING ASSETS............. 933,685 62,800 6.73% 949,083 73,154 7.71% 1,002,374 81,247 8.11%
---------- ------- ---------- ------- ---------- -------
Other Assets.................. 74,786 74,744 76,851
Less: Allowance for Loan Losses (8,304) (8,910) (9,132)
---------- ---------- ----------
TOTAL ASSETS.................. $1,000,167 $1,014,917 $1,070,093
========== ========== ==========
LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest Bearing Demand Deposits $ 99,781 $ 775 .78% $ 91,002 $ 1,379 1.52% $ 71,996 $ 1,173 1.63%
Savings Deposits.............. 143,318 1,941 1.35% 124,164 3,317 2.67% 122,691 4,644 3.79%
Time Deposits................. 380,249 15,960 4.20% 413,060 22,769 5.51% 468,048 26,349 5.63%
FHLB Advances and
Other Borrowings........... 165,247 9,882 5.98% 185,384 11,452 6.18% 213,792 13,480 6.31%
---------- ------- ---------- ------- ---------- -------
TOTAL INTEREST-BEARING
LIABILITIES................ 788,595 28,558 3.62% 813,610 38,917 4.78% 876,527 45,646 5.21%
---------- ------- ---------- ------- ---------- -------
Demand Deposit Accounts....... 95,415 89,934 86,500
Other Liabilities............. 12,856 11,141 11,278
TOTAL LIABILITIES............. 896,866 914,685 974,305
---------- ---------- ----------
Shareholders' Equity.......... 103,301 100,232 95,788
---------- ---------- ----------
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY....... $1,000,167 $1,014,917 $1,070,093
========== ========== ==========
NET INTEREST INCOME........... $34,242 $34,237 $35,601
======= ======= =======
NET INTEREST MARGIN........... 3.68% 3.62% 3.57%
| (1) |
Effective tax rates were determined as though interest earned on the Company's
investments in municipal bonds and loans was fully taxable.
|
| (2) |
Loans held-for-sale and non-accruing loans have been included in average loans.
Interest income on loans includes loan fees of $1,184, $958, and $952 for 2002,
2001, and 2000, respectively.
|
– 11 –
The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates:
Net Interest Income - Rate/Volume Analysis:
(Tax-Equivalent basis, dollars in thousands)
2002 compared to 2001 2001 compared to 2000
Increase/(Decrease) Due to(1) Increase/(Decrease) Due to(1)
-------------------------- --------------------------
Volume Rate Net Volume Rate Net
------ ---- --- ------ ---- ---
Interest Income:
Federal Funds Sold and Other
Short-term Investments............. $ (480) $ (859) $ (1,339) $ 1,878 $ (281) $ 1,597
Taxable Securities..................... 2,597 (2,321) 276 (3,521) (806) (4,327)
Nontaxable Securities ................. 923 (225) 698 623 (303) 320
Loans and Leases....................... (4,738) (5,251) (9,989) (5,162) (521) (5,683)
------- ------- -------- ------- ------- -------
Total Interest Income..................... (1,698) (8,656) (10,354) (6,182) (1,911) (8,093)
------- ------- -------- ------- ------- -------
Interest Expense:
Savings and Interest-bearing Demand.... 547 (2,527) (1,980) 566 (1,687) (1,121)
Time Deposits.......................... (1,701) (5,108) (6,809) (3,041) (539) (3,580)
FHLB Advances and Other Borrowings..... (1,213) (357) (1,570) (1,760) (268) (2,028)
------- ------- -------- ------- ------- -------
Total Interest Expense.................... (2,367) (7,992) (10,359) (4,235) (2,494) (6,729)
------- ------- -------- ------- ------- -------
Net Interest Income....................... $ 669 $ (664) $ 5 $(1,947) $ 583 $(1,364)
======= ======= ======== ======= ======= =======
| (1) | The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. |
See the Company’s Average Balance Sheet and the discussions headed USES OF FUNDS, SOURCES OF FUNDS, AND LIQUIDITY AND INTEREST RATE RISK MANAGEMENT for further information on the Company’s net interest income, net interest margin, and interest rate sensitivity position.
PROVISION FOR LOAN LOSSES
The Company provides for loan losses through regular provisions to the allowance for loan losses, which totaled $1,115,000, $660,000, and $2,231,000 2002, 2001 and 2000, respectively. These provisions were made at a level deemed necessary by management to absorb estimated, probable incurred losses in the loan portfolio. The higher level of provision during 2002 relates primarily to estimated losses in the Company’s loan portfolio and the general increase in the Company’s commercial loan portfolio. The lower level of provision during 2001 was primarily a result of the liquidation of the Company’s sub-prime, out-of-market residential mortgage loan portfolio. The higher provision in 2000 was due to an increase in estimated losses related to the mortgage division’s sub-prime, out-of-market residential mortgage loan portfolio and overall loan growth throughout the Company. As discussed previously, the Company sold its sub-prime, out-of-market residential real estate portfolio in February 2001, and the Company no longer originates these types of loans.
A detailed evaluation of the adequacy of the allowance for loan losses is completed quarterly by management, the results of which will be used to determine provisions for loan losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Refer also to the section entitled LENDING AND LOAN ADMINISTRATION for further discussion of the provision and allowance for loan losses.
NON-INTEREST INCOME
Non-interest income declined 3% in 2002. This decrease was primarily attributable to a decline in the Company’s insurance revenues. Non-interest income, excluding securities gains (losses) and the net gains on sales of loans and related assets and provision for losses on loans held-for-sale, increased $713,000 or 9% in 2001. Increases in the Company’s insurance revenues and an increased level of service charge income on deposit accounts resulted in the overall increase in 2001. Total non-interest income, inclusive of asset sale gains, increased 284% during 2001. The fluctuation in 2001 was primarily attributable to the provision for losses on loans held-for-sale related to the mortgage division’s sub-prime, out-of-market residential mortgage loans that were reclassified as held-for-sale in December 2000 and sold in February 2001.
– 12 –
% Change From
Non-interest Income (dollars in thousands)
Prior Year
2002 2001 2000 2002 2001
---- ---- ---- ---- ----
Trust and Investment Product Fees....................... $ 1,419 $ 1,290 $ 1,373 10% (6)%
Service Charges on Deposit Accounts..................... 2,574 2,485 2,139 4 16
Insurance Revenues...................................... 2,818 3,275 2,723 (14) 20
Other Operating Income.................................. 1,056 1,212 1,314 (13) (8)
------- -------- --------
Subtotal ........................................... 7,867 8,262 7,549 (5) 9
Net Gains (Losses) on Sales of Loans, Related Assets,
and Provision for Losses on Loans Held-for-Sale..... 1,625 1,509 (4,998) 8 n/m(1)
Securities Gains (Losses), net.......................... 17 1 (8) 1600 113
------- -------- --------
TOTAL NON-INTEREST INCOME........................... $ 9.509 $ 9,772 $ 2,543 (3) 284
======= ======== ========
(1) n/m = not meaningful
Insurance Revenues decreased 14% in 2002. The decline in Insurance Revenues resulted from a decline in contingency income from the Company’s property and casualty insurance operations and a decline in revenues generated by the Company’s credit reinsurance operations. Contingency income will fluctuate, as it represents amounts received from insurance companies based on claims experience. The decline in credit insurance and reinsurance revenues is largely attributable to a decline in consumer loan production and credit insurance sales penetration.
Insurance Revenues increased 20% in 2001 due primarily to the expansion of the Company’s property and casualty insurance operations. In addition, Insurance Revenues increased in 2001 due to the initiation during 2000 of the Company’s credit life and disability reinsurance operation through German American Reinsurance Company, Ltd (GARC).
Service Charges on Deposit Accounts increased 4% and 16% in 2002 and 2001, respectively. A change in fee structure implemented mid-year 2001 and a general increase in collections of fees were generally responsible for these increases.
German American Financial Advisors & Trust Company (GAFA) was formed mid-year 2002 to provide expanded financial planning, full service brokerage, trust administration and other financial services. The formation of GAFA provides customers an enhanced ability to fulfill all their financial needs through the Company’s affiliate banks and associated financial services companies. Trust and Investment Product Fees increased 10% in 2002 after a decrease in 2001 of 6%.
Other Operating Income decreased 13% and 8% in 2002 and 2001, respectively. The declines were primarily the result of increased impairment adjustments on the mortgage banking segment’s mortgage servicing rights portfolio. The increased impairment adjustments are due to the historically low levels of mortgage loan rates and the significant refinance activity in the residential mortgage loan industry.
Net gains on sales of loans and related assets, and the provision for losses on loans held-for-sale are derived from the Company’s core banking and mortgage banking segments. The gain on sale of loans and related assets increased 8% in 2002. Historically low interest rates have fueled relatively strong mortgage loan sales during 2002 and 2001. Loan sales remained stable in 2002 at $134.2 million compared to $135.3 million in 2001 (excluding the sub-prime sale discussed previously). Loan sales in 2000 were $31.1 million.
Net Gains (Losses) on Sales of Loans, Related Assets, and Provision for Losses on Loans Held-for-Sale increased $1,287,000 (exclusive of the sub-prime sale) in 2001. This increase was due to the significant increase in loan sales to the secondary market. The provision for losses on loans held-for-sale on the market adjustment of sub-prime loans reclassified in December 2000 totaled $5,220,000 resulting in the net loss on sales of loans, related assets, and provision for losses on loans held-for-sale of $4,998,000 during 2000.
– 13 –
NON-INTEREST EXPENSE
Non-interest expense decreased $407,000 or 1% in 2002 following an increase of $1,070,000 or 4% during 2001. The decline in 2002 resulted primarily from decreased Other Operating Expenses and Advertising Expenses tempered by an increase in Salaries and Employee Benefits. The increase in 2001 resulted largely from increased personnel costs.
% Change From
Non-interest Expense (dollars in thousands) Prior Year
2002 2001 2000 2002 2001
---- ---- ---- ---- ----
Salaries and Employee Benefits....................... $17,443 $16,669 $15,454 5% 8%
Occupancy, Furniture and Equipment Expense........... 4,050 3,866 3,900 5 (1)
FDIC Premiums........................................ 128 163 187 (21) (13)
Data Processing Fees................................. 1,098 1,126 884 (2) 27
Professional Fees ................................... 1,170 950 1,333 23 (29)
Advertising and Promotion............................ 738 1,014 870 (27) 17
Supplies............................................. 660 721 798 (8) (10)
Other Operating Expenses............................. 3,614 4,799 4,812 (25) ---
------- ------- ------- - -
TOTAL NON-INTEREST EXPENSE....................... $28,901 $29,308 $28,238 (1) 4
======= ======= =======
Salaries and Employee Benefits comprised approximately 61% of total non-interest expense in 2002, 57% in 2001, and 55% in 2000. The increases as a percentage of non-interest expenses are primarily the result of lower non-interest expenses exclusive of Salaries and Employee Benefits. Salaries and Employee Benefits increased 5% in 2002 and 8% in 2001. In 2002, the increase in Salaries and Employee Benefits was driven by increases in salary and retirement expenses, incentive compensation and employee insurance benefits. The increases in salary and retirement benefits were attributable to adjustments occurring in the normal course of operations. Significant earnings improvements in the company’s core banking segment resulted in increased employee incentive compensation. In 2001, the increase in Salaries and Employee Benefits was attributed to two primary factors. The Company transitioned to a pay-for-performance incentive plan in late 2000 and 2001 resulting in increased incentive compensation expense while salary expense remained flat. In addition, employee insurance benefit costs increased 17% during 2001.
Professional Fees increased 23% during 2002 following a decrease of 29% in 2001. A significant amount of increased professional fees in 2002 resulted from the formation of investment subsidiaries domiciled in the state of Nevada by four of the Company’s subsidiary banks. The increased Professional Fees expense was for investment portfolio management services and subsidiary management services provided by third parties. The level of Professional Fees decreased during 2001 due in large part to the merger and acquisition activities in late 2000.
Data Processing Fees remaining relatively flat in 2002. During 2001, Data Processing Fees increased $242,000 or 27%. This level of increase is due to a general rise in the number of accounts serviced by the Company’s third party data processor and an increase in fees associated with the electronic banking services provided to the Company’s customers.
Advertising and Promotion expense decreased 27% during 2002. This decline was attributable to the initiation of an image campaign by the Company in the first quarter of 2001 and generally a lower level of advertising and promotional spending in 2002. Advertising and Promotion expense increased 17% in 2001 due in large part to the introduction of the image campaign previously discussed.
Other Operating Expenses decreased 25% in 2002. This decrease was the result of several factors. The Company experienced a lower level of operating losses from its affordable housing tax credit limited partnership investments, reduced collection costs in the Company’s mortgage banking segment and a decreased allowance for insurance reserves required by the company’s credit reinsurance subsidiary. In addition, the Company recognized a lower level of amortization expense for intangible assets in 2002. The decline in amortization expense for intangible assets resulted from the Company’s adoption of new accounting guidance in 2002. The Company ceased amortizing goodwill as a result of this accounting change. Goodwill will be assessed at least annually for impairment and any such impairment will be recognized in the period identified.
Other Operating Expenses remained flat in 2001 compared with 2000. Collection costs declined $209,000 or 33% during 2001 due primarily to the sale of the mortgage division’s sub-prime residential real estate loan portfolio in early 2001. The decline in collection costs was in large part offset by the building of insurance reserves for the Company’s credit reinsurance subsidiary.
– 14 –
PROVISION FOR INCOME TAXES
The Company records a provision for current income taxes payable, along with a provision for deferred taxes payable in the future. Deferred taxes arise from temporary differences, which are items recorded for financial statement purposes in a different period than for income tax returns. The Company’s effective tax rate was 17.4%, 23.1%, and 8.0%, respectively, in 2002, 2001, and 2000. The effective tax rate in all periods is lower than the blended statutory rate of 39.6%. The lower effective rate in all periods primarily resulted from the Company’s tax-exempt investment income on securities and loans, and from income tax credits generated by investments in affordable housing projects. Also contributing to the lower effective tax rate in 2002 compared with 2001 was state income tax savings resulting from the formation of investment subsidiaries domiciled in the state of Nevada by four of the Company’s banking subsidiaries. The lower effective tax rate in 2000 compared with the other years presented was attributable to a lower level of taxable income due primarily to the provision for losses on loans held-for-sale. Note 11 to the consolidated financial statements provides additional details relative to the Company’s income tax provision.
CAPITAL RESOURCES
The Company and affiliate banks are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. The prompt corrective action regulations provide five classifications, including well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. The Company and all affiliate Banks at year-end 2002 were categorized as well-capitalized. See Note 9 to the Consolidated Financial Statements for actual and required capital ratios.
The Company continues to maintain a strong capital position. Shareholders’ equity totaled $104.5 million and $102.2 million at December 31, 2002 and 2001, respectively. Total equity represented 10.9% and 10.1%, respectively, of year-end total assets. The $2.3 million increase in shareholder’s equity was primarily attributable to retained earnings generated by the Company’s affiliate banks and insurance companies and an increase in market value of the Company’s securities available-for-sale.
The Company paid cash dividends of $6.1 million in 2002 and $5.9 million in 2001. The increase in 2002 dividends paid was primarily attributable to an increased number of shares outstanding arising from the Company’s 5% stock dividend declarations.
For a discussion of the expected effect on the Company’s capital resources and liquidity that may result in the event that the Company purchases a material number of shares of its common stock pursuant to its pending self tender offer, see “Expected Effects of Purchase of Shares Pursuant to Tender Offer,” below, in this Item 7.
USES OF FUNDS
LOANS
Total loans at year-end 2002 declined by $45.7 million or 7%. This decline was primarily isolated to the Company’s residential loan portfolio. Residential mortgage loans declined $71.3 million or 31%. The Company sold a majority of new residential loan production in the secondary market during 2002. The Company’s commercial and industrial loan portfolio increased $24.9 million or 11% while agricultural and poultry loans increased $7.6 million or 10%. Consumer loans declined $6.9 million or 6% during 2002.
During 2001, total loans declined by $52.2 million or 7%. As previously stated for 2002, the decline during 2001 was primarily isolated to the Company’s residential loan portfolio as a result of the sale of a majority of new residential loan production in the secondary market. Residential mortgage loans declined $84.7 million or 27%. The Company’s commercial and industrial loan portfolio increased $39.7 million or 21%. Consumer loans declined $11.8 million or 9% during 2001.
– 15 –
The Company’s loan portfolio is diversified, with the heaviest concentrations in commercial and industrial loans. The Company’s commercial lending is extended to various industries, including hotel, agribusiness and manufacturing, as well as health care, wholesale, and retail services. The Company’s concentration in residential mortgage loans has declined over the past three years due in large part to historically low interest rate environment causing significant refinance activity within the portfolio and the continued sale of a majority of residential loan production in the secondary market.
Loan Portfolio December 31,
dollars in thousands 2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Residential Mortgage Loans................. $156,180 $227,502 $312,199 $388,514 $323,045
Agricultural and Poultry................... 86,264 78,675 74,111 65,098 64,195
Commercial and Industrial Loans............ 252,744 227,872 188,213 166,476 141,031
Consumer Loans............................. 116,987 123,840 135,596 121,865 112,254
-------- -------- -------- -------- --------
Total Loans............................. 612,175 657,889 710,119 741,953 640,525
Less: Unearned Income................... (1,434) (723) (375) (344) (709)
-------- -------- -------- -------- --------
Subtotal................................ 610,741 657,166 709,744 741,609 639,816
Less: Allowance for Loan Losses......... (8,301) (8,388) (9,274) (9,101) (8,559)
-------- -------- -------- -------- --------
Loans, net.............................. $602,440 $648,778 $700,470 $732,508 $631,257
======== ======== ======== ======== ========
Ratio of Loans to Total Loans:
Residential Mortgage Loans................. 26% 34% 44% 52% 50%
Agricultural and Poultry................... 14% 12% 10% 9% 10%
Commercial and Industrial Loans............ 41% 35% 27% 23% 22%
Consumer Loans............................. 19% 19% 19% 16% 18%
-------- -------- -------- -------- --------
Totals.................................. 100% 100% 100% 100% 100%
=== === === === ===
The Company’s policy is generally to extend credit to consumer and commercial borrowers in its primary geographic market area in Southwestern Indiana. Commercial extensions of credit outside this market area are generally concentrated in real estate loans within a 120 mile radius of the Company’s primary market and are granted on a selective basis.
The following table indicates the amounts of loans (excluding residential mortgages on 1-4 family residences and consumer loans) outstanding as of December 31, 2002 which, based on remaining scheduled repayments of principal, are due in the periods indicated (dollars in thousands).
Within One to After
One Year Five Years Five Years Total
-------- ---------- ---------- -----
Commercial, Agricultural and Poultry............. $94,480 $122,649 $121,879 $339,008
Interest Sensitivity
Fixed Rate Variable Rate
---------- -------------
Loans maturing after one year.................... $51,632 $192,896
INVESTMENTS
The investment portfolio is a principal source for funding the Company’s loan growth and other liquidity needs of its subsidiaries. The Company’s securities portfolio consists of money market securities, uncollateralized U.S. Treasury and federal agency securities, municipal obligations of state and political subdivisions, asset- / mortgage-backed securities issued by U.S. government agencies and other intermediaries, and corporate investments. Money market securities include federal funds sold, interest-bearing balances with banks, and other short-term investments. The composition of the year-end balances in the investment portfolio is presented in Note 2 to the Consolidated Financial Statements and in the table below:
Investment Portfolio, at Amortized Cost December 31,
dollars in thousands 2002 % 2001 % 2000 %
---- - ---- - ---- -
Federal Funds Sold and Short-term Investments.... $ 8,118 3% $ 62,534 25% $ 2,955 1%
U.S. Treasury and Agency Securities.............. 9,500 4 3,000 1 96,315 44
Obligations of State and Political Subdivisions.. 67,216 27 76,546 30 54,150 25
Asset-/Mortgage-backed Securities................ 143,247 57 93,491 37 52,365 24
Corporate Securities............................. 4,990 2 --- N/A --- N/A
Equity Securities................................ 16,809 7 16,813 7 12,077 6
-------- --- -------- --- -------- ---
Total Securities Portfolio................... $249,880 100% $252,384 100% $217,862 100%
======== === ======== === ======== ===
– 16 –
The amortized cost of investment securities, exclusive of federal funds sold and short-term investments, increased $51.9 million to $241.8 million at year-end 2002 compared with $189.9 million at year-end 2001. The majority of this increase was the result of the significant decline in federal funds sold and short-term investments. The primary focus of the investment portfolio purchases during 2002 was in mortgage related securities, thereby significantly increasing the allocation of these types of securities in the overall portfolio. The mortgage related securities were purchased to provide structured cash flows in the current historically low interest rate environment.
The composition of the investment portfolio changed significantly during 2001. The overall decline and the significant change in U.S. Treasury and Agency securities was the result of the call and redemption of virtually all securities in this category during 2001. As these funds, along with other cash flows generated by the investment portfolio were reinvested during 2001, the composition of the portfolio changed. The funds were used to reinvest in tax advantaged obligations of state and political subdivisions and tax advantaged equity securities issued by U.S. governmental agencies. In addition, the funds were reinvested in asset-/mortgage-backed securities to provide structured cash flows.
Investment Securities, at Carrying Value
dollars in thousands
December 31,
2002 2001 2000
---- ---- ----
Securities Held-to-Maturity:
- ----------------------------
U.S. Treasury and other U.S.
Government Agencies and Corporations.................... $ --- $ --- $ ---
State and Political Subdivisions............................. 20,833 23,056 28,093
Asset-/Mortgage-backed Securities............................ --- --- 361
-------- -------- --------
Subtotal of Securities Held-to-Maturity................. 20,833 23,056 28,454
-------- -------- --------
Securities Available-for-Sale:
U.S. Treasury and other U.S.
Government Agencies and Corporations.................... $ 9,535 $ 3,039 $ 95,102
State and Political Subdivisions............................. 47,610 53,893 26,669
Asset-/Mortgage-backed Securities............................ 145,485 94,272 51,336
Corporate Securities......................................... 4,990 --- ---
Equity Securities............................................ 16,228 16,890 12,081
-------- -------- --------
Subtotal of Securities Available-for-Sale............... 223,848 168,094 185,188
-------- -------- --------
Total Securities.................................... $244,681 $191,150 $213,642
======== ======== ========
The Company’s $223.9 million available-for-sale portion of the investment portfolio provides an additional funding source for the liquidity needs of the Company’s subsidiaries and for asset/liability management requirements. Although management has the ability to sell these securities if the need arises, their designation as available-for-sale should not be interpreted as an indication that management anticipates such sales.
SOURCES OF FUNDS
The Company’s primary source of funding is its base of core customer deposits. Core deposits consist of demand deposits, savings, interest-bearing checking, money market accounts, and certificates of deposit of less than $100,000. Other sources of funds are certificates of deposit of $100,000 or more, brokered deposits, overnight borrowings from other financial institutions and securities sold under agreement to repurchase. The membership of the Company’s affiliate banks in the Federal Home Loan Bank System (FHLB) provides a significant additional source for both long and short-term collateralized borrowings. The following pages contain a discussion of changes in these areas.
– 17 –
The table below illustrates changes between years in the average balances of all funding sources:
Funding Sources - Average Balances % Change From
dollars in thousands Prior Year
2002 2001 2000 2002 2001
---- ---- ---- ---- ----
Demand Deposits
Non-interest Bearing............... $ 95,415 $ 89,934 $ 86,500 6% 4%
Interest Bearing................... 99,781 91,002 71,996 10 26
Savings Deposits....................... 55,056 49,071 51,073 12 (4)
Money Market Accounts.................. 88,262 75,093 71,618 18 5
Other Time Deposits.................... 321,911 347,969 349,675 (7) ---
-------- -------- --------
Total Core Deposits................ 660,425 653,069 630,862 1 4
Certificates of Deposits of $100,000 or
more and Brokered Deposits......... 58,338 65,091 118,373 (10) (45)
FHLB Advances and
Other Borrowings................... 165,247 185,384 213,792 (11) (13)
-------- -------- --------
Total Funding Sources.............. $884,010 $903,544 $963,027 (2) (6)
======== ======== ========
Maturities of time certificates of deposit of $100,000 or more are summarized as follows:
3 Months 3 thru 6 thru Over
Or Less 6 Months 12 Months 12 Months Total
------- -------- --------- --------- -----
December 31, 2002...................... $20,981 $4,300 $7,219 $24,051 $56,551
CORE DEPOSITS
The Company’s level of average core deposits increased 1% in 2002 and 4% in 2001. The Company’s ability to attract core deposits continues to be influenced by competition and the interest rate environment, as well as the increased availability of alternative investment products.
Demand, savings and money market deposits have provided a growing source of funding for the company in each of the periods reported. Average demand, savings and money market deposits totaled $338.5 million or 51% of core deposits in 2002 compared with $305.1 million or 47% in 2001 and $281.2 million or 45% in 2000.
Other time deposits consist of certificates of deposits in denominations of less than $100,000. These deposits declined by 7% during 2002 following a decline of less than 1% during 2001. Other time deposits comprised 49% of core deposits in 2002 compared with 53% in 2001 and 55% in 2000.
OTHER FUNDING SOURCES
Federal Home Loan Bank advances and other borrowings represent the Company’s most significant source of other funding for its bank subsidiaries. Average borrowed funds decreased $20.1 million or 11% during 2002. This decline followed a decline of $28.4 million or 13% in 2001. The decline in borrowed funds in both 2002 and 2001, both long-term and short-term, was the result of an increase in core deposits from the Company’s primary market areas and the overall decline in outstanding loans. Borrowings comprised 19%, 21%, and 22% of total funding sources in 2002, 2001, and 2000.
Certificates of deposits in denominations of $100,000 or more and brokered deposits are an additional source of other funding for the Company’s bank subsidiaries. Large denomination certificates and brokered deposits decreased $6.8 million or 10% during 2002 following a decline of $53.3 million or 45% in 2001. The decline in these types of deposits during 2002 and 2001, as with the decline in borrowed funds, was the result of an increase in core deposits and the overall decline in outstanding loans. Large certificates and brokered deposits comprised 7% of total funding sources in both 2002 and 2001 and 12% in 2000.
The bank subsidiaries of the Company also utilize short-term funding sources from time to time. These sources consist of overnight federal funds purchased from other financial institutions, secured repurchase agreements that generally mature within 30 days, and secured overnight variable rate borrowings from the FHLB. These borrowings represent an important source of short-term liquidity for the bank subsidiaries of the Company. Long-term debt is in the form of FHLB advances, which are secured by the pledge of certain investment securities and residential mortgage loans. See Note 8 to the Consolidated Financial Statements for further information regarding borrowed funds.
– 18 –
PARENT COMPANY FUNDING SOURCES
The Company is a corporation separate and distinct from its bank and other subsidiaries. At December 31, 2002, the parent company held cash and marketable investment securities of approximately $13,085,000, which provided sufficient liquidity to satisfy the parent company’s working capital needs for the foreseeable future, exclusive of its possible funding needs in connection with its pending tender offer. For information regarding the financial condition, result of operations, and cash flows of the Company, presented on a parent-company-only basis, see Note 17 – Parent Company Financial Statements, to the Company’s consolidated financial statements included in Item 8 of this Report.
The Company does not have access at the parent-company level to the sources of funds that are available to its bank subsidiaries to support their operations. The Company derives most of its parent-company revenues from dividends or interest paid to the parent company by its bank subsidiaries. These subsidiaries are subject to statutory restrictions on their ability to pay dividends to the parent company. The FRB possesses enforcement powers over bank holding companies and their non-bank subsidiaries that enable it to prevent or remedy actions that in its view may represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability in appropriate cases to proscribe the payment of dividends by banks and bank holding companies. The FDIC and DFI possess similar enforcement powers over the bank subsidiaries of the Company. The “prompt corrective action” provisions of federal banking law impose further restrictions on the payment of dividends by insured banks which fail to meet specified capital levels and, in some cases, their parent bank holding companies.
The Company intends to fund approximately $15,000,000 of its potential obligation to purchase shares pursuant to its pending self tender offer and to pay related fees and expenses by applying cash and investments currently held by the parent company. If the Company requires more than $15,000,000 in order to purchase shares validly tendered under the offer and pay related fees and expenses, the Company expects to finance the additional funds requirements by drawing against a revolving line of credit that it proposes to establish with Bank One, N.A., Chicago, Illinois (“Bank One”). Bank One has issued a commitment letter to the Company to establish a $10,000,000 revolving line of credit for the purpose of funding stock repurchases and parent company working capital needs, with a proposed maturity date for the repayment of principal and all accrued unpaid interest of two years from the date of establishment. Bank One has orally indicated a willingness to increase the amount of its revolving line of credit to an amount greater than $10,000,000, but not more than $15,000,000, and the Company may request a line of credit greater than $10,000,000 in the event that the self tender offer is oversubscribed and the Company elects to purchase more than the 1,000,000 shares that it is obligated to purchase. For a description of expected additional terms and conditions of this proposed revolving line of credit, see Item 1 of this Report. Although the parent company might not be required to borrow any funds under this line of credit if the tender offer is not fully subscribed, the parent company might borrow as much as $12,000,000 under this line of credit in connection with the consummation of the purchase of shares under the pending self tender offer, assuming that as many as 1,225,000 shares are tendered under the offer and the Company purchases the 1,000,000 shares that it is obligated to purchase under that offer (subject to the offer’s terms and conditions) and also elects to purchase all 225,000 additional shares that it may elect to purchase under the terms of the offer. For a discussion of the expected effect on the parent company’s capital resources and parent company liquidity that may result in the event that the Company purchases a material number of shares of its common stock pursuant to its pending self tender offer, see “Expected Effects of Purchase of Shares Pursuant to Tender Offer,” below, in this Item 7.
RISK MANAGEMENT
The Company is exposed to various types of business risk on an on-going basis. These risks include credit risk, liquidity risk and interest rate risk. Various procedures are employed at the Company’s affiliate banks to monitor and mitigate risk in their loan and investment portfolios, as well as risks associated with changes in interest rates. Following is a discussion of the Company’s philosophies and procedures to address these risks.
LENDING AND LOAN ADMINISTRATION
Primary responsibility and accountability for day-to-day lending activities rests with the Company’s affiliate banks. Loan personnel at each bank have the authority to extend credit under guidelines approved by the bank’s board of directors. Executive and board loan committees active at each bank serve as vehicles for communication and for the pooling of knowledge, judgment and experience of its members. These committees provide valuable input to lending personnel, act as an approval body, and monitor the overall quality of the banks’ loan portfolios. The Corporate Loan Committee, comprised of members of the Company’s executive officers and board of directors, strive to ensure a consistent application of the Company’s lending policies. The Company also maintains a comprehensive risk-weighting and loan review program for its affiliate banks, which includes quarterly reviews of problem loans, delinquencies and charge-offs. The purpose of this program is to evaluate loan administration, credit quality, loan documentation and the adequacy of the allowance for loan losses.
– 19 –
The Company maintains an allowance for loan losses to cover probable credit losses identified during its loan review process. The allowance is increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the required level of allowance for loan losses using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgement, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.
The allowance for loan losses is comprised of: (a) specific reserves on individual credits; (b) allocated reserves for certain loan categories and industries, and overall historical loss experience; and (c) unallocated reserves based on performance trends in the loan portfolios, current economic conditions, and other factors that influence the level of estimated probable losses. The need for specific reserves are considered for credits when: (a) the customer’s cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or, (d) other reasons where the ultimate collectibility of the loan is in question, or the loan characteristics require special monitoring.
Allowance for Loan Losses
dollars in thousands Years Ended December 31,
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Balance of allowance for possible
losses at beginning of period.......................... $ 8,388 $ 9,274 $ 9,101 $ 8,559 $ 8,803
Allowance of Acquired subsidiaries & Adjustments
to Conform Fiscal Years................................ --- --- --- 356 80
Loans charged-off:
Residential Mortgage Loans................................ 481 637 1,888 815 627
Agricultural and Poultry Loans ........................... 89 66 134 222 ---
Commercial and Industrial Loans........................... 183 659 347 192 348
Consumer Loans............................................ 832 990 748 823 1,080
------- ------- ------- ------- -------
Total Loans charged-off................................ 1,585 2,352 2,417 2,052 2,055
Recoveries of previously charged-off Loans:
Residential Mortgage Loans................................ 77 54 14 100 76
Agricultural and Poultry Loans............................ 2 191 29 135 19
Commercial and Industrial Loans........................... 59 374 120 42 77
Consumer Loans............................................ 245 187 196 212 215
------- ------- ------- ------- -------
Total Recoveries....................................... 383 806 359 489 387
------- ------- ------- ------- -------
Net Loans recovered / (charged-off)...................... (1,202) (1,546) (2,058) (1,563) (1,668)
Additions to allowance charged to expense................. 1,115 660 2,231 1,749 1,344
------- ------- ------- ------- -------
Balance at end of period.................................. $ 8,301 $ 8,388 $ 9,274 $ 9,101 $ 8,559
======= ======= ======= ======= =======
Net Charge-offs to Average Loans Outstanding.............. 0.19% 0.22% 0.27% 0.23% 0.27%
Provision for Loan Losses to Average Loans Outstanding.... 0.17% 0.09% 0.29% 0.25% 0.21%
Allowance for Loan Losses to Total Loans at Year-end...... 1.36% 1.27% 1.31% 1.23% 1.34%
The following table indicates the breakdown of the allowance for loan losses for the periods indicated (dollars in thousands):
Residential Mortgage Loans................................ $ 1,323 $ 1,813 $ 2,106 $ 2,048 $ 1,315
Agricultural and Poultry.................................. 403 603 777 620 910
Commercial and Industrial Loans........................... 5,810 4,457 4,618 3,987 2,905
Consumer Loans............................................ 545 305 348 915 1,047
Unallocated............................................... 220 1,210 1,425 1,531 2,382
------- ------- ------- ------- -------
Total Loans............................................... $ 8,301 $ 8,388 $ 9,274 $ 9,101 $ 8,559
======= ======= ======= ======= =======
The Company’s unallocated allowance for loan losses declined approximately $1.0 million during