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EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - TAYLOR CAPITAL GROUP INCdex312.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - TAYLOR CAPITAL GROUP INCdex311.htm
EX-99.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER - TAYLOR CAPITAL GROUP INCdex991.htm
EX-12.1 - COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES - TAYLOR CAPITAL GROUP INCdex121.htm
EX-32.1 - CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER - TAYLOR CAPITAL GROUP INCdex321.htm
EX-21.1 - LIST OF SUBSIDIARIES OF TAYLOR CAPITAL GROUP, INC. - TAYLOR CAPITAL GROUP INCdex211.htm
EX-23.1 - CONSENT OF KPMG LLP - TAYLOR CAPITAL GROUP INCdex231.htm
EX-10.25 - VOLUNTARY REDUCTION OF COMPENSATION LETTER SIGNED BY BRUCE W. TAYLOR - TAYLOR CAPITAL GROUP INCdex1025.htm
EX-10.26 - VOLUNTARY REDUCTION OF COMPENSATION LETTER SIGNED BY MARK A. HOPPE - TAYLOR CAPITAL GROUP INCdex1026.htm
EX-10.27 - EXECUTIVE SEVERANCE PLAN, AS AMENDED AND RESTATED - TAYLOR CAPITAL GROUP INCdex1027.htm
EX-99.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 111(B)(4) - TAYLOR CAPITAL GROUP INCdex992.htm
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2009

 

Commission file number 0-50034

 

 

 

TAYLOR CAPITAL GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   36-4108550
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)

 

9550 West Higgins Road

Rosemont, Illinois 60018

(Address, including zip code, of principal executive offices)

 

(847) 653-7978

(Registrant’s telephone number, including area code)

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $0.01 per share   The NASDAQ Stock Market, LLC
(Title of Class)   (Name of Exchange Which Registered)

 

Securities registered pursuant to Section 12(g) of the Act: None

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

 

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  x    No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 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 a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨   Accelerated filer   ¨    Non-accelerated filer   ¨    Smaller reporting company   x 

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  x

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based on the closing sales price on The Nasdaq Global Select Market on June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter was approximately $39,224,997.

 

At March 19, 2010, there were 11,076,197 shares of the registrant’s common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Notice of Annual Meeting and Proxy Statement for the registrant’s Annual Meeting of Stockholders to be held on or around May 13, 2010 are incorporated by reference into Part III hereof.

 

 

 


Table of Contents

TAYLOR CAPITAL GROUP, INC.

 

INDEX

 

            Page No.

Part I.

       

Item 1.

    

Business

   1

Item 1A.

    

Risk Factors

   9

Item 2.

    

Properties

   16

Item 3.

    

Legal Proceedings

   16

Item 4.

    

Reserved

   16

Part II.

       

Item 5.

    

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   17

Item 6.

    

Selected Financial Data

   18

Item 7.

    

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   20

Item 7A.

    

Quantitative and Qualitative Disclosures about Market Risk.

   74

Item 8.

    

Financial Statements and Supplementary Data

   75

Item 9.

    

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   127

Item 9A.

    

Controls and Procedures

   127

Item 9B.

    

Other Information

   128

Part III.

       

Item 10.

    

Directors, Executive Officers and Corporate Governance

   129

Item 11.

    

Executive Compensation

   129

Item 12.

    

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   129

Item 13.

    

Certain Relationships and Related Transactions, and Director Independence

   129

Item 14.

    

Principal Accountant Fees and Services

   129

Part IV.

       

Item 15.

    

Exhibits, Financial Statement Schedules

   130


Table of Contents

TAYLOR CAPITAL GROUP, INC.

 

PART I

 

Item 1. Business

 

Our Business

 

Taylor Capital Group, Inc. (the “Company”, “we”, “us”, or “our”) is a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago, and we derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank (“the Bank”). The Bank was founded in 1929 by forefathers of the Taylor family and has served the Chicago metropolitan area for over 80 years. We were formed in 1996 and acquired Cole Taylor Bank in 1997. We provide a range of products and services primarily to closely-held commercial customers and their owner operators in the Chicago metropolitan area. We also provide asset-based lending and residential mortgage origination services outside our Chicagoland region through offices in other geographic markets. At December 31, 2009, we had assets of approximately $4.4 billion, deposits of approximately $3.0 billion and stockholders’ equity of $258.8 million.

 

Our primary business is commercial banking and, as of December 31, 2009, approximately 95% of our loan portfolio was comprised of commercial loans. Our targeted commercial lending customers are closely-held businesses in industries such as manufacturing, wholesale and retail distribution, transportation, construction contracting and professional services. Our commercial lending activities primarily consist of providing loans for working capital, business expansion or acquisition; owner-occupied commercial real estate financing; revolving lines of credit; and stand-by and commercial letters of credit. In addition to our lending activities, we offer deposit products such as checking, savings and money market accounts; time deposits and repurchase agreements to our business customers and community-based customers, typically individuals and small, local businesses, located near our banking centers. We offer corporate treasury cash management services to our commercial customers, which include internet balance reporting, remote deposit capture, positive pay, automated clearing house products, imaged lock-box processing, controlled disbursement, and account reconciliation. We also cross-sell products and services to the owners and executives of our business customers designed to help them meet their personal financial goals. Our product offerings also include personal customized credit and wealth management services. We use third-party providers to augment our offerings to include investment management and brokerage services. Our products and services consist of commercial banking credit and deposit products delivered by a single operations area. We do not have separate and discrete operating segments.

 

Our Strategy

 

Our strategy to build stockholder value is based on a focused plan to be the commercial banking specialists for closely-held businesses and the people who own and manage them. Providing commercial banking services in this market niche has been an integral part of Cole Taylor Bank’s strategy since it was founded in 1929 and was reinforced by our recent management and operational changes. Our strategy is comprised of the following elements:

 

   

Relationship-oriented customer experience. Our customers are the center of what we do, so we partner with our customers to understand the dynamics of the businesses that we serve. Speed and responsiveness are critical elements of the customer experience, and we do our utmost to be available anytime and any place to meet their needs. We believe closely-held business owners value a long-term relationship with a quality banker who provides innovative advice and creative ideas and understands the challenges and opportunities these owners face. For this reason, we believe our relationship managers are the most important “product” that we offer as well as our customers’ access to our senior management.

 

   

Focus on our targeted customers. We focus our time and resources on closely-held businesses and the owners and managers of these businesses. We identify and pursue these customer niches as a natural

 

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extension of our focused strategy. We also seek to leverage our commercial relationships by cross-selling products and services to address the personal financial needs of these business owners and managers. We then expand on the relationships that we have built with these key decision-makers by helping them meet their personal financial goals through products such as personal customized credit, a wide array of deposit products, as well as financial planning and wealth management services provided by third party providers.

 

   

Optimal position in our market. We believe that we are well positioned to meet the needs of our target market. We are large enough to handle more complex credit facilities and treasury cash management services, but small enough to provide more personalized customer service. We also believe that it is important to our customers to have access to senior management who understand what is involved to run an owner-operated business. This relationship banking approach, coupled with our ability to offer customized products and financial solutions, is what we believe sets us apart from our competition.

 

   

Efficient growth. Historically, we have increased our total loans through organic growth, and we expect to continue to grow our business and develop new customer relationships and cross-sell other products and services to our commercial customers and the owners and managers of those businesses. At the same time, we continue to monitor our loan portfolio and have reduced our exposure to certain industries and sectors that we no longer consider economically desirable.

 

   

Effective credit risk management. A disciplined underwriting and credit administration and monitoring process is critical to our success. Credit risk is the primary risk we face in our business model, and we dedicate significant resources to monitor and protect our asset quality. We expect that the current economic downturn and its effect on the real estate market will continue to require greater attention from senior management to minimize potential losses in our loan portfolio.

 

Competition

 

We encounter intense competition for all of our products and services, including substantial competition in attracting and retaining deposits and in obtaining loan customers, both in the Chicago metropolitan area and in the types of products and services that we offer. We also encounter intense competition in the pricing of our products and services, including interest rates paid on deposits, interest rates charged on loans, as well as credit terms and underwriting criteria, and fees charged for trust, investment and other professional services. Our principal competitors are numerous and include other commercial banks, both locally and nationally, savings and loan associations, mutual funds, money market funds, finance companies, credit unions, mortgage companies, the United States Government, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms. We may also face a competitive disadvantage as a result of our smaller size, limited branch network and narrower product offerings. Many of our competitors are significantly larger than us and have access to greater financial and other resources. In addition, many of our non-bank competitors are not subject to all of the same federal regulations that govern bank holding companies and federally insured banks or the state regulations governing state chartered banks. As a result, our non-bank competitors may have advantages over us in providing some services.

 

Employees

 

Together with the Bank, we had approximately 434 full-time equivalent employees as of December 31, 2009. None of our employees is subject to a collective bargaining agreement. We consider our relationships with our employees to be good.

 

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Supervision and Regulation

 

General

 

Financial institutions, their holding companies and their affiliates are regulated under federal and state law and by the regulations and policies of various bank regulatory authorities, including the Illinois Department of Financial and Professional Regulation (the “DFPR”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC”). These laws, regulations and policies address, among other things, the scope of business; the kinds and amounts of investments; reserve requirements; capital levels relative to operations; the nature and amount of collateral for loans; the establishment of branches, mergers and consolidations; and the payment of dividends. This system of supervision and regulation establishes a comprehensive framework for our operations and those of our subsidiaries and is intended primarily for the protection of the FDIC-insured deposits and depositors of the Bank, rather than stockholders.

 

The following is a summary of the material elements of the regulatory framework that applies to us and our banking subsidiary. It does not describe all of the statutes, regulations and regulatory policies that apply or restate all of the requirements that are described, and the summary is qualified in its entirety by reference to applicable law. Any change in statutes, regulations or regulatory policies may have a material effect on our business and the business of our subsidiaries.

 

The Company

 

General. We, as the sole stockholder of the Bank, are a bank holding company. As a bank holding company, we are registered with, and are subject to regulation by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHCA”). In accordance with Federal Reserve policy, we are expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where we might not otherwise do so. Under the BHCA, we are subject to examination by the Federal Reserve. We are required to file with the Federal Reserve periodic reports of our operations and such additional information regarding us and our subsidiaries as the Federal Reserve may require. We are also subject to regulation by the DFPR under Illinois law.

 

Current Economic Environment. The U.S. government has taken a variety of actions over the past 18 months that were intended to stimulate the national economy, including the passage of legislation, such as the Emergency Economic Stabilization Act of 2008 (the “EESA”) and the American Recovery and Reinvestment Act of 2009 (the “ARRA”,) although known commonly as the economic stimulus bill), and the implementation of programs by federal agencies, including the Federal Reserve, the FDIC and the U.S. Treasury Department.

 

In 2008, pursuant to its authority under the EESA, the U.S. Treasury announced the Troubled Assets Relief Program’s Capital Purchase Program (the “CPP”), in which the U.S. Treasury would invest up to $250 billion in preferred stock and warrants to purchase common stock of qualified financial institutions that applied to participate. We applied to participate in the CPP, and on November 21, 2008, the U.S. Treasury invested $104.8 million in our Series B preferred stock, equal to 3% of our risk-weighted assets as of September 30, 2008. The terms of the Series B preferred stock, and the accompanying warrants to purchase 1,462,647 shares of common stock at a price of $10.75 per share, are described later in this Annual Report under the caption “Management’s Discussion and Analysis of Results of Operations and Financial Condition.”

 

As a result of this investment by the U.S. Treasury, we are required to certify to the U.S. Treasury that we complied with statutory, Treasury and contractual executive compensation restrictions imposed as part of this program. We will be required to re-certify this attestation on an annual basis so long as any of the shares of Series B preferred stock remain outstanding. The Compensation Committee of our Board of Directors also must provide the U.S. Treasury with an explanation of our senior executive compensation arrangements and how such arrangements are designed to ensure that they do not encourage unnecessary or excessive risk-taking.

 

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In addition, pursuant to the ARRA, we are subject to restrictions on executive compensation so long as any of the shares of Series B preferred stock remain outstanding. These restrictions include a prohibition on paying or accruing any bonus, retention award or incentive compensation to certain senior executive officers, other than limited exceptions for restricted stock grants and pre-existing contractual obligations and a prohibition on any severance payments to any of our senior executive officers or any of our next 20 most highly-compensated employees. Our Board of Directors also adopted a company-wide policy regarding excessive or luxury expenditures (available at www.TaylorCapitalGroup.com), and we are required to permit an advisory stockholder vote to approve executive compensation, as disclosed in our Proxy Statement, at each annual meeting of stockholders so long as any of the shares of Series B preferred stock remain outstanding.

 

We elected to participate in the FDIC’s transaction guarantee program. Under this program, the FDIC agreed to insure 100% of non-interest bearing and certain low-interest bearing deposit transaction accounts through December 31, 2009. This program was subsequently extended to June 30, 2010. During 2009, the FDIC assessed us a 10 basis point annual surcharge applied to eligible deposit accounts over $250,000 as part of its normal quarterly assessment process for participation in this program. This assessment increased to 20 basis points in 2010.

 

The FDIC has also provided for a temporary increase in deposit insurance coverage. Pursuant to the EESA, the FDIC temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The EESA provides that the basic deposit insurance limit will return to $100,000 after this program expires in December 31, 2013. (Other changes related to the regulation of deposit insurance are discussed below under “Deposit Insurance.”)

 

Acquisitions, Activities and Change in Control. The primary purpose of a bank holding company is to control and manage banks. The BHCA generally requires the prior approval of the Federal Reserve for any merger involving a bank holding company or any acquisition by a bank holding company of another bank or bank holding company.

 

The BHCA generally prohibits us from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking … as to be a proper incident thereto.” This authority would permit us to engage in a variety of banking-related businesses, including the operation of a thrift, consumer finance, equipment leasing, the operation of a computer service bureau (including software development), and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.

 

Bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may also engage in, or own shares in companies engaged in, a wider range of non-banking activities. The activities could include securities and insurance underwriting and sales, merchant banking and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and that does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. We have not yet applied for approval to operate as a financial holding company.

 

Federal law also prohibits any person or company from acquiring “control” of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator. “Control” is conclusively presumed to exist upon the acquisition of 25% or more of the outstanding voting securities of a bank or bank holding company, but may arise under certain circumstances at 10% ownership.

 

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Capital Requirements. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital levels fall below the minimum required levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses.

 

The Federal Reserve’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: (i) a risk-based requirement expressed as a percentage of total assets weighted according to risk; and (ii) a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others. For purposes of these capital standards, Tier 1 capital consists primarily of permanent stockholders’ equity less intangible assets (other than certain loan servicing rights and purchased credit card relationships). Total capital consists primarily of Tier 1 capital, plus certain other debt and equity instruments that do not qualify as Tier 1 capital and a portion of the company’s allowance for loan and lease losses. As of December 31, 2009, we had regulatory capital in excess of these minimum requirements.

 

The risk-based and leverage standards described above are minimum requirements. Higher capital levels may be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth or experiencing operating losses over a period of several successive quarters, may be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets), well above the minimum levels.

 

In order to maintain sufficient capital to act as a source of strength for our Bank, to better align our capital position to our peers and to support our future growth plans, we have developed a capital plan that anticipates increasing our capital levels in the second quarter of 2010. Accordingly, we intend to commence an offering to issue 1,200,000 shares of our common stock to induce the holders of our Series A preferred stock to convert their preferred shares into shares of our common stock. We also intend to pursue a $60 million private placement of shares of convertible preferred stock and subordinated notes. The terms of any such capital are expected to result in ownership and economic dilution to our current stockholders.

 

Dividend Payments. Our ability to pay dividends to our stockholders may be affected by general corporate law considerations, policies of the Federal Reserve applicable to bank holding companies, and limitations contained in the documents governing our trust preferred securities and Series A and Series B preferred stock. As a Delaware corporation, we are subject to the limitations of the Delaware General Corporation Law (the “DGCL”). The DGCL allows us to pay dividends only out of our surplus (as defined and computed in accordance with the provisions of the DGCL) or, if we have no such surplus, out of our net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. In addition, policies of the Federal Reserve caution that a bank holding company should not pay cash dividends that exceed its net income or that can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. We also have agreed, consistent with our past practice, to continue to provide our regulators notice before we pay dividends on our Series A and Series B preferred stock and the payment of interest on our trust preferred securities.

 

The Bank

 

General. The Bank is an Illinois-chartered bank, and the deposit accounts are insured by the FDIC’s Deposit Insurance Fund (“DIF”). The Bank is also a member of the Federal Reserve System (“member bank”). As an

 

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Illinois-chartered, FDIC-insured member bank, the Bank is also subject to the examination, supervision, reporting and enforcement requirements of the DFPR, as the chartering authority for Illinois banks; the Federal Reserve; as the primary federal regulator of member banks; and the FDIC, as administrator of the DIF.

 

Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of four risk categories based upon their capital group and supervisory group designations. Institutions classified in the highest capital group (i.e., those with a “well capitalized” capital group designation) and in the highest supervisory group (i.e., those with CAMELS ratings of 1 or 2) pay the lowest premium. Institutions that are in the lowest (i.e., undercapitalized) capital group and lowest supervisory group (i.e., those with CAMELS ratings of 4 or 5) pay the highest premium. The FDIC determines capital group assignments quarterly.

 

During the year ended December 31, 2009, DIF assessments ranged from 7 cents to 77.5 cents per $100 of assessable deposits, depending on an institution’s risk classification, its levels of unsecured debt and secured liabilities, and, in certain cases, its level of brokered deposits. In November 2009, the FDIC approved a final rule that required insured institutions to prepay their estimated risk-based insurance assessment for the fourth quarter of 2009 and for all of 2010, 2011, and 2012. In December 2009, we prepaid $31.9 million of deposit insurance assessments which is recorded in other assets on the Consolidated Balance Sheets. This prepaid asset will be reduced each quarter and recorded as an expense as the future quarterly assessments are applied.

 

FICO Assessments. DIF members are subject to assessments to cover the interest payments on outstanding Financing Corporation (“FICO”) obligations until the final maturity of such bond obligations in 2019. These FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. For the fourth quarter of 2009, the assessment on these obligations was 1.06 basis points.

 

Supervisory Assessments. All Illinois banks are required to pay supervisory assessments to the DFPR to fund its operations. The amount of the assessment is calculated on the basis of the Bank’s total assets. During the year ended December 31, 2009, the Bank paid supervisory assessments to the DFPR totaling $402,000.

 

Capital Requirements. The regulations of the Federal Reserve establish the following minimum capital standards for the banks regulated by the Federal Reserve: (i) a leverage requirement consisting of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated banks with a minimum requirement of at least 4% for all others; and (ii) a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. In general, the components of Tier 1 capital and total capital are the same as those for bank holding companies discussed above.

 

The capital requirements described above are minimum requirements. Higher capital levels may be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, regulations of the Federal Reserve provide that additional capital may be required to take adequate account of, among other things, interest rate risk or the risks posed by concentrations of credit, nontraditional activities or securities trading activities.

 

Further, federal law and regulations provide various incentives for financial institutions to maintain regulatory capital at levels in excess of minimum regulatory requirements. For example, a financial institution that is “well-capitalized” may qualify for exemptions from prior notice or application requirements otherwise applicable to certain types of activities and may qualify for expedited processing of other required notices or applications. Additionally, one of the criteria that determines a bank holding company’s eligibility to operate as a financial holding company is a requirement that all of its financial institution subsidiaries be “well-capitalized.” Under the regulations of the Federal Reserve, in order to be “well-capitalized” a financial institution must maintain a ratio of total capital to total risk-weighted assets of 10% or greater, a ratio of Tier 1 capital to total risk-weighted assets of 6% or greater and a ratio of Tier 1 capital to total assets of 5% or greater.

 

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Federal law also provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators’ powers depends on whether the institution in question is “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” as defined by regulation. Depending upon the capital category to which an institution is assigned and other factors, the regulators’ corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution’s asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution.

 

Although the Bank is considered “well capitalized” as defined by Federal Reserve regulations, we contributed an additional $25.0 million of capital to the Bank in the first quarter of 2010 to further strengthen the Bank’s regulatory capital. We intend to pursue a plan to raise additional regulatory capital at the holding company level and are committed to supporting the Bank and maintaining its capital levels.

 

Dividend Payments. Historically, our primary source of funds has been dividends from the Bank. Under the Illinois Banking Act, Illinois-chartered banks generally may not pay dividends in excess of their net profits. Without Federal Reserve approval, a state member bank may not pay dividends in any calendar year that, in the aggregate, exceed the bank’s calendar year-to-date net income plus the bank’s retained net income for the two preceding calendar years. As of December 31, 2009, the Bank could not declare or pay dividends to us without the approval of regulatory authorities.

 

The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2009. If funds were available for dividends, the Federal Reserve also may prohibit the payment of any dividends by the Bank if the Federal Reserve determines such payment would constitute an unsafe or unsound practice.

 

Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on extensions of credit to us, on investments in our stock or other securities and the acceptance of our stock or other securities as collateral for loans made by the Bank. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to our directors and officers, to our principal stockholders and to “related interests” of such directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person who is one of our directors or officers, a director or officer of the Bank or one of our principal stockholders may obtain credit from banks with which the Bank maintains a correspondent relationship.

 

Safety and Soundness Standards. The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

 

In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit

 

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an acceptable compliance plan or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth; require the institution to increase its capital; restrict the rates the institution pays on deposits; or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.

 

Branching Authority. The Bank has the authority under Illinois banking law to establish branches anywhere in the State of Illinois, subject to receipt of required regulatory approvals.

 

State Bank Investments and Activities. The Bank generally is permitted to make investments and engage in activities directly or through subsidiaries as authorized by Illinois law. However, under federal law and FDIC regulations, FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC-insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.

 

Federal Reserve System. Federal Reserve regulations, require depository institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts), as follows: for transaction accounts aggregating $55.2 million or less, the reserve requirement is 3% of total transaction accounts; for transaction accounts aggregating in excess of $55.2 million, the reserve requirement is $1.335 million plus 10% of the aggregate amount of total transaction accounts in excess of $55.2 million. The first $10.7 million of otherwise reservable balances are exempt from the reserve requirements. These reserve requirements are subject to annual adjustment by the Federal Reserve. The Bank is in compliance with the foregoing requirements

 

Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) subjects us to a broad range of corporate governance and accounting measures relating to increased corporate responsibility and accountability. These measures are designed to protect investors in publicly-traded companies by imposing penalties for accounting and auditing improprieties and other measures intended to lead to accuracy and reliability of disclosures under federal securities laws. Among other things, Sarbanes-Oxley and its implementing regulations impose membership requirements and additional responsibilities for our Audit Committee, restrictions on the relationship between us and our outside auditors (including restrictions on the types of non-audit services our auditors may provide to us), additional responsibilities for external financial statements on our chief executive officer and chief financial officer and disclosure requirements for corporate insiders. Management is also required to evaluate our disclosure controls and procedures and our internal controls over financial reporting.

 

Available Information

 

Our website is www.taylorcapitalgroup.com. We make available on our website under the caption “Stock Information,” free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the Securities and Exchange Commission (“SEC”). Materials that we file or furnish to the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information that we file electronically with the SEC.

 

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Item 1A. Risk Factors

 

You should read carefully and consider the following risks and uncertainties because they could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Our business may be adversely affected by the highly regulated environment in which we operate.

 

We are subject to extensive federal and state regulation and supervision, which is primarily for the protection of depositors and customers rather than for the benefit of stockholders. As a bank holding company, we are subject to regulation and supervision primarily by the Federal Reserve. Cole Taylor Bank, as an Illinois-chartered member bank, is subject to regulation and supervision by the DFPR and by the Federal Reserve. We undergo periodic examinations by our regulators, who have extensive discretion and power to prevent or remedy unsafe or unsound practices or violations of law by banks and bank holding companies. Our failure to comply with state and federal regulations can lead to, among other things, termination or suspension of our licenses, rights of rescission for borrowers, class action lawsuits and administrative enforcement actions. We cannot assure you that we will be able to fully satisfy the requirements imposed by the regulatory authorities that supervise us.

 

Further, we are significantly impacted by the policies of the Federal Reserve, whose fiscal policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments we hold and the ability of borrowers to repay their loans, which could have a material adverse effect on our financial condition and results of operation.

 

Regulatory restrictions and liquidity constraints at the holding company level could impair our ability to pay dividends or interest on our outstanding securities.

 

Historically, our primary source of funds at the holding company level has been dividends received from the Bank. The Bank is subject to dividend restrictions set forth by regulatory authorities, whereby it may not, without prior approval of regulatory authorities, declare dividends in excess of the sum of the current year’s earnings plus the retained earnings from the prior two years. As of December 31, 2009, the Bank could not declare or pay dividends to us without the approval of regulatory authorities.

 

In order to preserve capital, our Board of Directors suspended the payment of dividends on our common stock beginning in the second quarter of 2008. Current and future liquidity constraints at the holding company level could impair our ability to declare and pay dividends or interest on our outstanding securities in the future. We also have agreed, consistent with our past practice, to continue to provide our regulators notice before we pay dividends on our Series A and Series B preferred stock and the payment of interest on our trust preferred securities.

 

At December 31, 2009, $12 million was outstanding under our $15 million revolving credit facility. We repaid all amounts outstanding under this facility in March 2010, and we do not expect to renew this facility with our current lender when it expires on March 31, 2010.

 

Furthermore, we are committed to maintaining the Bank’s well capitalized status and made a $25.0 million capital contribution to the Bank during the first quarter of 2010. In order to maintain sufficient capital to act as a source of strength for our Bank, to better align our capital position to our peers and to support our future growth plans, we have developed a capital plan that anticipates increasing our capital levels in the second quarter of 2010. Accordingly, we intend to commence an offering to issue 1,200,000 shares of our common stock to induce the holders of our Series A preferred stock to convert their preferred shares into shares of our common stock. We also intend to pursue a $60 million private placement of shares of convertible preferred stock and subordinated notes. We cannot assure you that we will be able to raise such capital on terms acceptable to us, if at all. If we are not able to raise capital on terms that are acceptable to us, it will have a material adverse effect on our ability to serve as a source of strength to the Bank and we likely will be required to scale back our future growth and take other measures to improve our financial condition. In addition, our inability to raise additional equity would likely impact our ability to pay dividends on our issuances of preferred stock, and pay interest on our junior subordinated debt and the related issuance of trust preferred securities.

 

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The UST may also impose additional limitations on our ability to use funds we received from our participation in the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”), including the payment of dividends or interest on our outstanding securities. For example, we are currently prohibited from declaring or paying any dividends on our common stock without the UST’s consent until the earlier of November 21, 2012 or the date on which the UST no longer holds any of our Series B preferred stock. If we are unable to pay dividends or interest on our outstanding securities in the future, the market value of such securities may be materially adversely affected.

 

Our regulators could require us to maintain additional regulatory capital.

 

At December 31, 2009, both we and our Bank were categorized as “well capitalized” under the regulatory capital framework. Our regulators have the ability to require us to maintain higher capital levels. If our regulators required the Bank to hold additional capital above the well capitalized level, we would either have to make an additional capital contribution to the Bank, have the Bank raise regulatory capital, or reduce our asset levels. During the first quarter of 2010, we increased the Bank’s capital levels by making a $25.0 million capital contribution from the holding company. In order to maintain sufficient capital to act as a source of strength for our Bank, to better align our capital position to our peers and to support our future growth plans, we have developed a capital plan that anticipates increasing our capital levels in the second quarter of 2010. Accordingly, we intend to commence an offering to issue 1,200,000 shares of our common stock to induce the holders of our Series A preferred stock to convert their preferred shares into shares of our common stock. We also intend to pursue a $60 million private placement of shares of convertible preferred stock and subordinated notes. The inability to attract new capital investments or our ability to attract the capital on acceptable terms to us, could have a material adverse impact on our operations and financial position.

 

Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.

 

We maintain an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. We believe that our allowance for loan losses is maintained at a level adequate to absorb probable losses inherent in our loan portfolio as of the corresponding balance sheet date. However, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect our operating results.

 

In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including our historical charge-off experience, growth of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent and criticized loans. In addition, we use information about specific borrower situations, including their financial position and estimated collateral values under various liquidation scenarios, to estimate the risk and amount of loss for those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid.

 

Our estimates of the risk of loss and amount of loss on any loan are exacerbated by the significant uncertainties surrounding not only our borrowers’ probability of default, but also the fair value of the underlying collateral. The current illiquidity in the real estate market has increased the uncertainty with respect to real estate values. Because of the degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding the holding period until sale and the collateral liquidation method, our actual losses may significantly vary from our current estimates.

 

Our commercial loans and commercial real estate loans generally involve higher credit risk than residential real estate loans. Because payments on loans secured by commercial real estate or equipment are often dependent upon the successful operation and management of our customers’ businesses, repayment of such loans may be influenced to a great extent by the ability of our customers to execute on their business strategies and may be adversely impacted by adverse economic conditions in the markets we serve. If our customers are unable to successfully operate their businesses, our actual losses on our commercial loans may exceed our current estimates.

 

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In addition, federal and state regulators periodically review the adequacy of our allowance for loan losses. Such regulators may require us to make additional provisions to the allowance, recognize additional loan charge-offs based upon their judgments about information available to them at the time of their examinations, or require us to reduce the level of nonperforming assets. Any such additional provisions for loan losses or charge-offs required by these regulatory agencies, could have a material adverse effect on our financial condition and results of operations or result in decreased standing with our regulators and result in additional capital requirements.

 

We are subject to lending concentration risks.

 

We have focused on repositioning our portfolio to reduce our exposure to industries and sectors that we no longer considered economically desirable. As a business bank, our loan portfolio is comprised primarily of commercial loans to businesses. These loans are typically larger in amount than loans to individual consumers and, therefore, have higher potential losses on an individual loan basis. Credit quality issues on larger commercial loans, if they were to occur, could cause greater volatility in reported credit quality performance measures, such as total impaired or nonperforming loans and the deterioration of any one or a few of these loans may cause a significant increase in uncollectible loans, which would have a material adverse impact on our results of operations and financial condition.

 

New residential home sales continue to be at depressed levels, increasing financial stress on our real estate developer customers and adversely impacting their ability to repay their loan obligations as agreed. Further deterioration in the credit quality of our real estate construction loans would have a material adverse effect on our financial condition and results of operations.

 

Our financial condition, results of operations and reputation would be materially adversely impacted if we are unable to respond effectively to unanticipated deposit volatility.

 

As a part of our liquidity management, we must ensure we can respond effectively to potential volatility in our customers’ deposit balances. In 2009, we improved our liquidity position by increasing the amount of funding from our core customers in order to reduce reliance on brokered funding. We have customers that maintain significant deposit balances, the immediate withdrawal of which could have a material adverse affect on our daily liquidity management. In addition, the number of branches we maintain is small relative to our size, which hinders our ability to acquire deposits. We could encounter difficulty meeting a significant deposit outflow, in which case our capital position, reputation or profitability could be negatively affected. We primarily use advances from the Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”), broker/dealer repurchase agreements and federal funds purchased to meet our immediate liquidity needs. If we fail to effectively manage the risk of deposit volatility, our business, financial condition and reputation could be materially adversely affected.

 

Reduced access to wholesale funding sources may hinder our ability to replace deposit withdrawals and support our operations and future growth.

 

We must maintain access to sufficient funds to respond to the needs of our depositors and borrowers. As part of our liquidity management, we use a number of funding sources in addition to what is provided by in-market deposits and repayments and maturities of loans and investments. While we have increased our funding from our core customers to reduce our reliance on wholesale funding, we continue to use brokered money market accounts and certificates of deposits, out-of-local-market certificates of deposit, broker/dealer repurchase agreements, federal funds purchased and FHLB and FRB advances as a source of liquidity.

 

Under FDIC regulations, only “well-capitalized institutions” may issue brokered CDs without prior regulatory approval. The Bank is currently categorized as “well-capitalized” and therefore may continue to utilize this funding source. Brokered CD distributors may use other criteria in determining which banks to allow to issue brokered CDs through their distribution network. If our access to the brokered CD market were reduced in any material respect, it could lead to an inability to replace brokered deposits at maturity, which would result in higher costs to, or reduced asset levels at, the Bank.

 

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Our participation in the TARP CPP may place significant restrictions on our operations.

 

Under the TARP CPP, our ability to declare or pay dividends on any of our shares is limited. Specifically, we are not permitted to pay dividends on our common stock without the UST’s approval until November 21, 2012, unless all of our Series B preferred stock has been redeemed or transferred by the UST to unaffiliated third parties. In addition, our ability to repurchase our shares of our common stock and other securities is restricted. The consent of the UST generally is required for us to make any stock repurchases (other than in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice) until November 21, 2012, unless all of the outstanding shares of our Series B preferred stock have been redeemed or transferred by the UST to unaffiliated third parties. Further, we may not repurchase shares of our common stock or Series A preferred stock if we are in arrears on the payment of Series B Preferred dividends.

 

Due to our participation in the TARP CPP, we are also subject to the UST’s current standards for executive compensation and corporate governance for the period during which the UST holds our Series B preferred stock, as most recently set forth in the Interim Final Rule on TARP Standards for Compensation and Corporate Governance on June 10, 2009 and apply to the five most highly compensated senior executive officers, including our Chief Executive Officer and our Chief Financial Officer, and the next most 20 of our most highly compensated senior executive officers. The standards include (i) ensuring that incentive compensation plans and arrangements for senior executive officers do not encourage unnecessary and excessive risks that threaten our value or that encourage manipulation of reported earnings; (ii) a required clawback of any bonus or incentive compensation paid (or under a legally binding obligation to be paid) to a senior executive officer based on materially inaccurate financial statements, earnings, revenues, gains or other criteria; (iii) a prohibition on making “golden parachute payments” to senior executive officers and our next five most highly compensated employees; (iv) an agreement not to claim a deduction, for federal income tax purposes, for compensation paid to any of the senior executive officers in excess of $500,000 per year; (v) prohibitions on accruing and paying bonuses, retention awards and other incentive compensation to our five most highly paid employees other than restricted stock grants that do not fully vest during the TARP period, have a minimum 2-year vesting period and have a value of no more than one-third of the affected employee’s total annual compensation; (vi) retroactive review of bonuses, retention awards and other compensation paid to senior executive officers and our next 20 most highly compensated employees previously provided by TARP recipients if found by the UST to be inconsistent with the purposes of TARP or otherwise contrary to public interest; (vii) required establishment and posting of a company-wide policy regarding “excessive or luxury expenditures;” (viii) prohibitions on tax “gross ups” relating to severance, perquisites or other forms of compensation to the senior executive officers and our next 20 most highly compensated employees; (ix) disclosure of perquisites in excess of $25,000 that are paid to employees who are subject to bonus limitations; and (x) inclusion in a participant’s proxy statement for any annual stockholder meeting of a nonbinding “Say on Pay” stockholder vote on the compensation of executives. The restrictions on bonuses and incentive compensation in particular may result in us issuing additional shares of our common stock to compensate our executive officers that likely would result in dilution to our common stockholders and could have an adverse impact on the market value of our common stock.

 

Changes in our credit ratings could increase our financing costs or make it more difficult for us to obtain funding or capital on commercially acceptable terms.

 

We are rated by several different rating agencies, including Fitch, IDC, LACE and Bankrate.com. Adverse operating results and other factors may reduce our ratings with these agencies, which could subject us to negative publicity, adversely impact our ability to acquire or retain deposits and increase our cost of borrowing or limit our asset growth. Also, our credit ratings are an important factor to the institutions that provide our sources of liquidity, and reductions in our credit ratings could adversely affect our liquidity, increase our borrowing costs, limit our access to the capital markets or trigger unfavorable contractual obligations.

 

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We may be adversely affected by the soundness of other financial institutions.

 

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We regularly engage in transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. These transactions may expose us to certain default risks. In certain circumstances, the collateral that we hold may be insufficient to cover such risks, resulting in losses that could have a material adverse affect on our business, financial condition and results of operations.

 

Fluctuations in interest rates could reduce our profitability.

 

We are subject to interest rate risk. We realize income primarily from the difference between interest earned on loans and investments and the interest incurred on deposits and borrowings. We expect that we will periodically experience imbalances in the interest rate sensitivities of our assets and liabilities and the relationships of various interest rates to each other. Over any period of time, our interest-earning assets may be more sensitive to changes in market interest rates than our interest-bearing liabilities, or vice versa. In addition, the individual market interest rates underlying our loan and deposit products (e.g., LIBOR and prime) may not change to the same degree over a given time period. If market interest rates should move contrary to our position, our earnings may be negatively affected. In addition, our loan volume and quality and deposit volume and mix can be affected by market interest rates. Changes in levels of market interest rates could materially adversely affect our net interest spread, asset quality, origination volume and overall profitability.

 

As part of our asset and liability management process, we perform sensitivity analysis to determine our exposure to changes in interest rate and develop strategies to mitigate this exposure. We attempt to mitigate our interest rate risk by managing the volume and mix of our earning assets and funding liabilities and using derivative financial instruments to hedge interest rate risk associated with specific hedged items. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially adversely affected.

 

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors and customer or employee fraud.

 

There have been a number of highly publicized cases involving fraud or other misconduct by employees of financial services firms in recent years. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. Employee fraud, errors and employee and customer misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to civil claims for negligence.

 

We maintain a system of internal controls and procedures designed to reduce the risk of loss from employee or customer fraud or misconduct and employee errors as well as insurance coverage to mitigate against operational risks, including data processing system failures and errors and customer or employee fraud. Should our internal controls fail to prevent or detect an occurrence, or if an occurrence is not insured or exceeds applicable insurance limits, it could have a material adverse effect on our business, financial condition or results of operations.

 

Our business is subject to the conditions of the local economy in which we operate and continued weakness in the local economy and the real estate markets may adversely affect our business.

 

Our success is dependent to a significant extent upon economic conditions in the Chicago metropolitan area, where most of our loans are originated. The ongoing crisis caused by the current economic recession,

 

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unemployment, changes in housing market values, changes in securities markets or by inflation or other factors could continue to impact our customers and their ability to repay loans, the value of collateral securing our loans, and the stability of our deposits.

 

Our operating results have been negatively impacted by the continued historically high level of nonperforming loans in our commercial loan portfolio. Continued weakness in the Chicago metropolitan area economy may have a material adverse affect on our business, financial condition and operating results, including higher provisions for loan losses and net loan charge-offs, lower net interest income caused by an increase in nonaccrual loans, and higher legal and collection costs. In addition, we may be required to continue to devote substantial additional attention and resources to nonperforming asset management rather than focusing on business growth activities. Continued adverse conditions in the local economy could also reduce demand for new loans and impair our ability to attract and retain deposits.

 

Our business is subject to domestic and international economic conditions and other factors, many of which are beyond our control and could adversely affect our business.

 

Our business is affected by domestic and international factors that are beyond our control, including economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, competition, changes in government monetary and fiscal policies, and consolidation within our customer base and within our industry. Because of uncertainty in the market, certain lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including to other financial institutions because of concern about the stability of the financial markets and the strength of counterparties. Any resulting lack of available credit or any lack of confidence in the banking and financial sector, decreased consumer confidence, increased volatility in the financial markets and reduced business activity could materially and adversely affect our business, financial condition and results of operations.

 

Competition from financial institutions and other financial services providers may adversely affect our growth and profitability.

 

We operate in a highly competitive industry and experience intense competition from other financial institutions in our market. We compete with these institutions in making loans, attracting deposits and recruiting and retaining talented people. We have observed that the competition in our market for making commercial loans has resulted in more competitive pricing and credit structure, as well as intense competition for qualified commercial lending officers. We also may face a competitive disadvantage as a result of our smaller size, limited branch network, narrower product offerings and lack of geographic diversification. Although our competitive strategy is to provide a distinctly superior customer and employee experience, we can give no assurance that this strategy will be successful. Our growth and profitability depend on our continued ability to compete effectively within our market area.

 

Our business strategy is dependent on our continued ability to attract, develop and retain highly qualified and experienced personnel in senior management and customer relationship positions.

 

We believe our future success is dependent, in part, on our ability to attract and retain highly qualified and experienced personnel in key senior management and other positions. Our competitive strategy is to provide each of our commercial customers with a highly qualified relationship manager that will serve as the customer’s key point of contact with us. Achieving the status of a “trusted advisor” for our customers also requires that we minimize relationship manager turnover and provide stability to the customer relationship. Competition for experienced personnel is intense, and we may not be able to successfully retain and attract such personnel.

 

Our recent operating losses have reduced our cash-based incentive awards. In addition, our participation in the TARP CPP program places limits on executive compensation. While we have not recently experienced significant employee turnover, the inability to retain and attract key personnel could negatively impact our operations.

 

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New lines of business or new products and services may subject us to certain additional risks.

 

During 2008, we expanded our asset-based lending initiative and in 2009, we announced the formation of a new residential mortgage loan origination line of business. From time to time, we will consider and may enter into new lines of business or offer new products or services. These activities can involve a number of uncertainties, risks and expenses, including the investment of significant time and resources, and we can give no assurance that our projected price and profitability targets will be attainable or that our efforts will be successful. These initiatives could also require us to enter geographical markets that are new to us. In addition, new lines of business and new products and services could significantly impact the effectiveness of our system of internal controls. Failure to successfully manage these risks could have a material adverse affect on our business, results of operations and financial condition.

 

We may experience difficulties in managing our growth.

 

Our future success depends on our achieving growth in commercial banking relationships that result in increased commercial loans outstanding at yields that are profitable to us. Achieving our growth targets requires us to attract customers who currently bank at other financial institutions in our market, thereby increasing our share of the market. Our strategy is to provide a local, high-touch relationship servicing experience that we believe is attractive to customers in our marketplace. In addition, we actively pursue high quality relationship managers to extend our reach in the market place. Although we believe that we have the necessary resources in place to successfully manage our future growth, our growth strategy exposes us to certain risks and expenses, and we cannot assure you that we will be able to expand our market presence or that any such expansion will not adversely affect our results of operations.

 

Our strategy for future growth also may place a significant strain on our management, personnel, systems and resources. Maintaining credit quality while growing our loan portfolio is critical to achieving and sustaining profitable growth. We may not be able to manage our growth effectively. If we fail to do so, our business would be materially harmed.

 

In furtherance of our growth strategy, we may also seek to acquire other financial institutions or parts of those institutions in the future and we may engage in branch expansion. In connection with future acquisitions, we may issue equity securities which could cause ownership and economic dilution to our current stockholders. Furthermore, there is no assurance that, following any future mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve a level of profitability that will justify the investment that we made in any such acquisition.

 

We are subject to security risks relating to our internet banking activities that could damage our reputation and our business.

 

Security breaches in our internet banking activities could expose us to possible liability and damage our reputation. Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from compromises or breaches of our security measures that could result in damage to our reputation and our business.

 

Our reputation could be damaged by negative publicity.

 

Reputational risk, or the risk to our business, earnings and capital from negative publicity, is inherent in our business. Negative publicity can result from actual or alleged conduct in a number of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, inadequate protection of customer data, ethical behavior of our employees, and from actions taken by regulators and others as a result of that conduct. Damage to our reputation could impact our ability to attract new or maintain existing loan and deposit customers, employees, and business relationships.

 

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Item 2. Properties

 

Our principal offices are located at our Corporate Center at 9550 West Higgins Road, Rosemont, Illinois. We lease approximately 112,000 square feet for our Corporate Center under an operating lease that expires on August 31, 2014, with two five-year renewal options which could extend the lease to 2024. We also have an approximately 4,000 square foot banking center on the first floor of our Corporate Center.

 

We also maintain approximately 36,000 square feet of general office space for our administrative offices in downtown Chicago at 225 West Washington under an operating lease with a 15-year term and two five-year renewal options which could extend the lease to 2032.

 

We currently have nine banking centers located in the Chicago metropolitan area. Of the nine banking center locations, we own five of the buildings from which the banking centers are operated, including our Ashland, Skokie, Yorktown, Old Orchard, and Milwaukee locations. We lease the land under the buildings at Yorktown, Old Orchard and Milwaukee. We lease the buildings for our Wheeling (term to February 2015), Burbank (term to June 2014), Rosemont (term to August 2014), and South Clark (term to June 2018) banking facilities.

 

The following is a list of our administrative and customer banking locations:

 

Facility

  

Address

   Square
Feet

Corporate Center

   9550 West Higgins Road, Rosemont, Illinois    112,212

West Washington

   225 West Washington, Chicago, Illinois    35,931

Milwaukee

   1965 North Milwaukee, Chicago, Illinois    27,394

Burbank

   5501 West 79th Street, Burbank, Illinois    14,807

Skokie

   4400 West Oakton, Skokie, Illinois    15,800

Old Orchard

   Golf Road and Skokie Boulevard, Skokie, Illinois    10,000

Wheeling

   350 East Dundee Road, Wheeling, Illinois    8,274

Ashland

   1542 W. 47th Street, Chicago, Illinois    6,000

Yorktown

   Three Yorktown Center, Lombard, Illinois    5,966

South Clark

   20 South Clark, Chicago, Illinois    2,700

 

We have expanded our asset-based lending services and opened offices in geographical areas outside the Chicago metropolitan region. Currently, we maintain offices in Houston, Texas, Kansas City, Missouri, Milwaukee, Wisconsin, Baltimore, Maryland, and Atlanta, Georgia. Each of these offices operates under short-term operating leases.

 

The principal administrative offices of our new residential mortgage loan originations line of business are located in an 8,000 square foot facility in Hamburg, Michigan. The operating lease on this facility expires in November 2014, but can be terminated at any time upon a 180 day notice. The mortgage division also has smaller retail offices located in Ann Arbor and Northville, Michigan.

 

Item 3. Legal Proceedings

 

We are a party to litigation from time to time arising in the normal course of business. As of the date of this annual report, management knows of no threatened or pending legal action against us that is likely to have a material adverse effect on our business, financial condition or results of operations.

 

Item 4. Reserved

 

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TAYLOR CAPITAL GROUP, INC.

 

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Our common stock trades on the Nasdaq Global Select Market under the symbol “TAYC”. The high and low sales price per share of our common stock for the periods indicated is set forth below:

 

     High    Low

2009

     

Quarter Ended March 31

   $ 8.69    $ 2.82

Quarter Ended June 30

     7.65      2.64

Quarter Ended September 30

     7.48      6.24

Quarter Ended December 31

     11.50      5.19

2008

     

Quarter Ended March 31

   $ 21.60    $ 14.77

Quarter Ended June 30

     18.00      6.83

Quarter Ended September 30

     15.49      5.10

Quarter Ended December 31

     13.28      5.57

 

As of March 19, 2010, the closing price per share of our common stock as reported on the Nasdaq was $11.79.

 

As of March 19, 2010, there were 141 stockholders of record of the common stock, based upon securities position listings furnished to us by our transfer agent. We believe the number of beneficial owners is greater than the number of record holders because a large portion of our common stock is held of record through brokerage firms in “street name”.

 

The following table sets forth, for each quarter in 2009 and 2008, the dividends declared on our common stock:

 

     2009 Dividends Per
Share of Common
Stock
   2008 Dividends Per
Share of Common
Stock

First quarter

   $ —      $ 0.10

Second quarter

     —        —  

Third quarter

     —        —  

Fourth quarter

     —        —  

 

Holders of our common stock are entitled to receive any cash dividends that may be declared by our Board of Directors. During the second quarter of 2008, our Board of Directors discontinued dividend payments to common stockholders. In connection with our participation in TARP CPP and the issuance of our Series B preferred stock, we need the consent of the U.S. Treasury before we can pay any dividends on our common stock. Subject to such restrictions, the declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, the capital requirements of the Company and our subsidiaries, regulatory conditions and considerations and other factors as our Board of Directors may deem relevant.

 

As a holding company, we ultimately are dependent upon the Bank to provide funding for our operating expenses, debt service and dividends. Various banking laws applicable to the Bank limit the payment of dividends, management fees and other distributions by the Bank to us, and may, therefore, limit our ability to pay dividends on our common stock. Because of recent operating losses, our Bank does not have the ability to pay us dividends without regulatory approval, and we do not expect that our Bank will be able to pay dividends to us in the near-term. We will also be prohibited from paying dividends on our common stock if we fail to make distributions or required payments on the trust preferred securities and our outstanding preferred stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Liquidity” for additional details of restrictions on our ability to pay dividends and the ability of the Bank to pay dividends to us.

 

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Item 6. Selected Financial Data

 

The selected consolidated financial data presented below under the caption “Taylor Capital Group, Inc.” as of and for the five years ended December 31, 2009, is derived from our historical financial statements. The selected financial information presented below under the caption of “Cole Taylor Bank” is derived from unaudited financial statements of the Bank or from the audited consolidated financial statements of Taylor Capital Group, Inc. You should read this information in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this annual report. Results from past periods are not necessarily indicative of results that may be expected for any future period.

 

    Year Ended December 31,  
    2009     2008     2007     2006     2005  
    (dollars in thousands, except per share data)  

TAYLOR CAPITAL GROUP, INC. (consolidated):

         

Statements of Operations Data:

         

Net interest income

  $ 122,911      $ 92,351      $ 104,705      $ 111,192      $ 108,607   

Provision for loan losses

    89,611        144,158        31,900        6,000        5,523   
                                       

Net interest income (loss) after provision for loan losses

    33,300        (51,807     72,805        105,192        103,084   

Noninterest income:

         

Service charges

    11,306        9,136        7,709        7,738        9,022   

Trust and investment management fees

    1,697        3,578        3,864        4,155        4,545   

Gain (loss) on investment securities

    17,595        (2,399     —          —          127   

Sale of branch and land trusts

    —          —          —          —          3,572   

Other noninterest income

    2,993        2,122        5,138        4,372        599   
                                       

Total noninterest income

    33,591        12,437        16,711        16,265        17,865   

Noninterest expense:

         

Salaries and employee benefits

    42,914        47,855        37,771        40,652        40,255   

Goodwill impairment

    —          —          23,237        —          —     

Other noninterest expense

    54,693        45,515        33,517        32,607        29,400   
                                       

Total noninterest expense

    97,607        93,370        94,525        73,259        69,655   
                                       

Income (loss) before income taxes

    (30,716     (132,740     (5,009     48,198        51,294   

Income tax expense (benefit)

    834        (8,212     4,561        2,035        19,523   
                                       

Net income (loss)

    (31,550     (124,528     (9,570     46,163        31,771   

Preferred dividends and discounts

    (11,483     (18,830     —          —          —     
                                       

Net income (loss) applicable to common stockholders

  $ (43,033   $ (143,358   $ (9,570 )   $ 46,163      $ 31,771   
                                       

Common Share Data:

         

Basic earnings (loss) per share

  $ (4.10   $ (13.72   $ (0.89 )   $ 4.17      $ 3.13   

Diluted earnings (loss) per share

    (4.10     (13.72     (0.89 )     4.12        3.07   

Cash dividends per common share

    —          0.10        0.40        0.28        0.24   

Book value per common share

    9.02        13.47        24.10        24.36        19.99   

Dividend payout ratio

    N.M.        N.M.        N.M.        6.75     7.77

Weighted average shares – basic earnings per share

    10,492,911        10,450,177        10,782,316        10,940,162        10,045,358   

Weighted average shares – diluted earnings per share

    10,492,911        10,450,177        10,782,316        11,118,818        10,286,647   

Shares outstanding – end of year

    11,076,707        11,115,936        10,551,994        11,131,059        10,973,829   

 

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     Year Ended December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands, except per share data)  

TAYLOR CAPITAL GROUP, INC. (consolidated):

          

Balance Sheet Data (at end of year):

          

Total assets

   $ 4,403,502      $ 4,388,889      $ 3,556,463      $ 3,379,667      $ 3,280,672   

Investment securities

     1,271,271        1,094,594        892,371        669,085        656,753   

Total loans

     3,035,328        3,233,261        2,533,333        2,500,685        2,384,931   

Allowance for loan losses

     106,185        128,548        54,681        37,516        37,481   

Goodwill

     —          —          —          23,237        23,237   

Total deposits

     2,976,800        3,131,046        2,580,192        2,639,927        2,543,644   

Other borrowings

     337,669        275,560        389,054        262,319        298,426   

Notes payable and other advances

     627,000        462,000        205,000        80,000        75,000   

Junior subordinated debentures

     86,607        86,607        86,607        86,607        87,638   

Subordinated notes, net

     55,695        55,303        —          —          —     

Preferred stock

     158,844        157,314        —          —          —     

Common stockholders’ equity

     99,962        149,773        254,256        271,192        219,318   

Total stockholders’ equity

     258,806        307,087        254,256        271,192        219,318   

Earnings Performance Data:

          

Return on average assets

     (0.70 )%      (3.27 )%      (0.28 )%      1.40     1.05

Return on average stockholders’ equity

     (10.74     (51.01     (3.47     19.55        17.41   

Net interest margin (non tax-equivalent) (1)

     2.77        2.46        3.22        3.49        3.75   

Noninterest income to revenues

     13.24        5.73        6.86        6.86        9.13   

Efficiency ratio (2)

     70.27        87.11        77.85        57.48        55.13   

Loans to deposits

     101.97        103.26        98.18        94.72        93.76   

Average interest earning assets to average interest bearing liabilities

     125.32        120.66        122.78        122.42        123.83   

Ratio of earnings to fixed charges: (3)

          

Including interest on deposits

     0.59     (0.16 )x      0.96x        1.43x        1.72x   

Excluding interest on deposits

     (0.00 )x      (3.63 )x      0.82x        2.92x        3.61x   

Asset Quality Ratios:

          

Allowance for loan losses to total loans

     3.50     3.98     2.16     1.50     1.57

Allowance for loan losses to nonperforming loans (4)

     75.06        64.15        72.27        113.15        278.69   

Net loan charge-offs to average total loans

     3.53        2.52        0.59        0.25        0.24   

Nonperforming assets to total loans plus repossessed property (5)

     5.48        6.58        3.09        1.34        0.61   

Capital Ratios:

          

Total stockholders’ equity to assets – end of year

     5.88     7.00     7.15     8.02     6.69

Average stockholders’ equity to average assets

     6.55        6.41        8.21        7.18        6.05   

Leverage ratio

     7.60        8.73        9.40        10.17        8.90   

Tier 1 risk-based capital ratio

     9.79        10.22        11.44        12.10        10.44   

Total risk-based capital ratio

     12.72        13.02        12.74        13.35        12.02   

COLE TAYLOR BANK:

          

Net income (loss)

   $ (23,977 )   $ (117,196 )   $ (2,971 )   $ 40,247      $ 40,089   

Return on average assets

     (0.54 )%      (3.08 )%      (0.09 )%      1.22     1.33

Stockholder’s equity to assets – end of year

     6.95        7.36        8.82        9.38        8.58   

Leverage ratio

     6.77        7.11        8.74        9.04        8.46   

Tier 1 risk-based capital ratio

     8.73        8.32        10.62        10.76        9.91   

Total risk-based capital ratio

     11.64        11.12        11.88        12.01        11.16   

 

N.M. Not Meaningful
(1) Net interest margin is determined by dividing net interest income, as reported, by average interest-earning assets.
(2) The efficiency ratio is determined by dividing noninterest expense by an amount equal to net interest income plus noninterest income, adjusted for gains or losses on investment securities.
(3) For purposes of calculating the ratio of earnings to fixed charges, earnings consist of earnings (loss) before income taxes plus interest and rent expense. Fixed charges consist of interest expense, rent expense and preferred stock dividend requirements.
(4) Nonperforming loans consist of nonaccrual loans and loans contractually past due 90 days or more but still accruing interest.
(5) Nonperforming assets consist of nonperforming loans and other real estate owned and other repossessed assets.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Introduction

 

We are a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago. We derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank. We provide a range of banking services to our customers, with a primary focus on serving closely-held businesses in the Chicago metropolitan area and the people who own and manage those businesses.

 

The following discussion and analysis presents our consolidated financial condition at December 31, 2009 and December 31, 2008 and the results of operations for the years ended December 31, 2009, December 31, 2008, and December 31, 2007. This discussion should be read together with the “Selected Consolidated Financial Data,” our audited consolidated financial statements and the notes thereto and other financial data contained elsewhere in this annual report. In addition to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and forward-looking statements as a result of certain factors, including those discussed in the section captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K.

 

Outlook

 

During 2008, we embarked on a growth strategy and focused primarily on lending to privately held businesses, including expanding our asset-based lending capability and opening offices in several additional states. In connection with that strategy, we added a number of new members to our senior management team, beginning with the hiring of a new President in February 2008, followed by the hiring of over 50 new commercial bankers. Together with our existing bankers, this new team of commercial bankers established 180 new commercial banking relationships in 2008 and over 200 in 2009. We also originated more than $750 million in new commercial loans in 2008 and more than $650 million in new loans in 2009. At the same time, we repositioned our loan portfolio in an effort to reduce our exposure to industries and sectors that we no longer considered economically desirable.

 

In December 2009, we established a new residential mortgage origination line of business by hiring a team of individuals with extensive mortgage banking experience. We expect that the unit will have offices in several states, with production coming from established relationships with mortgage brokers, retail originations and production from our Bank’s branch locations. The operation began originating loans during the first quarter of 2010. We expect that this new line of business will be a source of fee income for us and provide additional earnings diversification.

 

In part to fund growth strategy, we raised approximately $120 million in additional regulatory capital in September 2008 to fund asset expansion and improve our regulatory capital position, consisting of a private placement of $60 million of 8% non-cumulative convertible perpetual preferred stock, Series A (“Series A Preferred”), to certain institutional and individual accredited investors and the sale of $60 million in principal amount of 10% subordinated notes issued by our Bank. In November 2008, we also received $104.8 million from the U.S. Treasury Department in exchange for the issuance of 104,823 shares of our Fixed Rate Cumulative perpetual preferred stock, Series B (“Series B Preferred”) and warrants to purchase 1,462,647 shares of our common stock at an exercise price of $10.75 per share as part of the TARP Capital Purchase Program.

 

Throughout 2009, we focused our efforts on improving our operating results by increasing the level of net interest income and noninterest income while attempting to hold the level of noninterest expense relatively flat by reducing salaries and benefit costs and certain other overhead expenses. We also improved our loan pricing, including the use of interest rate floors in new loan originations, and increased the size and duration of our investment portfolio to take advantage of higher yields. On the liability side, we continued to strengthen our liquidity position by obtaining more funding from core customers which allowed us to reduce our reliance on more costly brokered deposits.

 

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As defined by regulatory guidelines, both the holding company and the Bank remain “well capitalized.” Still, the amount of our losses over the last two years, together with our expansion plans and continuing loan losses as a result of the sustained severe economic conditions confronting our customers, have placed a strain on our capital resources. In addition, we have repaid all of the $12 million outstanding on our revolving line of credit, and we do not expect to renew this facility with the current lender when it expires on March 31, 2010. During the first quarter of 2010, we also increased the Bank’s capital levels by making a $25.0 million capital contribution from the holding company. In order to maintain sufficient capital to act as a source of strength for our Bank, to better align our capital position to our peers and to support our future growth plans, we have developed a capital plan that anticipates increasing our capital levels in the second quarter of 2010. Accordingly, we intend to commence an offering to issue 1,200,000 shares of our common stock to induce the holders of our Series A preferred stock to convert their preferred shares into shares of our common stock. We also intend to pursue a $60 million private placement of shares of convertible preferred stock and subordinated notes.

 

Results of Operations

 

We reported a net loss applicable to common stockholders of $43.0 million, or ($4.10) per diluted common share outstanding for the year ended December 31, 2009, compared to a net loss applicable to common stockholders of $143.4 million, or ($13.72) per diluted common share, during 2008. The lower net loss applicable to common stockholders in 2009 was due to a $54.5 million decrease in the provision for loan losses and increases in net interest income of $30.6 million and noninterest income of $21.2 million. These decreases to the net loss in 2009 were partly offset by a $9.0 million increase in income tax expense and a $4.2 million increase in noninterest expense. In addition, preferred stock dividends and discounts decreased to $11.5 million during 2009 from $18.8 million during 2008. This decrease was primarily due to a $16.7 million charge in 2008 for an implied non-cash dividend to the holders of our 8% non-cumulative convertible perpetual Series A Preferred stock to reflect the beneficial conversion feature upon issuance of this preferred stock. This decrease was partly offset by higher dividends and discounts as 2009 had the full year’s impact of the preferred stock issued in September and November 2008.

 

Noninterest income, without considering the gains and losses from the investment securities portfolio, also increased in 2009 as compared to 2008, as increases in service charge revenue and other income were partly offset by lower trust and investment management fees and losses from our mortgage banking activities. Total noninterest expense increased by $4.2 million, or 4.5%, during 2009 as compared to 2008. This increase included $7.7 million of higher assessments from the FDIC and an increase of $7.0 million in expenses related to our nonperforming assets, which offset a decrease of more than $10 million in other components of noninterest expense.

 

Our total assets remained relatively unchanged at $4.40 billion at December 31, 2009, compared to $4.39 billion at December 31, 2008. During 2009, while total assets remained relatively unchanged, the composition of those assets changed. Total investments increased $176.7 million during 2009 to $1.27 billion at December 31, 2009 from $1.09 billion at December 31, 2008. Our gross loan portfolio declined by $197.9 million during 2009 to $3.04 billion at December 31, 2009, as compared to $3.23 billion at December 31 2008. On the liability side, during 2009, we increased our in-market deposits by $393.3 million, or 19.5%, to $2.41 billion at December 31, 2009, as compared to $2.01 billion at December 31, 2008. At the same time, our out-of market deposits decreased by $547.6 million, or 49.0%, to $570.4 million at December 31, 2009, from $1.12 billion at December 31, 2008.

 

We reported a net loss applicable to common stockholders for the year ended December 31, 2008 of $143.4 million, or ($13.72) per common share, compared with a net loss of $9.6 million, or ($0.89) per common share, for the year ended December 31, 2007. The largest component of the net loss in 2008 was a $144.2 million provision for loan losses, compared with a provision of $31.9 million in 2007. The net loss in 2008 was also impacted by the establishment of a $46.4 million, or $4.44 per common share, valuation reserve against our deferred tax assets and total preferred stock dividends of $18.8 million in 2008. The net loss in 2007 included a non-cash, after-tax charge of $23.2 million, or $2.14 per share, for the write-off of our goodwill.

 

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Application of Critical Accounting Policies

 

Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America and general reporting practices within the financial services industry. For additional details, see “Notes to Consolidated Financial Statements – Summary of Significant Accounting and Reporting Policies” from our audited financial statements contained elsewhere in this annual report.

 

The preparation of financial statements in conformity with these accounting principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available to us as of the date of the consolidated financial statements and, accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. The estimates, assumptions and judgments made by us are based upon historical experience or other factors that we believe to be reasonable under the circumstances. Certain accounting policies inherently have greater reliance on the use of estimates, assumptions and judgments, and as such, have a greater possibility of producing results that could be materially different than originally reported. We consider our policies for the allowance for loan losses, the realizability of deferred tax assets and the valuation of financial instruments such as investment securities and derivatives to be critical accounting policies.

 

The following accounting policies materially affect our reported earnings and financial condition and require significant estimates, assumptions and judgments.

 

Allowance for Loan Losses

 

We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in our loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include a general allowance computed by applying loss factors to categories of loans outstanding in the portfolio, specific allowances for identified problem loans and portfolio categories, and an unallocated allowance. We maintain our allowance for loan losses at a level considered adequate to absorb probable losses inherent in our portfolio as of the balance sheet date. In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including historical charge-off experience, changes in the size of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent and criticized loans. In addition, we use information about specific borrower situations, including their financial position, work-out plans and estimated collateral values under various liquidation scenarios to estimate the risk and amount of loss on loans to those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of risk of loss and amount of loss on any loan are complicated by the uncertainties surrounding not only our borrowers’ probability of default, but also the fair value of the underlying collateral. The current illiquidity in the real estate market has increased the uncertainty with respect to real estate values. Because of the degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding holding period until sale and the collateral liquidation method, our actual losses may materially vary from our current estimates.

 

Our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have higher potential losses for each loan. These larger loans can cause greater volatility in our reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate for any one loan may have a material impact on our reported impaired loans and related loss estimates. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of any one or a few of these loans can cause an increase in uncollectible loans and, therefore, our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, our allowance for loan losses is adjusted through the recording of a provision for loan losses.

 

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Income Taxes

 

We maintained net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan losses. For income tax return purposes, only net charge-offs are deductible, not the provision for loan losses. Under generally accepted accounting principles, a deferred tax asset valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. We consider both positive and negative evidence regarding the ultimate realizability of our deferred tax assets. Examples of positive evidence may include the existence, if any, of taxes paid in available carry-back years and the likelihood that taxable income will be generated in future periods. Examples of negative evidence may include a cumulative loss in the current year and prior two years and negative general business and economic trends. We currently maintain a valuation allowance against substantially all of our deferred tax asset because it is more likely than not that all of these deferred tax assets will not be realized. This determination was based, largely, on the negative evidence of a cumulative loss in the most recent three year period caused primarily by the loan loss provisions made during those periods. In addition, general uncertainty surrounding future economic and business conditions has increased the likelihood of volatility in our future earnings.

 

Derivative Financial Instruments

 

We use derivative financial instruments (“derivatives”), including interest rate exchange, floor and collar agreements, and forward loan sale commitments to either accommodate individual customer needs or to assist in our interest rate risk management. All derivatives are measured and reported at fair value on our Consolidated Balance Sheet as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the effective portion of the hedged risk, are recognized in current earnings during the period of the change in the fair values. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value. Similarly, the changes in the fair value of derivatives that do not qualify for hedge accounting or are not designated as an accounting hedge are also reported currently in earnings.

 

At the inception of a formally designated hedge and quarterly thereafter, an assessment is made to determine whether changes in the fair values or cash flows of the derivatives have been highly effective in offsetting the changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. If it is determined that derivatives are not highly effective as a hedge, hedge accounting is discontinued for the period. Once hedge accounting is terminated, all changes in fair value of the derivatives flow through the consolidated statements of operations in other noninterest income, which results in greater volatility in our earnings.

 

The estimates of fair values of certain of our derivative instruments, such as interest rate swap, floors, and collar derivatives, are calculated using independent valuation models to estimate market-based valuations. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both us and our counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in volatility in our statement of operations.

 

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Valuation of Investment Securities

 

The fair value of our investment securities portfolio is determined in accordance with generally accepted accounting principles, which requires that we classify financial assets and liabilities measured at fair value into a three-level fair value hierarchy. The determination of fair value is highly subjective and requires management to rely on estimates, assumptions, and judgments that can affect amounts reported in our financial statements. We obtain the fair value of investment securities from an independent pricing service. We review the pricing methodology for each significant class of assets used by this third party pricing service to assess the compliance with accounting standards for fair value measurement and classification in the fair value measurement hierarchy. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current rating from credit rating agencies, and the bond’s terms and conditions, among other things. We have determined that these valuations are classified in Level 2 of the fair value hierarchy.

 

While we use an independent pricing service to obtain the fair values of our investment portfolio, we do employ certain control procedures to determine the reasonableness of the valuations. We validate the overall reasonableness of the fair values by comparing information obtained from our independent pricing service to other third party valuation sources for selected assets and review the valuations and any differences in valuations with members of management who have the relevant technical expertise to assess the results. However, we do not alter the fair values provided by our independent pricing service.

 

At December 31, 2009, our investment portfolio includes $1.10 billion of mortgage related investment securities consisting of mortgage-backed securities and collateralized mortgage obligations. We do not have subprime loans in the portfolio. Of the total mortgage related investment securities, $1.07 billion, or 97.6%, were issued by government and government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. This portfolio included $26.8 million of private-label mortgage related securities that have received heightened monitoring by management because the Company believes the fair values of these securities may have been impacted by illiquidity in the market place and a lack of active trading in these securities. While none of these securities contain subprime mortgage loans, the portfolio does include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. While the fair value of these securities may have been impacted by market illiquidity, the Company does not modify the fair value determined by the independent pricing service but takes additional steps to review for other-than-temporary impairment.

 

Each quarter we review our investment securities portfolio to determine whether unrealized losses are temporary or other than temporary, based on an evaluation of the creditworthiness of the issuers/guarantors, as well as the underlying collateral, if applicable. Our analysis includes an evaluation of the type of security, the length of time and extent to which the fair value has been less than the security’s carrying value, the characteristics of the underlying collateral, the degree of credit support provided by subordinate tranches within the total issuance, independent credit ratings, changes in credit ratings and a cash flow analysis, considering default rates, loss severities based upon the location of the collateral, and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We use other independent pricing sources to obtain fair value estimates and perform discounted cash flow analysis for selected securities. When the discounted cash flow analysis obtained from those independent pricing sources indicates that we expect all future principal and interest payments will be received in accordance with their original contractual terms, we do not intend to sell the security, and we more-likely-than-not will not be required to sell the security before recovery, the unrealized loss is deemed temporary. If such analysis shows that we expect not to be able to recover our entire investment, then an other-than-temporary impairment charge will be recorded in current earnings for the amount of the credit loss component. The amount of impairment that related to factors other than the credit loss is recognized in other comprehensive income. Our assessments of creditworthiness and

 

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the resultant expected cash flows are complicated by the uncertainties surrounding not only the specific security and its underlying collateral but also the severity of the current overall economic downturn. Our cash flow estimates for mortgage related securities are based on estimates of mortgage default rates, severity of loss, and prepayments, which are difficult to predict. Changes in assumptions can result in material changes in expected cash flows. Therefore, unrealized losses that we have determined to be temporary may at a later date be determined to be other-than-temporary and have a material impact on our statement of operations.

 

Results of Operations

 

Net Interest Income

 

Net interest income is the difference between total interest income and fees generated by interest-earning assets and total interest expense incurred on interest-bearing liabilities. Net interest income is our principal source of earnings. The amount of net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of rates earned or incurred on those assets and liabilities.

 

Year Ended December 31, 2009 as Compared to Year Ended December 31, 2008

 

Net interest income increased to $122.9 million in 2009, compared to $92.4 million in 2008, up $30.6 million, or 33.1%. With an adjustment for tax-exempt income, our consolidated net interest income for 2009 was $126.0 million, compared to $95.6 million for 2008. This non-GAAP presentation is discussed below. See “Tax-Equivalent Adjustments to Yields and Margins”. During 2009, net interest income benefited from both a $683.0 million increase in average interest-earning assets and a 29 basis point increase in the net interest margin.

 

Our net interest margin increased to 2.84% in 2009 as compared to 2.55% in 2008. The net interest margin increased in 2009 as our funding costs decreased by more than the yield on our interest-earning assets. Market interest rates declined during 2008 and remained at historically low levels throughout 2009. Since approximately 71% of the loan portfolio is tied to floating or variable indexes, the declining market rates had an immediate impact on our earning asset yields in 2008, which continued in 2009 as higher rate assets were repaid and replaced at lower current market rates. Because of our portfolio of term deposits, our cost of funds can lag changes in market interest rates. Our net interest margin increased in 2009, as the low interest rate environment enabled our portfolio of term deposits to continue to reprice to the current market rates. In addition, our cost of funds decreased in 2009 as we improved our funding mix by reducing reliance on more costly out-of-market funding, increasing noninterest-bearing deposit balances from customers, and taking advantage of low cost short-term funding opportunities from the FHLB and the FRB’s Term Auction Facility.

 

During 2009, the interest-earning asset yield declined to 5.03% from 5.54% during 2008, a decrease of 51 basis points. The yield earned on loans decreased to 5.04% during 2009 from 5.69% in 2008, while the yield on our investment securities portfolio decreased to 5.01% in 2009 from 5.32% in 2008. We took additional steps during 2009 to increase net interest income and maintain our earning asset yields by improving loan pricing, including the use of interest rate floors, and increasing the size and duration of our investment portfolio to take advantage of higher yields. Over the same time period, the cost of funds decreased 86 basis points, from 3.61% during 2008 to 2.75% during 2009. The cost of our deposits decreased 76 basis points to 2.75% during 2009 from 3.51% during 2008. In addition, overall borrowing costs benefited from our increased use of attractively priced short-term borrowings.

 

Our average interest-earning assets during 2009 were $4.43 billion, an increase of $683.0 million, or 18.2%, as compared to the $3.75 billion of average interest-earning assets during 2008. Both an increase in average loans and investment balances produced the overall increase in interest earning assets. The growth strategy implemented in 2008 caused the $380.7 million, or 13.6%, increase in average loan balances between the two annual periods. Average loan balances were $3.17 billion during 2009, compared to $2.79 billion during 2008.

 

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We also increased the size of the investment portfolio in an effort to increase average earning assets and enhance net interest margin. Average investment balances increased to $1.26 billion during 2009 from $895.4 million during 2008, an increase of $364.7 million or 40.7%.

 

The increase in average earning assets was largely funded with short-term borrowings and an increase in noninterest-bearing deposits. Average interest–bearing deposit balances remained relatively unchanged at $2.52 billion during 2009, compared to $2.51 billion during 2008. Our average noninterest-bearing deposit balances increased $175.2 million, or 42.8%, to $584.5 million during 2009, as compared to $409.3 million in 2008. In addition, average notes payable and other advances increased $327.1 million and other borrowings increased by $53.4 million during 2009, as compared to 2008.

 

Year Ended December 31, 2008 as Compared to Year Ended December 31, 2007

 

Net interest income was $92.4 million for the year ended December 31, 2008, as compared to $104.7 million for 2007, a decrease of $12.4 million, or 11.8%. With an adjustment for tax-exempt income, our consolidated net interest income was $95.6 million, $12.6 million, or 11.6%, less than tax equivalent net interest income of $108.2 million during 2007. This non-GAAP presentation is discussed in a following section captioned “Tax-Equivalent Adjustments to Yields and Margins”.

 

Our tax-equivalent net interest margin was 2.55% during 2008, 78 basis points lower than the net interest margin of 3.33% during 2007. The decline in the net interest margin resulted from the decline in interest-earning asset yields outpacing the decline in our interest-bearing funding cost. The yield on our interest-earning assets decreased 155 basis points to 5.54% in 2008 from 7.09% during 2007, primarily as a result of the decline in short term market interest rates driving down the yield on our portfolio of variable rate loans. The percentage of fixed rate loans declined to 31% of the portfolio at December 31, 2008, as compared to 43% at December 31, 2007. This change in the mix of our loans also contributed to the decline in our net interest margin. The decline in loan yield was offset by an increase in loan volume and an increase in both volume and yield on the investment portfolio. Over the same time period, the cost of our interest-bearing liabilities decreased 101 basis points to 3.61% during 2008 from 4.62% during 2007.

 

Average interest-earning assets increased $495.8 million, or 15.2%, to $3.75 billion during 2008, compared to $3.25 billion during 2007. Both average loans and investment balances increased in 2008 as compared to 2007. Average loans were $2.79 billion in 2008, an increase of $283.3 million, or 11.3%, as compared to average loans of $2.51 billion in 2007. Average investment securities increased $184.2 million, or 25.9%, to $895.4 million during 2008, as compared to average investment securities of $711.2 million during 2007. Average interest-bearing liabilities increased $457.5 million, or 17.3%, to $3.11 billion during 2008, compared to $2.65 billion during 2007. Most of the increase occurred in average total deposits, which increased $352.0 million in 2009, or 13.7%, in 2008 to $2.92 billion from $2.57 billion. This increase in average deposits was mainly due to the use of out-of-market funding sources, such as brokered certificates of deposit to fund asset growth. In addition, increases in average borrowings of $49.2 million, FHLB advances of $57.9 million and equity of $32.0 million also supported interest-earning asset growth in 2008.

 

Tax-Equivalent Adjustments to Yields and Margins

 

As part of our evaluation of net interest income, we review our consolidated average balances, our yield on average interest-earning assets, and the costs of average interest-bearing liabilities. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities. Because management reviews net interest income on a taxable equivalent basis, the analysis contains certain non-GAAP financial measures. In these non-GAAP financial measures, interest income and net interest income are adjusted to reflect tax-exempt interest income on an equivalent before-tax basis assuming a tax rate of 35%. This assumed rate may differ from our actual effective income tax rate. In addition, we adjusted the interest-earning asset yield, net interest margin, and the net interest rate spread to a fully taxable equivalent basis. We believe that these measures

 

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and ratios present a more meaningful measure of the performance of interest-earning assets because they provide a better basis for comparison of net interest income regardless of the mix of taxable and tax-exempt instruments.

 

The following table reconciles the tax-equivalent net interest income to net interest income as reported in our Consolidated Statements of Operations. In addition, the interest-earning asset yield, net interest margin and net interest spread are shown with and without the tax equivalent adjustment.

 

     For the Year Ended December 31,  
     2009     2008     2007  
     (dollars in thousands)  

Net interest income as reported

   $ 122,911      $ 92,351      $ 104,705   

Tax equivalent adjustment-investments

     2,944        3,140        3,272   

Tax equivalent adjustment-loans

     115        126        240   
                        

Tax equivalent net interest income

   $ 125,970      $ 95,617      $ 108,217   
                        

Yield on interest-earning assets without tax adjustment

     4.96     5.45     6.98

Yield on interest-earning assets - tax equivalent

     5.03     5.54     7.09

Net interest margin without tax adjustment

     2.77     2.46     3.22

Net interest margin – tax equivalent

     2.84     2.55     3.33

Net interest spread – without tax adjustment

     2.21     1.84     2.36

Net interest spread – tax equivalent

     2.28     1.93     2.47

 

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The following table presents, for the periods indicated, certain information relating to our consolidated average balances and reflects our yield on average interest-earning assets and costs of average interest-bearing liabilities. The table contains certain non-GAAP financial measures to adjust tax-exempt interest income on an equivalent before-tax basis assuming a tax rate of 35%.

 

    Year Ended December 31,  
    2009     2008     2007  
    AVERAGE
BALANCE
    INTEREST   YIELD/
RATE
(%)
    AVERAGE
BALANCE
    INTEREST   YIELD/
RATE
(%)
    AVERAGE
BALANCE
    INTEREST   YIELD/
RATE
(%)
 
    (dollars in thousands)  

INTEREST-EARNING ASSETS:

                 

Investment securities (1):

                 

Taxable

  $ 1,127,899      $ 54,694   4.85   $ 754,811      $ 38,633   5.12   $ 564,962      $ 26,643   4.72

Tax-exempt (tax equivalent) (2)

    132,184        8,412   6.36        140,550        8,970   6.38        146,208        9,348   6.39   
                                               

Total investment securities

    1,260,083        63,106   5.01        895,361        47,603   5.32        711,170        35,991   5.06   
                                               

Cash Equivalents

    1,688        20   1.17        64,025        1,421   2.18        35,731        1,810   5.00   
                                               

Loans (2) (3):

                 

Commercial and commercial real estate

    2,982,534        150,021   4.96        2,627,905        147,727   5.53        2,328,460        178,398   7.56   

Residential real estate mortgages

    87,483        4,485   5.13        56,660        3,150   5.56        61,253        3,555   5.80   

Home equity and consumer

    101,356        4,266   4.21        106,158        5,770   5.44        117,682        9,128   7.76   

Fees on loans

      1,191         2,043         1,689  
                                               

Net loans (tax equivalent) (2)

    3,171,373        159,963   5.04        2,790,723        158,690   5.69        2,507,395        192,770   7.69   
                                               

Total interest earning assets (2)

    4,433,144        223,089   5.03        3,750,109        207,714   5.54        3,254,296        230,571   7.09   
                                               

NON-EARNING ASSETS:

                 

Allowance for loan losses

    (131,131         (88,046         (39,524    

Cash and due from banks

    65,674            57,269            55,175       

Accrued interest and other assets

    116,888            91,655            91,677       
                                   

TOTAL ASSETS

  $ 4,484,575          $ 3,810,987          $ 3,361,624       
                                   

INTEREST-BEARING LIABILITIES:

                 

Interest-bearing deposits:

                 

Interest-bearing demand deposits

  $ 661,403      $ 7,610   1.15      $ 748,001      $ 13,114   1.75      $ 888,242      $ 34,919   3.93   

Savings deposits

    41,848        35   0.08        45,247        58   0.13        54,169        150   0.28   

Time deposits

    1,816,169        61,519   3.39        1,718,572        75,107   4.37        1,233,280        61,961   5.02   
                                               

Total interest-bearing deposits

    2,519,420        69,164   2.75        2,511,820        88,279   3.51        2,175,691        97,030   4.46   
                                               

Other borrowings

    366,844        8,844   2.38        313,430        9,648   3.03        264,232        11,051   4.13   

Notes payable and other advances

    509,049        6,557   1.27        181,986        5,511   2.98        124,055        6,342   5.04   

Junior subordinated debentures

    86,607        6,066   7.00        86,607        7,013   8.10        86,607        7,931   9.16   

Subordinated notes

    55,499        6,488   11.69        14,192        1,646   11.60        —          —    
                                               

Total interest-bearing liabilities

    3,537,419        97,119   2.75        3,108,035        112,097   3.61        2,650,585        122,354   4.62   
                                               

NONINTEREST-BEARING LIABILITIES:

                 

Noninterest-bearing deposits

    584,512            409,322            393,494       

Accrued interest, taxes and other liabilities

    68,801            49,483            41,442       
                                   

Total noninterest-bearing liabilities

    653,313            458,805            434,936       
                                   

STOCKHOLDERS’ EQUITY

    293,843            244,147            276,103       
                                   

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

  $ 4,484,575          $ 3,810,987          $ 3,361,624       
                                   

Net interest income (tax equivalent) (2)

    $ 125,970       $ 95,617       $ 108,217  
                             

Net interest spread (2) (4)

      2.28       1.93       2.47
                             

Net interest margin (2) (5)

      2.84       2.55       3.33
                             

 

(1) Investment securities average balances are based on amortized cost.
(2) Calculations are computed on a taxable-equivalent basis using a tax rate of 35%.
(3) Nonaccrual loans are included in the above stated average balances.
(4) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(5) Net interest margin is determined by dividing taxable equivalent net interest income by average interest-earning assets.

 

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The following table presents, for the periods indicated, a summary of the changes in interest earned and interest expense incurred resulting from changes in volume and rates for the major components of interest-earning assets and interest-bearing liabilities on a tax-equivalent basis assuming a tax rate of 35%. The change due to both rate and volume has been allocated in proportion to the dollar amount of the change in each. The impact of changes in the mix of interest-earning assets and interest-bearing liabilities is reflected in net interest income.

 

    2009 over 2008
INCREASE/(DECREASE)
    2008 over 2007
INCREASE/(DECREASE)
 
    Volume     Rate     Day (1)     Net     Volume     Rate     Day (1)   Net  

INTEREST EARNED ON:

               

Investment securities:

               

Taxable

  $ 18,196      $ (2,135   $ —        $ 16,061      $ 9,576      $ 2,415      $ —     $ 11,991   

Tax-exempt

    (530     (28     —          (558     (362     (15     —       (377

Cash equivalents

    (947     (450     (4     (1,401     947        (1,341     5     (389

Loans

    20,673        (18,966     (434     1,273        19,895        (54,504     528     (34,081
                           

Total interest-earning assets

          15,375              (22,856
                           

INTEREST PAID ON:

               

Interest-bearing demand deposits

    (1,380     (4,088     (36     (5,504     (4,853     (17,048     96     (21,805

Savings deposits

    (4     (19     —          (23     (21     (71     —       (92

Time deposits

    4,102        (17,485     (205     (13,588     21,827        (8,850     170     13,147   

Other borrowings

    1,460        (2,238     (26     (804     1,802        (3,235     30     (1,403

Notes payable and other advances

    5,522        (4,461     (15     1,046        2,274        (3,121     17     (830

Junior subordinated debentures

    —          (928     (19     (947     —          (941     22     (919

Subordinated debt

    4,833        13        (4     4,842        1,646        —          —       1,646   
                           

Total interest-bearing liabilities

          (14,978           (10,256
                                                             

Net interest income, tax-equivalent

  $ 21,675     $ 8,809      $ (131   $ 30,353      $ 12,878     $ (25,676   $ 198   $ (12,600
                                                             

 

(1) The year ended December 31, 2008 had 366 days compared to 365 days for the years ended December 31, 2009 and 2007.

 

Provision for Loan Losses

 

We determine a provision for loan losses that we consider sufficient to maintain an allowance to absorb probable losses inherent in our portfolio as of the balance sheet date. For additional information concerning this determination, see “Application of Critical Accounting Policies—Allowance for Loan Losses,” “Nonperforming Assets”, “Impaired Loans” and “Allowance for Loan Losses.”

 

Our provision for loan losses totaled $89.6 million during 2009, a decrease of $54.5 million, or 37.8%, as compared to the $144.2 million provision for loan losses recorded in 2008. Although the provision for loan losses in 2009 was higher than historical levels, the provision was lower than 2008. The provision for loan losses in 2008 reflected the rapid rise in nonperforming and impaired loans and the increase in the severity of the estimated loss associated with these loans. Although we experienced weakness in all portions of our loan portfolio, our residential construction and land loans produced most of these losses. A decrease in housing demand and real estate valuations contributed to these losses. While nonperforming loans and impaired loans remain at historically elevated levels, these amounts decreased during 2009. Nonperforming loans totaled $141.5 million at December 31, 2009, compared to $200.4 million at year-end 2008, a decrease of $58.9 million, or 29.4%. In addition, impaired loans decreased to $141.7 million at December 31, 2009, compared to $206.7 million at December 31, 2008, a decrease of $65.0 million, or 31.4%. However, as we have dealt with our

 

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problem assets, the level of net charge-offs increased to $112.0 million during 2009 as compared to $70.3 million in 2008. Our provision for loan losses decreased in 2009, as compared to 2008, as the level of nonperforming and impaired loans decreased. Since net charge-offs in 2009 exceeded the provision for loan losses, the total allowance for loan losses decreased from $128.5 million at December 31, 2008 to $106.2 million at December 31, 2009. See “Nonperforming Assets” and “Allowance for Loan Losses” for further discussion of the credit quality of our loan portfolio and our allowance for loan losses.

 

The provision for loan losses of $144.2 million during 2008 was $112.3 million higher than the $31.9 million provision for loan losses during 2007. Increases in nonperforming loans, impaired loans, and net charge-offs caused us to increase our allowance for loan losses in 2008. Net charge-offs totaled $70.3 million, or 2.52% of average total loans, during 2008 compared to $14.7 million, or 0.59% of average total loans, in 2007. In addition, the level of nonperforming loans increased to $200.4 million, or 6.20% of total loans, at December 31, 2008, compared to nonperforming loans of $75.7 million, or 2.99% of total loans, at December 31, 2007.

 

Noninterest Income

 

The following table presents the composition of our noninterest income for the periods indicated:

 

     Year Ended December 31,
     2009     2008     2007
     (in thousands)

Service charges

   $ 11,306      $ 9,136      $ 7,709

Trust and investment management fees

     1,697        3,578        3,864

Mortgage banking, net

     (1,961     23        3

Gain (loss) on investment securities

     17,595        (2,399     —  

Loan syndication fees

     —          116        2,600

Other derivative income

     1,399        1,936        392

Letter of credit and other loan fees

     2,186        376        527

Change in market value of employee deferred compensation plan

     478        (1,354     525

Other noninterest income

     891        1,025        1,091
                      

Total noninterest income

   $ 33,591      $ 12,437      $ 16,711
                      

 

Year Ended December 31, 2009 as Compared to Year Ended December 31, 2008

 

Noninterest income during 2009 totaled $33.6 million, up from $12.4 million during 2008. The gain on the sale of investment securities in 2009 of $17.6 million and a $2.4 million loss due to other-than-temporary impairment of an investment security in 2008 accounted for most of this increase. Higher service charges and letter of credit and other fees, partly offset by a decrease in trust and investment management fees and losses from mortgage banking activities, also contributed to this increase.

 

We principally derive service charges from deposit accounts. Service charges increased $2.2 million, or 23.8%, in 2009 to $11.3 million as compared to $9.1 million in 2008. Service charge income is affected by a number of factors, such as the volume of deposit accounts and service transactions, the price established for each deposit service, the earnings credit rate and the collected balances customers maintain in their commercial checking accounts. The increase in service charge revenue in 2009 was largely due to increased customer accounts and activity that resulted from the commercial banking growth initiative that we began in 2008. In addition, a decrease in the earnings credit rate given to customers on their collected account balances also contributed to the higher service charge revenue.

 

Trust and investment management fees declined to $1.7 million during 2009 from $3.6 million during 2008, a decrease of $1.9 million or 52.6%. Trust fees totaled $968,000 during 2009, compared to $2.4 million during

 

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2008. Trust fees were earned in connection with our offering of corporate trust services, primarily our paying agent and escrow services. Trust fees declined during 2009 because of a reduced volume of business and a decrease in the spread income we earn on invested trust funds. During the first quarter of 2010, we entered into an agreement to sell our trust business to a third party. After the sale is completed, we expect a reduction in trust fees, as well as in noninterest expense, primarily in salaries and benefits, from sale of these operations. This transaction is scheduled to close during the second quarter of 2010.

 

Investment management fees in 2009 declined to $729,000 from $1.2 million during 2008 due to fewer assets under management. During the second quarter of 2009, the third-party investment management firm that had been providing sub-advisory services to the Bank’s clients became the primary investment advisor and assumed all portfolio management responsibilities for our wealth management customers.

 

The $2.0 million loss during 2009 from mortgage banking activities was primarily due to economic hedges associated with our residential mortgage loans held for sale. In order to mitigate interest rate risk associated with these loans held for sale, we entered into forward loan sale commitments. The loss resulted from a realized settlement loss on matured forward loan sale commitments and an unrealized gain of $540,000 on the unsettled outstanding forward loan sales as of December 31, 2009. In addition, during the fourth quarter we sold approximately $10.5 million of mortgage loans held for sale and recorded a small gain. In December 2009, we announced the formation of a residential mortgage loan origination line of business, which began to originate loans in the first quarter of 2010. Although this new unit did not impact this category of noninterest income in 2009, we expect that its operations will provide mortgage banking fee income during 2010.

 

During 2009, we recorded gains on the sale of available-for-sale investment securities of $17.6 million from the sale of approximately $500 million of investment securities, mostly mortgage-related securities. We realized gains when we sold mortgage-backed securities that had been experiencing higher than anticipated prepayments and to take advantage of the low level of interest rates and tightening spreads in the market later in the year. The $2.4 million loss recorded in 2008 was an other-than-temporary impairment of one private label mortgage-backed security. See “Investment Securities” below for a further discussion.

 

Other derivative income totaled $1.4 million during 2009, compared to $1.9 million during 2008. The income in 2009 was primarily attributable to recording the initial fair value from the offering of derivative instruments to our customers. Other derivative income in 2008 was comprised of $712,000 from customer derivatives and $1.2 million from changes in the fair value of derivatives that are not designated as accounting hedges. See “Derivative Financial Instruments” following for further discussion of our derivative instruments.

 

Standby letters of credit and other loan fees totaled $2.2 million during 2009, compared to $376,000 during 2008. The increase in fees during 2009 was primarily due to our expanded asset based lending operations.

 

Our employees’ deferred compensation plan allows the participants to direct the investments of their deferred compensation in selected mutual funds. The investment in these mutual funds are assets of the Company and carried at fair value, while an equal and offsetting liability is recorded to reflect the obligation of the Company to the plan participants. The change in the fair value of assets in our employees’ deferred compensation plan is reported in noninterest income and the offsetting change in our liability to deferred compensation plan participants is included in salary expense and, therefore, has no net impact on the Company’s operating results. During 2009, the fair value of these assets increased by $478,000 compared to a decline in the fair value of $1.4 million in 2008.

 

Other noninterest income includes fees from automated teller machines, safe deposit box rentals, fees from insurance and financial planning services, and gains or losses from investments in limited partnerships. Total other noninterest income was $891,000 during 2009 as compared to $1.0 million in 2008.

 

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Year Ended December 31, 2008 as Compared to Year Ended December 31, 2007

 

Noninterest income totaled $12.4 million during 2008, a decrease of $4.3 million, or 25.6%, compared to $16.7 million for 2007. The decrease in noninterest income in 2008 was due to an impairment loss of $2.4 million, resulting from the write-down to fair value of a private-label mortgage-backed security, lower loan syndication fees of $2.5 million, and a $1.4 million decrease in the market value of assets in our employees’ deferred compensation plan assets. These decreases were partly offset by increases in service charges of $1.4 million and other derivative income of $1.5 million.

 

Service charges increased $1.4 million, or 18.5%, in 2008 to $9.1 million, as compared to $7.7 million in 2007. The increase in service charge revenue in 2008 was primarily caused by a decrease in the earnings credit rate given to customers on their collected account balances to offset gross activity charges.

 

Trust and investment management fees were $3.6 million during 2008 as compared to $3.9 million during 2007, a decrease of $286,000, or 7.4%. Trust fees totaled $2.3 million during both 2008 and 2007. Investment management fee income decreased $323,000, or 20.9%, to $1.2 million in 2008, compared to $1.5 million in 2007. The decline in fee income resulted primarily from the decline in assets under management, which was the result of both the decline in the general equity markets and fewer investment management customers.

 

In December 2008, we recorded a $2.4 million loss for other-than-temporary impairment on a private-label mortgage-backed security. The security was collateralized by adjustable rate loans with an initial fixed interest rate period and interest only payments for the first five years. These mortgage loans are primarily in California and were scheduled for payment resets in mid-2009. We recognized an impairment loss for the amount by which the par value exceeded the fair value as determined by a nationally recognized independent pricing service. See “Investment Securities” below for a further discussion.

 

Loan syndication fees totaled $116,000 in 2008, compared with $2.6 million in 2007. Historically, we earned fees in connection with the syndication of real estate development loans. The decline in loan syndication fees was a result of reduced lending activity in the real estate development market.

 

Other derivative income totaled $1.9 million during 2008, compared to $392,000 during 2007. The other derivative income of in 2008 was comprised of $712,000 related to recording the initial fair value from customer derivatives and $1.2 million from changes in the fair value of derivatives that are not designated as accounting hedges. Other derivative income of $392,000 in 2007 was primarily derived from changes in the fair value of derivative instruments not designated as accounting hedges.

 

In 2008, we recorded a loss from the change in the market value of our employees’ deferred compensation plan of $1.4 million compared to a gain of $525,000 in 2007. The change in the fair value of assets in our employees’ deferred compensation plan impacts both noninterest income and salary expense and, therefore, has no net impact on the Company’s operating results.

 

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Noninterest Expense

 

The following table presents the composition of our noninterest expense for the periods indicated:

 

     Year Ended December 31,  
     2009     2008     2007  
     (dollars in thousands)  

Salaries and employee benefits:

      

Salaries, employment taxes and medical insurance

   $ 38,440      $ 36,406      $ 32,402   

Sign-on bonuses and severance

     386        6,088        575   

Incentives, commissions and retirement benefits

     4,088        5,361        4,794   
                        

Total salaries and employee benefits

     42,914        47,855        37,771   

Goodwill impairment

     —          —          23,237   

Occupancy of premises

     8,146        7,812        8,673   

Furniture and equipment

     2,230        3,094        3,431   

Nonperforming asset expense

     11,726        4,711        643   

FDIC assessment

     10,380        2,687        307   

Legal fees, net

     5,961        5,016        2,464   

Early extinguishment of debt

     527        2,500        —     

Other professional services

     1,518        2,311        2,427   

Computer processing

     1,858        1,995        1,737   

Other noninterest expense

     12,347        15,389        13,835   
                        

Total noninterest expense

   $ 97,607      $ 93,370      $ 94,525   
                        

Efficiency Ratio (1)

     70.27     87.11     77.85
                        

 

(1) The efficiency ratio is determined by dividing noninterest expense by an amount equal to net interest income plus noninterest income, excluding gains or losses on investment securities.

 

Year Ended December 31, 2009 as Compared to Year Ended December 31, 2008

 

Total noninterest expense was $97.6 million during 2009, an increase of $4.2 million, or 4.5%, as compared to noninterest expense of $93.4 million during 2008. The increase in expense was primarily due to higher FDIC assessments of $7.7 million and higher nonperforming asset expense of $7.0 million. These increases were partly offset by lower salaries and employee benefits expense of $4.9 million, a $2.0 million decrease in losses on early extinguishment of debt, and general decreases in other categories of expense.

 

Total salaries and employee benefits expense in 2009 was $42.9 million, compared to $47.9 million during 2008, a reduction of $4.9 million, or 10.3%. The decline in expense in 2009 was largely due to higher sign-on bonuses and severance we incurred in 2008 as part of the implementation of our growth strategy. In addition, lower incentives, commissions, and retirement benefits during 2009, partly offset by an increase in base salaries, also contributed to the decrease in expense. During 2009, we put in place certain expense control measures to reduce salaries and benefits costs, which included reducing staffing levels, eliminating annual cash-based incentive awards and suspending the annual merit increase. During 2010, we expect that our total salaries and employee benefits expense will increase as the result of the addition of the new residential mortgage loan originations unit. We also anticipate that the number of full-time equivalent employees will increase through 2010 as our mortgage loan business grows.

 

Salaries, employment taxes, and medical insurance expenses increased $2.0 million, or 5.6%, to $38.4 million during 2009, as compared to $36.4 million for 2008. Most of the increase in salaries was associated with an increase in the liability to our deferred compensation plan participants caused by an increase in the fair value of assets held in the plan. During 2009, the market value of these assets increased by $478,000, compared to a

 

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decline in the market value of $1.4 million in 2008. The change in the market value of assets in our employees’ deferred compensation plan is reported in noninterest income, and the offsetting change in our liability to these participants is reported in salary expense and has no net impact to the Company’s operating results. The remainder of the increase was due to higher base salaries associated with our growth strategy and the additional hiring that took place in 2008. These increases were partly offset by a decrease in employment taxes and medical insurance. As part of our expense control measures, we reduced the number of full time equivalent employees by eliminating certain positions in the first quarter of 2009. The number of full-time equivalent employees was 434 at December 31, 2009, compared to 451 at December 31, 2008.

 

Sign-on bonuses and severance expense was $386,000 in 2009 and consisted primarily of severance costs. Sign-on bonuses and severance expense was $6.1 million in 2008, and consisted of severance expense of $4.1 million and sign-on bonuses of $2.0 million. The higher expense in 2008 was associated with severance related to changes in senior management and certain of our supporting staff and signing bonuses to attract new employees.

 

Incentives, commissions, and retirement benefits also decreased during 2009 to $4.1 million, as compared to $5.4 million during 2008. The decrease was largely due to expenses in 2008 for guaranteed bonuses, primarily as a result of our recruiting activities. In addition, lower sales incentives also contributed to the decrease in expense in 2009.

 

Occupancy of premises expense increased to $8.1 million during 2009, as compared to $7.8 million during 2008, an increase of $334,000 or 4.3%. Most of the increase was due to the opening of leased asset-based lending offices in other states.

 

Furniture and equipment expense decreased to $2.2 million during 2009, as compared to $3.1 million in 2008, a decrease of $864,000, or 27.9%. Most of the decrease was associated with lower depreciation expense at our corporate offices in Rosemont, Illinois as the furniture and equipment purchased when the facility opened in late 2003, became fully depreciated in 2008.

 

Nonperforming asset expense increased to $11.7 million during 2009 as compared to $4.7 million during 2008. The increase was primarily associated with $5.8 million of additional write-downs recorded in the fourth quarter of 2009 on certain nonaccrual commercial loans held for sale. Additional write-downs and higher losses on the disposition of other real estate owned assets during 2009 also contributed to the increase in expense. The amount of nonperforming asset expense is impacted by the complexity and number of nonperforming loans and other real estate owned assets and could continue to be significant in future periods.

 

FDIC assessments increased in 2009 as compared to 2008, because the FDIC imposed an industry-wide special assessment and a general increase in premiums for all financial institutions. In addition, our election to participate in the FDIC’s Transaction Account Guarantee Program also increased our expense. FDIC assessments were $10.4 million for 2009, compared to $2.7 million for 2008, an increase of $7.7 million. FDIC assessments in 2009 included an industry-wide special assessment to help recapitalize the FDIC’s Deposit Insurance Fund, which amounted to $2.1 million. The remainder of the increase was mostly due to higher insurance assessments that went into effect for all financial institutions. In addition, in an effort to increase the balance of its Deposit Insurance Fund, during the fourth quarter of 2009, the FDIC required all banks to prepay the estimated amount of the next three years’ premium payments. At December 31, 2009, the Bank’s prepaid FDIC premiums totaled $29.1 million and were included in other assets on our Consolidated Balance Sheets.

 

Legal fees were $6.0 million in 2009, as compared to $5.0 million in 2008, an increase of $945,000, or 18.8%. Legal fees are reported net of reimbursements received from customers. The increase was primarily due to legal fees incurred as a result of our efforts to address the greater amount of nonperforming assets.

 

During 2009, we incurred $527,000 of expense for the early redemption of approximately $29.0 million of above market rate brokered certificates of deposits, compared to $2.5 million of expense for the early redemption

 

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of approximately $190 million of above market rate brokered certificates of deposits in 2008. The unamortized issuance costs and other discounts on these deposits were written off at the time of redemption. As of December 31, 2009, we do not have additional brokered CDs that we can call at our option.

 

Other professional fees totaled $1.5 million in 2009, as compared to $2.3 million in 2008, a decrease of $793,000 or 34.3%. Most of the decrease was associated with lower third-party asset management fees paid to the sub-advisor for our investment management clients. During 2009, we expanded the relationship with this third party to become the primary investment advisor going forward and, as part of this arrangement, we were no longer obligated to pay the sub-advisor fee.

 

Other noninterest expense was $12.3 million in 2009, compared to $15.4 million in 2008. Other noninterest expense principally includes costs for certain consulting and professional fees, advertising and public relations, business meals and travels, board of directors’ fees, operational losses and other operating expenses, such as telephone, postage, office supplies, and printing. During 2009, as part of our cost control measures, we experienced decreases in many areas of other expenses, such as advertising, business travel and meals, consulting and other professional fees, and directors’ fees.

 

Our efficiency ratio was 70.27% in 2009, compared to 87.11% in 2008. The improvement in our efficiency ratio in 2009 was primarily the result of the increase in net interest income and noninterest income, excluding the gains and losses from investment securities.

 

Year Ended December 31, 2008 as Compared to Year Ended December 31, 2007

 

Total noninterest expense in 2008 was $93.4 million, a decrease of $1.2 million, or 1.2%, from $94.5 million in 2007. Noninterest expense in 2007 included a one-time charge of $23.2 million for the impairment of our goodwill.

 

Total salaries and employee benefits expense in 2008 was $47.9 million, compared to $37.8 million in 2007, an increase of $10.1 million, or 26.7%. During 2008, we implemented a strategic growth plan, which included the hiring of a new senior management team and 50 commercial relationship managers. In addition, we replaced a number of our existing support staff. Our recruiting increased base salary expense, cash sign-on bonuses, incentives and stock-based awards to attract new employees.

 

Salaries, employment taxes and medical insurance expense increased $4.0 million, or 12.4%, to $36.4 million in 2008, as compared to $32.4 million in 2007. Base salaries increased $5.3 million, or 18.3%, as the number of total full-time equivalent employees increased to 451 at December 31, 2008, from 418 at December 31, 2007. In addition, employment taxes and medical insurance premiums also increased. The increases in salaries, taxes and insurance were partially offset by the $1.4 million reduction in the market value of the employees’ deferred compensation plan assets.

 

Sign-on bonuses and severance expense totaled $6.1 million in 2008 and was comprised of severance of $4.1 million and sign-on bonuses of $2.0 million. In comparison, during 2007, severance costs totaled $318,000 and sign-on bonuses were $257,000.

 

Total incentives, commissions and retirement benefits increased $567,000, or 11.8%, to $5.4 million in 2008, compared to $4.8 million in 2007. The increase was primarily a result of increased stock-based awards in 2008 associated with the hiring during the year. Equity-based compensation increased to $2.2 million in 2008, as compared to $1.6 million in 2007. While we did not accrue for any annual performance-based bonus pool in 2008, we did incur incentive and guaranteed bonus expense, primarily as a result of our recruiting activities in 2008.

 

We recorded a $23.2 million goodwill impairment charge in 2007 to write-off our remaining goodwill. Because of adverse changes in the business climate that impacted the Bank and the decline in the market price of our common stock to levels below our book value, we determined that the entire amount of our goodwill was impaired and recorded the goodwill impairment charge in the fourth quarter of 2007.

 

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Our occupancy of premises expense was $7.8 million in 2008, as compared to $8.7 million in 2007. Occupancy expenses were higher in 2007 because we moved our downtown Chicago facility from one leased facility to another, as the lease on the existing facility was set to expire in December 2007. As a result, we incurred lease expense for the new facility and the existing facility as we transitioned to the new space. In addition, we incurred costs to physically move to the new facility.

 

Furniture and equipment expense was $3.1 million in 2008, compared to $3.4 million in 2007. Lower depreciation and maintenance produced the decrease in the yearly comparisons.

 

An increase in nonperforming assets and loans in our work-out area caused an increase in nonperforming asset expense in 2008, as compared to 2007. Nonperforming asset expense was $4.7 million in 2008, as compared to $643,000 in 2007. The higher expense included the recognition of a $2.9 million liability for unfunded commitments under standby letters of credit associated with certain of our impaired loans. In addition, we recognized additional provisions of $857,000 to reduce the carrying value of certain other real estate owned in 2008.

 

FDIC assessments were $2.7 million in 2008, as compared to $307,000 in 2007. In 2007, the FDIC increased the rates paid for deposit insurance and, at the same time, granted assessment credits to qualifying institutions. The Bank utilized its assessment credit throughout 2007 and in the first quarter of 2008 to offset the increased deposit insurance premiums.

 

Total legal fees, net of reimbursements, were $5.0 million in 2008, compared to $2.5 million in 2007. The increase in legal fees in 2008 was primarily related to our lending and collection activities, in particular relating to our nonperforming assets. In addition, we incurred increased legal fees in 2008 for revising our employee benefit plans, recruiting and regulatory matters.

 

In 2008, we incurred early extinguishment of debt expense of $2.5 million for the early redemption of approximately $190 million of above market rate brokered certificates of deposits. The unamortized issuance costs and discounts on these deposits were charged to expense at the time of redemption.

 

Other noninterest expense was $15.4 million in 2008, compared to $13.8 million in 2007. Increases in business entertainment, loan related expenses and board of directors’ fees, all contributed to the higher level of other noninterest expense in 2008, as compared to 2007. The increase in business entertainment was due to the increase in the number of commercial bankers. Board of directors’ fees increased as a result of an increase in the number of board meetings as well as an increase in the number of directors.

 

Our efficiency ratio was 87.11% in 2008, compared to 77.85% in 2007. The increase in the efficiency ratio in 2008 was primarily caused by the decrease in net interest income.

 

Income Taxes

 

During 2009, despite a pre-tax loss of $30.7 million, we recorded total income tax expense of $834,000. Because of the valuation allowance on our deferred tax asset, we were not able to record an income tax benefit related to the pre-tax loss incurred. A current income tax benefit that would normally result from a pre-tax loss was offset by additional deferred tax expense due to an increase in the required valuation allowance. Additional contributing factors to the income tax expense recorded in 2009 included the release of the residual tax effects of changes in the beginning of the year valuation allowance previously allocated to other comprehensive income. These residual tax effects, which totaled $2.5 million during 2009, resulted from changes in the deferred tax liability associated with deferred gains on terminated cash flow hedges recorded in other comprehensive income. This increase in income tax expense was partly offset by income tax benefits primarily resulting from adjustments to prior years’ alternative minimum tax liability. We expect income tax expense of $1.3 million during 2010 associated with the release of the residual tax effects.

 

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Since the third quarter of 2008, we have maintained a valuation allowance on our deferred tax assets as we have concluded that based upon the weight of all available evidence, it was “more likely than not” that not all of the deferred tax assets would be realized. The valuation allowance increased $15.7 million during 2009 to $62.1 million at December 31, 2009, as compared to $46.4 million at December 31, 2008. The increase in the required valuation allowance was largely due to the increase in our net deferred tax assets and changes in the beginning of the year valuation allowance solely attributable to identifiable events recorded in other comprehensive income, primarily changes in unrealized gains on available-for-sale investment securities, the tax effects of which were allocated to other comprehensive income. At December 31, 2009, the net deferred tax asset, after considering the $62.8 million valuation allowance, was $4.6 million, which was supported by available tax planning strategies. We evaluate the valuation allowance each period taking into account our inventory of deferred tax assets and liabilities, including those recorded on items included in equity as other comprehensive income, which are recorded net of tax.

 

During 2008, we reported an income tax benefit of $8.2 million for the year on a pre-tax loss of $132.7 million. We recorded an income tax benefit in 2008 because of our ability to carry back the 2008 pre-tax loss to recover taxes paid in prior years. This benefit was partly offset by the recording of an after-tax, non-cash charge of $46.4 million to establish a valuation allowance against our deferred tax asset. After considering the valuation allowance, at December 31, 2008, we had a net deferred tax asset of $6.9 million which was supported by available carry backs of operating losses to taxes paid in previous years and available tax planning strategies.

 

Income tax expense was $4.6 million for the year ended December 31, 2007, notwithstanding the pre-tax loss of $5.0 million, primarily because the goodwill impairment charge of $23.2 million was not deductible for income tax purposes. In addition, during 2007, the State of Illinois passed legislation that increased our effective tax rate beginning in 2008. As a result of the enactment of this legislation, we recognized a reduction in income tax expense of $376,000 by increasing our deferred tax assets.

 

Impact of Inflation and Changing Prices

 

The consolidated financial statements and notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of our financial position and operating results in terms of historical amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, nearly all of our assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on our performance than do the effects of the general levels of inflation. Interest rates do not necessarily move in the same direction or, to the same extent, as the price of goods and services.

 

Financial Condition

 

While our total assets were relatively unchanged at $4.40 billion at December 31, 2009 and $4.39 billion at December 31, 2008, the composition of those assets changed in 2009. During 2009, total loan balances decreased $197.9 million, or 6.1%, to $3.04 billion at December 31, 2009, compared to $3.23 billion at year-end 2008. Offsetting this decrease was an increase in investment securities, which totaled $1.27 billion at December 31, 2009, or $176.7 million higher than from the prior year end.

 

On the liability side, total deposits decreased $154.2 million, or 4.9%, to $2.98 billion at December 31, 2009, from $3.13 billion at December 31, 2008. However, notes payable and other advances increased $165.0 million in 2009 and other borrowings increased $62.1 million. Our total stockholders’ equity decreased $48.3 million during 2009 to $258.8 million at December 31, 2009, from $307.1 million at December 31, 2008, primarily due to the net loss incurred during 2009.

 

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Interest-bearing Cash Equivalents

 

Interest-bearing cash equivalents consist of interest-bearing deposits with banks or other financial institutions, federal funds sold and securities purchased under agreements to resell with original maturities of less than 30 days. All federal funds are sold overnight with daily settlement required.

 

Investment Securities

 

Our investment portfolio is designed to provide a source of income with minimal risk of loss, as a source of liquidity and with interest rate risk management opportunities. In managing our investment portfolio within the composition of the entire balance sheet, we balance our earnings, credit, interest rate risk, and liquidity considerations, with a goal of maximizing longer-term overall profitability.

 

The following table presents the composition of our investment portfolio by major category as of the dates indicated:

 

     AVAILABLE-FOR-SALE    HELD-TO-MATURITY    TOTAL
     Amortized
cost
   Estimated
fair value
   Amortized
cost
   Estimated
fair value
   Amortized
cost
   Estimated
fair value
     (in thousands)

December 31, 2009:

                 

U.S. government sponsored agency securities

   $ 44,956    $ 45,094    $ —      $ —      $ 44,956    $ 45,094

Mortgage-backed securities:

                 

Residential

     803,516      810,032      —        —        803,516      810,032

Commercial

     159,688      161,393      —        —        159,688      161,393

Collateralized mortgage obligations

     127,641      130,098      —        —        127,641      130,098

State and municipal obligations

     120,716      122,307      —        —        120,716      122,307

Other debt securities

     2,220      2,347      —        —        2,220      2,347
                                         

Total

   $ 1,258,737    $ 1,271,271    $ —      $ —      $ 1,258,737    $ 1,271,271
                                         

December 31, 2008:

                 

U.S. government sponsored agency securities

   $ 64,993    $ 66,985    $ —      $ —      $ 64,993    $ 66,985

Residential mortgage-backed securities

     704,684      722,933      —        —        704,684      722,933

Collateralized mortgage obligations

     152,198      151,703      —        —        152,198      151,703

State and municipal obligations

     137,958      138,175      —        —        137,958      138,175

Other debt securities

     14,563      14,773      25      25      14,588      14,798
                                         

Total

   $ 1,074,396    $ 1,094,569    $ 25    $ 25    $ 1,074,421    $ 1,094,594
                                         

December 31, 2007:

                 

U.S. government sponsored agency securities

   $ 105,720    $ 106,305    $ —      $ —      $ 105,720    $ 106,305

Residential mortgage-backed securities

     472,477      476,124      —        —        472,477      476,124

Collateralized mortgage obligations

     167,509      165,577      —        —        167,509      165,577

State and municipal obligations

     143,271      144,340      —        —        143,271      144,340

Other debt securities

     —        —        25      25      25      25
                                         

Total

   $ 888,977    $ 892,346    $ 25    $ 25    $ 889,002    $ 892,371
                                         

 

 

Investment securities do not include investments in FHLB and FRB stock of $31.2 million, $29.6 million, and $15.3 million, at December 31, 2009, 2008, and 2007, respectively. These investments are stated at cost.

 

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Our total investment portfolio was $1.27 billion at December 31, 2009 as compared to $1.09 billion at December 31, 2008, an increase of $176.7 million, or 16.1%. During 2009, we increased the size of our investment portfolio in an effort to increase interest-earning assets and enhance net interest income by extending the duration of our portfolio. During the year, we purchased $975.3 million of mortgage-backed securities and collateralized mortgage obligations issued by Ginnie Mae, Fannie Mae, and Freddie Mac. A portion of these securities were funded with the sale of investment securities and proceeds from principal repayments and maturities. During the year ended December 31, 2009, we received $497.4 million of proceeds from the sale of investment securities and recorded a gain of $17.6 million. We realized gains when we sold mortgage-backed securities that had been experiencing higher than anticipated prepayments and when we took advantage of the low level of interest rates and tightening spreads in the market later in the year to reposition our portfolio. The overall weighted-average life of our investment portfolio at December 31, 2009 was approximately 6.9 years, compared to approximately 6.0 years at December 31, 2008.

 

During 2008, our investment portfolio increased by $202.2 million, or 22.7%, to $1.09 billion at December 31, 2008, compared to $892.4 million at year-end 2007. In 2008, we purchased $352.8 million of securities, the majority of which were Ginnie Mae mortgage-backed securities acquired in the fourth quarter of 2008.

 

Mortgage-related securities include residential and commercial mortgage-backed securities and collateralized mortgage obligations, and comprised 86.6% of our investment portfolio at December 31, 2009, compared to 79.9% at December 31, 2008. As of December 31, 2009, over 97% of mortgage-related securities that we held were securities issued by government and government-sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. We do not hold subprime loans in our mortgage-related investment securities portfolio. Although none of these securities contain subprime mortgage loans, the portfolio does include Alt-A loans, adjustable rate mortgages with initial interest only periods and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. While the fair value of these securities has been impacted by market illiquidity, we do not modify the fair value determined by an independent pricing service, but take additional steps to review for other-than-temporary impairment. The following table shows the composition of our mortgage-related securities as of December 31, 2009 by type of issuer.

 

     Amortized Cost    Fair Value
     Pass Thru
Securities
   CMOs    Total    Pass Thru
Securities
   CMOs    Total

Ginnie Mae, Fannie Mae, Freddie Mac

   $ 952,892    $ 106,201    $ 1,059,093    $ 964,823    $ 109,875    $ 1,074,698

Private issuers

     10,312      21,440      31,752      6,602      20,223      26,825
                                         

Total

   $ 963,204    $ 127,641    $ 1,090,845    $ 971,425    $ 130,098    $ 1,101,523
                                         

 

At December 31, 2009, we had a net unrealized gain on the available-for-sale securities of $12.5 million, or 1.0% of amortized cost, compared to a net unrealized gain on the available for sale securities of $20.2 million, or 1.9% of amortized cost, at December 31, 2008. At December 31, 2009, we held 55 investment securities with a carrying value of $412.6 million that were in a gross unrealized loss position of $11.5 million. We analyzed each of these securities to determine if other-than-temporary impairment has occurred. Our analysis included an evaluation of the type of security; the length of time and extent to which the fair value has been less than the security’s carrying value; the characteristics of the underlying collateral; the degree of credit support provided by subordinate tranches within the total issuance; independent credit ratings; changes in credit ratings; and a cash flow analysis, considering default rates, loss severities based upon the location of the collateral and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We obtain fair value estimates from additional independent sources and perform cash flow analysis to determine if other-than-temporary impairment has occurred. Of the 55 securities with gross unrealized losses at

 

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December 31, 2009, only six securities have been in a loss position for 12 months or more, including one security for which we recognized other-than-temporary impairment during the fourth quarter of 2008. Our analysis at December 31, 2009, indicated that these six securities did not have other-than-temporary impairment or did not have any additional other-than-temporary impairment. For additional details, see “Notes to Consolidated Financial Statements–Investment Securities” from our audited financial statements contained elsewhere in this annual report.

 

During the first quarter of 2010, we sold three of our private-label collateralized mortgage obligations for an aggregate gain of $396,000. At December 31, 2009, these three securities had a total amortized cost basis of $21.4 million and were in an unrealized loss position of $1.2 million, including one security that had been in a continuous unrealized loss position for more than 12 months. We did not intend to sell these securities at December 31, 2009, but in early 2010, the market values for the higher tiered tranches of these securities increased and we took the opportunity to further reduce our exposure to private-label securities. Each of the three securities was sold at a gain.

 

The other-than-temporary impairment charge that the Company recorded in 2008 was adjusted effective April 1, 2009 when the Company adopted amended accounting guidance on investments in debt and equity securities which modified the requirements for recognizing other-than-temporary impairment and changed the model used to determine the amount of impairment. Under the revised guidance, declines in fair value of investment securities below their amortized costs basis that are deemed to be other-than-temporary are reflected in earnings as a realized loss to the extent the impairment is related to credit loss. The amount of impairment related to other factors is recognized in other comprehensive income. Upon adoption, we recorded the cumulative effect of initial application as an adjustment to the opening balance of retained earnings with a corresponding adjustment to accumulated other comprehensive income for one private label mortgage-related security for which an other-than-temporary impairment was recognized in the fourth quarter of 2008 through earnings. The amount of the anticipated credit loss on this investment security was $488,000 upon adoption and no additional credit loss has been recorded since the adoption.

 

At December 31, 2009, we held no securities of any single issuer that exceeded 10% of stockholders’ equity, other than U.S. government agencies. Although we hold securities issued by municipalities within the State of Illinois that, in the aggregate, exceed 10% of stockholders’ equity, none of the holdings from any individual municipal issuer exceed this threshold.

 

As a member, we are required to hold stock in the FHLB and the FRB, which as of December 31, 2009 and 2008 consisted of the following:

 

     December 31,
2009
   December 31,
2008
     (in thousands)

Federal Home Loan Bank of Chicago (FHLBC)

   $ 22,250    $ 22,500

Federal Reserve Bank (FRB)

     8,960      7,130
             
   $ 31,210    $ 29,630
             

 

The amount of FHLBC stock required to be held is based on the Bank’s asset size and the amount of borrowings from the FHLBC. After increasing our investment in FHLBC stock earlier in 2009, we sold $5.0 million of stock at par during the fourth quarter of 2009 in response to a decrease in borrowings from the FHLBC. Currently, the FHLBC is under a formal written agreement with its regulator requiring the regulator’s prior approval for the payment of dividends or redemptions of capital stock. We assessed the ultimate recoverability of our FHLBC stock and we believe no impairment has occurred. For additional details of the other borrowings, see the “Notes to Consolidated Financial Statements—Investment Securities” from our audited financial statements contained elsewhere in this annual report. We did not hold any FHLBC debt securities in our investment portfolio as of December 31, 2009.

 

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The amount of FRB stock required to be held is based on the Bank’s common stock and surplus. The Bank’s surplus increased during 2009 primarily due to a capital contribution from the holding company of $15 million, which caused the Bank to increase its holdings of FRB stock by $1.4 million.

 

Investment securities with an approximate book value of $674 million and $904 million at December 31, 2009 and 2008, respectively, were pledged to collateralize certain deposits, securities sold under agreements to repurchase, FHLB advances, and for other purposes as required or permitted by law.

 

Investment Portfolio – Maturity and Yields

 

The following table summarizes the contractual maturity of investment securities and their weighted-average yields:

 

    AS OF DECEMBER 31, 2009  
    WITHIN ONE
YEAR
    AFTER ONE
BUT WITHIN
FIVE YEARS
    AFTER FIVE
BUT WITHIN
TEN YEARS
    AFTER TEN
YEARS
    TOTAL  
    AMOUNT   YIELD     AMOUNT   YIELD     AMOUNT   YIELD     AMOUNT   YIELD     AMOUNT   YIELD  
    (dollars in thousands)  

Available-for-sale securities (1):

                   

U.S. government sponsored
agency securities

  $ 30,078   3.26   $ —     —     $ —     —     $ 15,016   3.52   $ 45,094   3.35

Mortgage-backed securities (2):

                   

Residential

    158,852   4.65        367,391   4.59        283,789   4.41        —     —          810,032   4.54   

Commercial

    48,765   3.23        73,867   3.33        38,761   4.19        —     —          161,393   3.51   

Collateralized mortgage obligations (2)

    33,217   4.90        87,670   4.94        9,211   4.04        —     —          130,098   4.87   

States and municipal obligations (3)

    600   6.20        3,511   7.35        27,145   6.45        91,051   6.18        122,307   6.28   

Other debt securities

    692   1.68        1,567   1.68        88   1.68        —     —          2,347   1.68   
                                                           

Total available-for-sale

  $ 272,204   4.27   $ 534,006   4.48   $ 358,994   4.53   $ 106,067   5.81   $ 1,271,271   4.56
                                                           

 

(1) Based on estimated fair value.
(2) Maturities of mortgage-backed securities and collateralized mortgage obligations (“CMOs”) are based on anticipated lives of the underlying mortgages, not contractual maturities. CMO maturities are based on cash flow (or payment) windows derived from broker market consensus.
(3) Rates on obligations of states and political subdivisions have been adjusted to tax equivalent yields using a 35% income tax rate.

 

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Loan Portfolio

 

Our primary source of income is interest on loans. The following table presents the composition of our loan portfolio by type of loan as of the dates indicated:

 

     As of December 31,  
     2009     2008     2007     2006     2005  
     (in thousands)  

Commercial and industrial

   $ 1,264,369      $ 1,485,673      $ 850,196      $ 770,863      $ 665,023   

Commercial real estate secured

     1,171,777        1,058,930        839,629        791,962        793,965   

Real estate – construction

     364,443        531,452        671,678        744,317        684,737   
                                        

Total commercial loans

     2,800,589        3,076,055        2,361,503        2,307,142        2,143,725   

Residential real estate – mortgages

     57,887        53,859        60,195        62,453        63,789   

Home equity loans and lines of credit

     86,227        92,085        99,696        116,516        161,058   

Consumer loans

     8,221        9,163        10,551        13,237        14,972   

Other loans

     557        2,115        1,421        1,396        1,497   
                                        

Gross loans

     2,953,481        3,233,277        2,533,366        2,500,744        2,385,041   

Less: Unearned discount

     (6     (16     (33     (59     (110
                                        

Total loans

     2,953,475        3,233,261        2,533,333        2,500,685        2,384,931   

Less: Allowance for loan losses

     (106,185     (128,548     (54,681     (37,516     (37,481
                                        

Loans, net

   $ 2,847,290      $ 3,104,713      $ 2,478,652      $ 2,463,169      $ 2,347,450   
                                        

Loans Held for Sale

   $ 81,853      $ —        $ —        $ —        $ —     
                                        

 

At December 31, 2009, our total loans consisted of loans held for our portfolio of $2.95 billion and commercial and residential mortgage loans held for sale of $81.9 million. In comparison, at December 31, 2008 we had portfolio loans of $3.23 billion and did not have any loans that were classified as held for sale.

 

Loans Held for Portfolio

 

Our portfolio loans at December 31, 2009 of $2.95 billion represented a decrease of $279.8 million, or 8.7%, as compared to portfolio loans at December 31, 2008 of $3.23 billion. Approximately 95% of our loan portfolio is comprised of commercial loans, which includes commercial and industrial, commercial real estate secured, and real estate-construction loans. Total commercial loans decreased $275.5 million, or 9.0%, to $2.80 billion at year-end, compared to $3.08 billion at December 31, 2008. Although we actively originated new loans during 2009, including the funding of approximately $650 million of new commercial loans, this growth was offset as we repositioned our portfolio to reduce our exposure in industries and sectors that we no longer considered economically desirable. In addition to these portfolio management activities, gross loan charge-off and lower line usage by our customers combined to produce the lower commercial loan balances in 2009.

 

During 2008, the implementation of our growth strategy resulted in the $714.6 million, or 30.3%, increase in commercial loans during the year. The commercial loans portfolio at December 31, 2008 was $3.08 billion as compared to $2.36 million at December 31, 2007.

 

Commercial and industrial (“C&I”) loans consist of loans to businesses or for business purposes that are either unsecured or secured by collateral other than commercial real estate. Total C&I loans decreased $221.3 million, or 14.9%, to $1.26 billion at December 31, 2009 as compared to $1.49 billion at December 31, 2008. These loans are generally made to operating companies in a variety of businesses, but do not include commercial real estate investment loans. We continue to actively develop new customer relationships and originate C&I loans, as part of a larger, strategic realignment of our balance sheet. At the same time, we began to reduce our credit exposure to certain types of customers where we did not feel the risk/return characteristics were consistent

 

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with new opportunities in the market place. This realignment, along with a decline in the usage rates on available lines of credits, reduced our C&I loan balances during 2009. Our C&I portfolio did increase in 2008 as part of our growth strategy, which focused on the origination of C&I loans, thereby reducing the impact of real estate construction loans on our results of operations. Total C&I loans increased $635.5 million, or 74.7%, in 2008 as compared to 2007.

 

Loans secured by commercial real estate consist of commercial owner-occupied properties, as well as investment properties. At December 31, 2009, December 31, 2008 and December 31, 2007, the composition of our commercial real estate secured portfolio by type of collateral was approximately as follows:

 

    December 31, 2009     December 31, 2008     December 31, 2007  
    Balance   Percentage
of Total
Commercial
Real Estate
Loans
    Balance   Percentage
of Total
Commercial
Real Estate
Loans
    Balance   Percentage
of Total
Commercial
Real Estate

Loans
 
    (dollars in thousands)  

Commercial non-owner occupied:

           

Retail strip centers or malls

  $ 211,817   18   $ 206,637   20   $ 170,552   20

Office/mix use property

    149,951   13        145,978   13        171,151   20   

Commercial properties

    144,745   12        130,227   12        63,222   8   

Specialized – other

    121,530   10        92,193   9        70,797   8   

Other commercial properties

    64,602   6        61,478   6        23,974   3   
                                   

Subtotal commercial non-owner occupied

    692,645   59        636,513   60        499,696   59   

Commercial owner occupied

    334,744   29        270,346   26        208,037   25   

Multi-family properties

    144,388   12        152,071   14        131,896   16   
                                   

Total commercial real estate secured

  $ 1,171,777   100   $ 1,058,930   100   $ 839,629   100
                                   

 

Total commercial real estate loans were $1.17 billion at December 31, 2009 as compared to $1.06 billion at December 31, 2008, an increase of $112.8 million, or 10.7%. During 2009, loans secured by commercial owner occupied properties increased by $64.4 million, while loans on commercial non-owner occupied properties increased by $56.1 million. Most of the increase in non-owner occupied was in the specialized-other category, which includes loans on properties such as nursing homes, gas stations and convenience stores, churches, and hotels/motels. Our growth strategy also produced the increase in commercial real estate secured loans during 2008. During 2008, these loans increased by $219.3 million, or 26.1%, with the increase occurring in both owner and non-owner occupied real estate

 

Our real estate construction and land portfolio includes loans for the development of both residential and commercial properties. Real estate construction and land loans consist primarily of loans to professional real estate developers for the construction of single-family homes, town-homes, and condominium conversions. As of the dates indicated, the composition of our real estate construction loans was as follows:

 

     December 31, 2009     December 31, 2008     December 31, 2007  
     Balance    Percentage
of Total
Loans
    Balance    Percentage
of Total
Loans
    Balance    Percentage
of Total
Loans
 
     (dollars in thousands)  

Residential construction and land

   $ 221,859    7   $ 349,998    11   $ 492,780    19

Commercial construction and land

     142,584    5        181,454    5        178,898    8   
                                       

Total real estate – construction

   $ 364,443    12   $ 531,452    16   $ 671,678    27
                                       

 

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Our residential real estate construction and loan portfolio decreased $128.1 million, or 36.6%, during 2009 to total $221.9 million at December 31, 2009, as compared to $350.0 million at year-end 2008 and $492.8 million at year-end 2007. Because of the slow down in the residential real estate markets and reduced real estate valuations, we have been actively reducing our exposure to this portion of the loan portfolio.

 

At the dates indicated, the composition of our residential real estate-construction portfolio by type of collateral was as follows:

 

    December 31, 2009     December 31, 2008     December 31, 2007  
    Balance   Percentage
of Total
Residential
Construction

Loans
    Balance   Percentage
of Total
Residential
Construction

Loans
    Balance   Percentage
of Total
Residential
Construction

Loans
 
    (dollars in thousands)  

Residential properties:

           

Single family attached and detached housing

  $ 55,849   25   $ 105,526   30   $ 176,739   36

Condo (new & conversions)

    54,424   25        95,705   27        127,112   26   

Multi-family

    51,191   23        57,495   17        68,976   14   

Completed for sale

    11,968   5        16,830   5        28,436   5   
                                   

Total residential construction

    173,432   78        275,556   79        401,263   81   

Land – unimproved & farmland

    37,317   17        52,321   15        68,188   14   

Land – improved & entitled

    2,271   1        3,921   1        5,344   1   

Land – under development

    8,839   4        18,200   5        17,985   4   
                                   

Total land

    48,427   22        74,442   21        91,517   19   
                                   

Total residential construction and land

  $ 221,859   100   $ 349,998   100   $ 492,780   100
                                   

 

Our commercial construction and land portfolio declined $38.9 million, or 21.4%, to $142.6 million at December 31, 2009, as compared to $181.5 million at December 31, 2008, and $178.9 million at December 31, 2007.

 

Our portfolio of consumer-oriented loan products, which includes residential real estate mortgages, home equity loans and lines of credit, and consumer loans, continued to decline as we have previously discontinued or de-emphasized most types of consumer lending. Consumer-oriented loan products totaled $152.9 million at year-end 2009, compared to $157.2 million at December 31, 2008 and $171.9 million at December 31, 2007.

 

Our portfolio of residential real estate mortgages totaled $57.9 million at December 31, 2009, as compared to $53.9 million at December 31, 2008 and $60.2 million at December 31, 2007. While we did not actively seek to originate mortgage loans in 2009, we did offer these products to our current customers, particularly to our business-owner customers. In the first quarter of 2010, we began operations of our new residential mortgage loan origination unit. We plan on selling the loans originated by this unit to institutional investors rather than hold the loans for portfolio.

 

Our portfolio of home equity loans and lines of credit also continues to decline as a result of our decision to discontinue the origination of third-party sourced home equity products in 2002. At December 31, 2009, this portfolio totaled $86.2 million, compared to $92.1 million and $99.7 million at December 31, 2008 and December 31, 2007, respectively. This portfolio as a percentage of total loans decreased to 3% at year-end 2009.

 

Other consumer loans were $8.2 million at December 31, 2009, $9.2 million at December 31, 2008, and $10.6 million at December 31, 2007 and represented less than 1% of our total loans at December 31, 2009. Of

 

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our total consumer loans at December 31, 2009, 77% were indirect manufactured home loans, 1% were indirect auto and boat loans, and the remaining 22% were other personal secured and unsecured loans. Since we no longer originate these types of loans, we expect our indirect consumer loan portfolio to continue to decline as these loans are repaid.

 

The following table shows our maturity distribution of gross loans as of the dates indicated:

 

     As of December 31, 2009 (1)
     ONE YEAR
OR LESS
   OVER 1 YEAR THROUGH
5 YEARS
   OVER 5 YEARS     
          FIXED RATE    FLOATING
OR
ADJUSTABLE
RATE
   FIXED
RATE
   FLOATING
OR
ADJUSTABLE
RATE
   TOTAL
     (in thousands)

Commercial and commercial real estate

   $ 933,059    $ 571,396    $ 828,223    $ 53,477    $ 49,991    $ 2,436,146

Real estate – construction

     261,437      5,247      97,759      —        —        364,443

Residential real estate – mortgages

     6,023      7,323      4,846      9,689      30,006      57,887

Home equity loans and lines of credit

     12,332      3,045      38,216      406      32,228      86,227

Consumer

     1,457      1,926      —        4,516      322      8,221

Other loans

     557      —        —        —        —        557
                                         

Total gross loans

   $ 1,214,865    $ 588,937    $ 969,044    $ 68,088    $ 112,547    $ 2,953,481
                                         

 

(1) Maturities are based upon contractual dates. Demand loans are included in the one year or less category and totaled $2.9 million as of December 31, 2009.

 

Loans Held for Sale

 

At December 31, 2009, we held $81.9 million of commercial and residential mortgage loans classified as held for sale.

 

In an effort to reduce the level of nonperforming loans, we decided to sell certain of our commercial nonaccrual loans in 2009. In connection with this decision, during the third quarter of 2009, we completed the sale of a group of loans and also transferred certain other nonaccrual commercial loans into the held for sale category as we actively marketed these loans for sale. Upon transfer into the held for sale category, we recorded a charge-off to reduce the loans to their estimated net fair value. We recorded an additional write-down of $5.8 million in the fourth quarter. The additional write-down was included in nonperforming asset expense in noninterest expense on the Consolidated Statements of Operations.

 

We also have residential mortgage loans classified as held for sale at December 31, 2009 which we had the intent to sell to third party institutional investors. During the third quarter of 2009, we purchased a participation interest in 20 pools of residential single family mortgages totaling approximately $100 million. These loans were to have been pooled into pass-through certificates to be issued by a mortgage originator and guaranteed by the Government National Mortgage Association, otherwise known as Ginnie Mae, and sold to third party investors. The mortgage originator completed the securitization of a portion of these loans in early August and we received payment for the sale of these loans. However, the mortgage loan originator was not able to securitize the remaining single family loans because Ginnie Mae removed the originator from its list of eligible issuers, so we took possession of the underlying collateral and are now working to dispose of those loans. We completed a sale of approximately $10.5 million of these loans in the fourth quarter of 2009 at a small gain, and we are working to complete another sale during the first quarter of 2010. Subsequent to December 31, 2009, we are currently re-evaluating our disposition strategy in order to obtain the highest economic value from these loans. As a result, we may continue to pursue the sale of certain of these loans or we may transfer other loans into portfolio.

 

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Nonperforming Assets

 

Our lending officers and their managers are responsible for the ongoing review of present and projected future performance of the loans within their assigned portfolio and for risk rating such loans in accordance with the Bank’s risk rating system. In addition, a loan review function independently risk rates loans to monitor and confirm the reasonableness of the lending officer’s risk rating conclusion. Delinquency reports are reviewed monthly by the lending officers, their managers and credit administration. The responsible lending officer reports to a loan committee about the current status of loans past due or current but graded below a designated level. The committee evaluates whether the loan is appropriately risk rated and determines if the loan should be placed on nonaccrual, the need for a specific allowance for loan loss, or, if appropriate, a partial or full charge-off. Most loans rated substandard or below are transferred to a separate loan work-out department, staffed by collection professionals. We have enlarged our loan work-out department to effectively handle the increased volume of nonperforming assets. When the loan is transferred to work-out, an independent legal review of the loan documents is performed and current appraisals are obtained for loans secured by real estate.

 

The following table sets forth the amounts of nonperforming loans and nonperforming assets as of the dates indicated:

 

     As of December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands)  

Loans contractually past due 90 days or more but still accruing interest

   $ 59      $ 153      $ 4,253      $ 10,046      $ 2,615   

Nonaccrual loans

     141,403        200,227        71,412        23,111        10,834   
                                        

Total nonperforming loans

     141,462        200,380        75,665        33,157        13,449   

Other real estate owned and repossessed assets

     26,231        13,179        2,606        412        1,139   
                                        

Total nonperforming assets

   $ 167,693      $ 213,559      $ 78,271      $ 33,569      $ 14,588   
                                        

Restructured loans not included in nonperforming assets

   $ 1,196      $ —        $ —        $ —        $ —     

Nonperforming loans to total loans

     4.66     6.20     2.99     1.33     0.56

Nonperforming assets to total loans plus repossessed property

     5.48     6.58     3.09     1.34     0.61

Nonperforming assets to total assets

     3.81     4.87     2.20     0.99     0.44

 

The following table presents loans past due 30 to 89 days and still accruing as of the dates indicated:

 

     As of December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands)  

Loans contractually past due 30 through 89 days and still accruing

   $ 13,206      $ 25,272      $ 63,553      $ 59,199      $ 24,870   

30 – 89 days past due to total loans

     0.44 %     0.78     2.51     2.37     1.04

 

Nonperforming Loans

 

Nonperforming loans include nonaccrual loans and interest-accruing loans contractually past due 90 days or more. We evaluate all loans on which principal or interest is contractually past due 90 days or more to determine if they are adequately secured and in the process of collection. If sufficient doubt exists as to the full collection of principal and interest on a loan, we place it on nonaccrual and we discontinue recognizing interest income. After a loan is placed on nonaccrual status, any current period interest previously accrued but not yet collected is reversed against current income. Interest is included in income subsequent to the date the loan is placed on nonaccrual status only as interest is received and so long as management is satisfied that there is a high

 

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probability that principal will be collected in full. The loan is returned to accrual status only when the borrower has made required payments for a minimum length of time and demonstrates the ability to make future payments of principal and interest as scheduled.

 

The following table presents the composition of nonaccrual loans as of December 31 for the periods indicated:

 

     As of December 31,

Loan Category

   2009    2008    2007

Commercial and industrial

   $ 26,687    $ 42,263    $ 4,348

Commercial real estate secured

     36,420      23,068      10,679

Residential construction and land

     62,795      114,160      52,978

Commercial construction and land

     4,245      14,934      411
                    

Total commercial loans

     130,147      194,425      68,416

Consumer loans

     11,256      5,802      2,996
                    

Total nonaccrual loans

   $ 141,403    $ 200,227    $ 71,412
                    

 

After increasing in 2008, nonaccrual loans decreased during 2009 to $141.4 million at December 31, 2009 as compared to $200.2 million at December 31, 2008, a decrease of $58.8 million, or 29.4%. Nonperforming loans at December 31, 2007 were $71.4 million. The decrease in total nonperforming loans during 2009 was largely due to $116.2 million of gross loan charge-offs during the year, transfers into other real estate owned of $29.1 million, and repayments and other resolutions of certain assets. These decreases were partly offset by new nonaccrual loans.

 

Residential construction and land loans continue to be our largest category of nonaccrual loans and comprise approximately 44% of all nonaccrual loans at December 31, 2009. Nonaccrual residential construction and land loans were $62.8 million at December 31, 2009, as compared to $114.2 million at December 31, 2008 and $53.0 million at December 31, 2007. The decrease in these nonperforming loans during 2009 was largely due to net charge-offs and the transfer to other real estate owned.

 

Commercial real estate secured loans were our second largest category of nonaccrual loans. This category increased to $36.4 million at December 31, 2009, from $23.1 million at December 31 2008 and $10.7 million at December 31, 2007. New nonaccrual loans, partly offset by charge-offs, resulted in the increase in this category.

 

C&I nonaccrual loans decreased to $26.7 million at December 31, 2009 as compared to $42.3 million at December 31, 2008 and $4.3 million at December 31, 2007. Commercial construction and land nonaccrual loans totaled $4.2 million at December 31, 2009, as compared to $14.9 million at year-end 2008 and $411,000 at the end of 2007. Charge-offs and transfers to other real estate owned, partly offset by new nonaccrual loans, primarily caused the decrease in each of these categories during 2009.

 

The level of nonaccrual loans in our consumer portfolio increased to $11.3 million at December 31, 2009 from $5.8 million at December 31, 2008 and $3.0 million at December 31, 2007. Approximately half of the consumer nonaccrual loans are residential mortgage loans and the other half are from our portfolio of home equity loans and lines of credit.

 

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Other Real Estate Owned and Repossessed Assets

 

Other real estate owned and repossessed assets increased from $13.2 million at December 31, 2008 to $26.2 million at December 31, 2009. The following table provides a rollforward, for the periods indicated, of other real estate and repossessed assets:

 

     For the Period Ended December 31,  
     2009     2008     2007  

Balance at beginning of period

   $ 13,179      $ 2,606      $ 412   

Transfers from loans

     29,076        14,478        3,203   

Additional investment in foreclosed properties

     342        1,625        —     

Dispositions

     (14,310     (4,673     (1,002

Additional impairment

     (2,056     (857     (7
                        

Balance at end of period

   $ 26,231      $ 13,179      $ 2,606   
                        

 

During 2009, we transferred $29.1 million from loans into other real estate and repossessed assets. Of this amount transferred, $19.7 million was from our residential construction and land portfolio, $4.4 million was from our C&I portfolio and the remainder was divided equally between our commercial real estate secured and commercial construction and land portfolios. We capitalized costs totaling $342,000 to improve certain properties to prepare them for sale. During 2009, we also received net proceeds of $13.6 million on the sale of other real estate owned assets that had a carrying value of $14.3 million, resulting in a net loss of $758,000, which was included as additional nonperforming asset expense in noninterest expense. We also wrote down the carrying value of certain other real estate owned and repossessed assets by $2.1 million during 2009 to reflect a decrease in the estimated fair value of those assets. The level of other real estate owned and repossessed assets increased during 2009 and we expect that these assets may continue to increase in the future as we work through the elevated level of nonperforming assets.

 

Impaired Loans

 

Similar to nonperforming loans, after increasing in 2008, the level of impaired loans decreased during 2009. At December 31, 2009, impaired loans totaled $141.7 million, compared to $206.7 million at December 31, 2008, a decrease of $65.0 million, or 31.4%. Total impaired loans were $91.0 million at December 31, 2007.

 

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The balance of impaired loans and the related allowance for loan losses for impaired loans is as follows:

 

     Dec. 31,
2009
   Dec. 31,
2008
   Dec. 31,
2007
     (in thousands)

Impaired loans:

        

Commercial and industrial

   $ 31,447    $ 54,543    $ 19,982

Commercial real estate secured

     36,420      23,068      15,902

Residential construction and land

     68,389      114,160      53,477

Commercial construction and land

     4,245      14,934      411

Consumer-oriented

     1,196      —        1,200
                    

Total impaired loans

   $ 141,697    $ 206,705    $ 90,972
                    

Recorded balance of impaired loans:

        

With related allowance for loan losses

   $ 95,936    $ 120,973    $ 66,547

With no related allowance for loan losses

     45,761      85,732      24,425
                    

Total impaired loans

   $ 141,697    $ 206,705    $ 90,972
                    

Allowance for losses on impaired loans:

        

Commercial and industrial

   $ 10,085    $ 13,431    $ 1,323

Commercial real estate secured

     4,485      2,750      770

Residential construction and land

     19,070      23,849      7,282

Commercial construction and land

     —        1,421      —  

Consumer-oriented

     —        —        —  
                    

Total allowance for losses on impaired loans

   $ 33,640    $ 41,451    $ 9,375
                    

 

The decrease in impaired loans during 2009 primarily resulted from net charge-offs, transfers into other real estate owned and the payment or resolution of certain assets, partially offset by additions to impaired loans during the period. The allowance for loan losses related to impaired loans also decreased during 2009 and totaled $33.6 million at December 31, 2009, as compared to $41.5 million at December 31, 2008 and $9.4 million at December 31, 2007. The decrease in the allowance for losses on impaired loans in 2009 was primarily due to net charge-offs during the period, partially offset by an increase in the estimated impairment on these loans. Residential construction and land loans comprise nearly half of all impaired loans and comprised 57% of the allowance for loan losses on impaired loans.

 

At December 31, 2009, we determined that $95.9 million of our loans were impaired and had related allowances for loan losses of $33.6 million. We also held $45.8 million of impaired loans, for which the individual analysis did not result in a measure of impairment, and, therefore, no related allowance for loan losses was provided. At December 31, 2009, impaired loans with no related allowance for loan losses included the commercial nonaccrual loans classified as held for sale that were charged down to their estimated net fair value upon transfer to held for sale. Once we determine the loan is impaired, we perform an individual analysis to establish the amount of the related allowance for loan losses, if any, based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based upon the fair value of the collateral, less cost to sell. Generally, since the majority of our impaired loans are collateral-dependent real estate loans, the fair value is determined by a current appraisal. The individual impairment analysis also takes into account available and reliable borrower guarantees and any cross-collateralization agreements. Certain other loans are collateralized by business assets, such as equipment, inventory, and accounts receivable. The fair value of these loans is based upon estimates of realizability and collectability of the underlying collateral. While impaired loans exhibit weaknesses that may inhibit repayment in compliance with the original note terms, the impairment analysis may not result in a related allowance for loan losses for each individual loan.

 

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Impaired loans include all nonaccrual loans, accruing loans judged to have higher risk of noncompliance with the present contractual repayment schedule for both interest and principal, as well as troubled debt restructurings. Unless modified in a troubled-debt restructuring, certain homogenous loans, such as residential mortgage and consumer loans, are collectively evaluated for impairment and are, therefore, excluded from impaired loans. As of December 31, 2009, we had four commercial loans, totaling $10.4 million which were considered to have a higher risk of noncompliance with the present loan terms. Even though these loans were still accruing interest, we report the loans as impaired loans. In addition, during 2009, we completed the modification of certain consumer-orientated loans, primarily home equity loans, with a remaining total principal balance of $1.2 million, which were considered troubled-debt restructurings. These loans are reported as impaired loans and evaluated for impairment.

 

At December 31, 2009, we held $4.1 million of loans classified as a troubled debt restructuring. Total troubled debt restructurings included consumer loans of $1.2 million and a commercial loan of $2.9 million. The commercial loan is now considered nonaccrual and included in nonperforming loans. At December 31, 2009, we did not have additional commitments to lend on loans considered troubled debt restructurings.

 

A reconciliation of $141.4 million of nonaccrual and $141.7 million of impaired loans as of December 31, 2009 is presented below:

 

     Nonaccrual
Loans
   Impaired
Loans
     (dollars in thousands)

Commercial nonaccrual loans

   $ 130,147    $ 130,147

Commercial loans on accrual but impaired

     n/a      10,354

Consumer-oriented loans

     11,256      1,196
             
   $ 141,403    $ 141,697
             

n/a – not applicable

     

 

Potential Problem Loans

 

As part of our standard credit administration process, we risk rate our commercial loan portfolio. As part of this process, loans that are rated with a higher level of risk are monitored more closely. We internally identify certain loans in our loan risk ratings that we have placed on heightened monitoring because of certain weaknesses that may inhibit the borrower’s ability to perform under the contractual terms of the loan agreement but have not reached the status of nonaccrual loans. As of December 31, 2009, these potential problem loans totaled $75.6 million, which included $10.4 million of commercial loans that are current and still accruing interest, but are considered impaired. Of these potential problem loans at December 31, 2009, $30.7 million were in our real estate–construction portfolio, $30.0 million were in our commercial and industrial portfolio, and the remaining $14.9 million were loans in our secured by commercial real estate category. In comparison, potential problem loans at December 31, 2008 totaled $69.3 million. The largest categories of potential problem loans at December 31, 2008 included C&I loans of $26.7 million and residential-construction and land loans of $25.9 million. We do not necessarily expect to realize losses on potential problem loans, but we recognize potential problem loans can carry a higher probability of default and may require additional attention by management.

 

Allowance for Loan Losses

 

We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include the formula described below, specific allowances for identified problem loans and portfolio categories, and an unallocated allowance.

 

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We calculate the formula portion of the allowance by applying loss factors to categories of loans outstanding in the portfolio. The loans are categorized by loan type as commercial and industrial; commercial real estate secured; residential real estate construction; commercial real estate construction loans; residential real estate mortgage; and consumer loans. Those categories are further segregated by risk classification (for commercial loans) and by delinquency status (for consumer loans). Each commercial, commercial real estate and real estate construction loan has a risk grade based on formal defined criteria. For consumer loans, we further categorize the loans into consumer loan product types; for example, home equity loans and loans secured by manufactured homes. Segregation of the loans into more discrete pools facilitates greater precision in matching historic and expected loan losses with the source of the loss. We adjust these pools from time to time, based on the changing composition of the loan portfolio, grouping loans with similar attributes and risk characteristics. We calculate actual historic loss rates based upon current and prior year’s charge-off experience for each separate loan grouping identified. The historical loss rates are then weighted based on our evaluation of the duration of the economic cycle to arrive at a current expected loss rate. During 2009 and 2008, we attributed more weight to our loss experience in the most recent two years. The current expected loss rates are adjusted, if deemed appropriate, for other relevant factors affecting the loan groupings, including changes in lending practices, trends in past due loans and industry, geographical, collateral and size concentrations. Finally, the resulting loss factors are multiplied against the current period loans outstanding to derive an estimated loss.

 

Specific allowances are established in cases where management has identified conditions or circumstances related to a loan that indicate a loss will probably be incurred, but the degree of certainty and loss quantification has not reached the charge-off level. The amount in the allowance for loan losses for impaired loans is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral, net of cost to sell. In recent periods, our estimate of the amount of loss on a loan secured by real estate has increased in complexity as a result of the current illiquidity in the real estate market. The degree of uncertainty and the sensitivity of real estate valuations to the underlying assumptions regarding holding period until sale and the collateral liquidation method can have a material impact on our loss estimates on loans. If the measure of the impaired loan is less than the recorded investment in the loan, a specific allowance is established.

 

The unallocated portion of the allowance contains amounts that are based on our evaluation of conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The factors assessed are more qualitative in nature. Conditions affecting the entire lending portfolio evaluated in connection with the unallocated portion of the allowance include: general economic and business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations and findings of our independent loan review process. We review these conditions quarterly in discussion with our senior lenders and credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, we estimate of the effect of such condition may be reflected as part of the formula allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment, we evaluate the probable loss related to such conditions and reflect them in the unallocated portion of the allowance.

 

Management believes that the allowance for loan losses is adequate to absorb probable losses on existing loans that may become uncollectible. However, there can be no assurance that our allowance will prove sufficient to cover actual loan losses in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the adequacy of our allowance for loan losses. Such agencies may require us to make additional provisions to the allowance based upon their judgments about information available to them at the time of their examinations.

 

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The following table shows an analysis of our allowance for loan losses and other related data for the periods indicated:

 

     Year Ended December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands)  

Average total loans

   $ 3,171,373      $ 2,790,723      $ 2,507,395      $ 2,430,590      $ 2,271,681   
                                        

Total loans at end of year

   $ 3,035,328      $ 3,233,261      $ 2,533,333      $ 2,500,685      $ 2,384,931   
                                        

Allowance for loan losses:

          

Allowance at beginning of year

   $ 128,548      $ 54,681      $ 37,516      $ 37,481      $ 37,484   
                                        

Charge-offs:

          

Commercial and commercial real estate

     (50,945     (16,176     (5,261     (5,341     (5,240

Real estate – construction

     (63,103     (54,778     (8,926     (1,059     (103

Residential real estate – mortgages

     (356     —          (180     (7     (260

Consumer (1)

     (1,756     (1,517     (1,425     (824     (1,485
                                        

Subtotal

     (116,160     (72,471     (15,792     (7,231     (7,088
                                        

Recoveries:

          

Commercial and commercial real estate

     1,868        1,523        702        904        761   

Real estate – construction

     2,070        220        54        1        89   

Residential real estate – mortgages

     2        2        —          2        —     

Consumer (1)

     246        435        301        359        712   
                                        

Subtotal

     4,186        2,180        1,057        1,266        1,562   
                                        

Total net charge-offs

     (111,974     (70,291     (14,735     (5,965     (5,526
                                        

Provision for loan losses

     89,611        144,158        31,900        6,000        5,523   
                                        

Allowance at end of year

   $ 106,185      $ 128,548      $ 54,681      $ 37,516      $ 37,481   
                                        

Annualized net charge-offs to average total loans

     3.53     2.52     0.59     0.25     0.24

Allowance to total loans at end of year

     3.50     3.98     2.16     1.50     1.57

Allowance to non-performing loans

     75.06     64.15     72.27     113.15     278.69

 

(1) Consumer loan charge-offs and recoveries include charge-offs and recoveries relating to indirect and direct auto loans, home equity loans and lines of credit, overdrafts and all other types of consumer loans.

 

Our allowance for loan losses was $106.2 million at December 31, 2009, or 3.50% of end-of-year loans and 75.06% of nonperforming loans. In comparison, the allowance for loan losses was $128.5 million at December 31, 2008, or 3.98% of total loans and 64.15% of nonperforming loans. At December 31, 2007, the allowance for loan losses was $54.7 million, or 2.16% of total loans and 72.27% of nonperforming loans.

 

Our allowance for loan losses decreased during 2009 as net charge-offs exceeded the provision for loan losses. The level of nonperforming and impaired loans began increasing near the end of 2007 and accelerated in 2008, and we increased our provisions for loan losses and the allowance for loan losses during 2008 in response to the increase in the number of problem assets. While nonperforming loans during 2009 continue to be at historically elevated levels, the rate of inflows for nonperforming loans in 2009 was less than the rate experienced in 2008, and we continue to work aggressively at reducing the amount of nonperforming and impaired loans. Total nonperforming loans decreased from $200.4 million at December 31, 2008, to $141.5 million at December 31, 2009, while the level of impaired loans decreased to $141.7 million at December 31, 2009, from $206.7 million at December 31, 2008. However, as we continue to work through our nonperforming assets and impaired loans, the level of charge-offs increased in 2009, resulting in an overall decrease in the allowance for loan losses.

 

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We charge off loans when the loss is highly probable and clearly identified. During 2009, net charge-offs were $112.0 million, or 3.53% of average loans. In comparison, net charge-offs were $70.3 million, or 2.52% of average loans, during 2008 and $14.7 million, or 0.59% of average loans, during 2007. Net charge-offs have increased as we continue to work through the increased volume of nonperforming and impaired loans. During both 2009 and 2008, most of our loan charge-offs were from our real estate-construction portfolio, primarily residential construction and land loans. In addition, during 2009, the level of charge-offs in our C&I portfolio increased as we worked through problem loans from this category. We expect that net charge-offs in 2010 will remain higher than historical levels as we continue to work to resolve our impaired and nonperforming loans.

 

The unallocated portion of the allowance for loan losses is based on our evaluation of conditions that are not directly measured in the determination of the formula or specific allowances. During 2008, we increased the unallocated portion of allowance for loan losses in response to the increase in problem loans and because of the economic downturn, which increased the uncertainty inherent in our computation of the allowance for loan losses, including the expected loss rates applied to our portfolio. In increasing the unallocated portion of the allowance for loan losses in 2008, we considered the uncertainty surrounding current real estate and collateral valuations, the duration of the economic downturn and its impact on business conditions, forecasts of national and local economic conditions, concern about exposure in portions of the loan portfolio that were no longer considered economically desirable, and other factors. During 2009, we reduced the unallocated portion of the allowance for loan losses as the level of problem assets declined and the formula portion of our allowance increased as a result of the our historical loss experience rates including the historically high level of net charge-offs during the past two years. In addition to the higher loss experience and the reduced level of nonperforming and impaired loans, our considerations in the determination of the unallocated portion of the allowance for loan losses included, but were not limited to, the current national and local economic climate, forecasts of economic recovery, proactive reductions to certain exposures in our loan portfolio, and our current lending policies, underwriting standards and loan review system.

 

As a business bank, our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have higher potential for losses on an individual loan basis. The individually larger commercial loans can cause greater volatility in reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate with respect to a single sizable loan can have a material impact on our reported impaired loans and related loss exposure estimates and, therefore, our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, the allowance for loan losses is adjusted through the recording of a provision for loan losses.

 

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The table below presents an allocation of the allowance for loan losses among the various loan categories and sets forth the percentage of loans in each category to gross loans. The allocation of the allowance for loan losses as shown in the table should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. While we allocated the allowance to loan losses to loan categories for analytical purposes, the total allowance for loan losses is available to absorb losses from any category of loans.

 

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES