SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 001-13735

Midwest Banc Holdings, Inc.

(Exact name of Registrant as specified in its charter)

 

 

501 West North Avenue, Melrose Park, Illinois 60160

(Address of principal executive offices including ZIP Code)

 

(708) 865-1053

(Registrant’s telephone number including Area Code)

 

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

 

Depositary Shares each representing 1/100^th of a Share of Series A

Noncumulative Redeemable Convertible Preferred Stock,

$25.00 liquidation preference, NASDAQ Capital Market

(Title of Class)

 

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

 

Common Stock, $0.01 par value, NASDAQ Capital Market

(Title of Class)

 

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

 

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

 

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 þ     No o

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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.  þ

 

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

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the voting and nonvoting common equity held by nonaffiliates of the registrant on June 30, 2009, based on the last sales price quoted on the NASDAQ Global Market System on that date, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $21.0 million.

 

As of March 30, 2010, the number of shares outstanding of the registrant’s common stock, par value $0.01 per share, was 38,176,225.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Company’s Proxy Statement for the 2010 Annual Meeting of Stockholders are incorporated by reference into Part III.

 

 

MIDWEST BANC HOLDINGS, INC.

 

FORM 10-K

 

INDEX

 

 

 

The Company

 

Midwest Banc Holdings, Inc. (the “Company”), a Delaware corporation founded in 1983, is a community-based bank holding company headquartered in Melrose Park, Illinois. Through its wholly owned subsidiaries, the Company provides a wide range of services, including traditional banking services, personal and corporate trust services, and insurance brokerage and retail securities brokerage services. The Company’s principal operating subsidiary is Midwest Bank and Trust Company (the “Bank”), an Illinois state bank that operates 26 banking centers in the Chicago metropolitan area. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. Midwest Financial and Investment Services, Inc., a subsidiary of the Bank, is a Financial Industry Regulatory Authority (“FINRA”), registered broker/dealer that provides securities brokerage and insurance services to customers of the Bank.

 

The Company focuses on establishing and maintaining long-term relationships with customers and is committed to providing for the financial services needs of the communities it serves. In particular, the Company continues to emphasize its relationships with individual customers and small-to-medium-sized businesses. The Company actively evaluates the credit needs of its markets, including low- and moderate-income areas, and offers products that are responsive to the needs of its customer base. The markets served by the Company provide a mix of real estate, commercial and industrial, and consumer lending opportunities, as well as a stable core deposit base.

 

Recent Developments

 

Outlook for 2010

 

Regulatory Capital:  As a result of significant credit quality deterioration during 2009, the Bank was “undercapitalized” for regulatory capital ratio purposes at December 31, 2009. Credit quality continued to deteriorate in early 2010 and, as a result, the Bank’s interim capital position was “significantly undercapitalized” as of January 31, 2010. The Company expects the Bank to be “critically undercapitalized” at March 31, 2010. See Item 1. “Business — Supervision and Regulation — Capital Requirements.” In addition, the Company was “undercapitalized” at December 31, 2009 and is expected to remain undercapitalized at March 31, 2010.

 

Any failure by the Company to improve the Bank’s regulatory capital ratios in a timely manner will result in material adverse consequences, including the possibility that the Company may become subject to a voluntary or involuntary bankruptcy filing, the Bank could be placed into FDIC receivership by its regulators, or the Bank could be acquired by a third party in a transaction in which the Company receives no value for its interest in the Bank, any of which events would be expected to result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

The Company and the Bank were notified on March 25, 2010 by the Federal Reserve Bank of Chicago (the “Federal Reserve Bank”) that the Bank’s capital plan, submitted on March 15, 2010, was not accepted. According to the Federal Reserve Bank, the plan was not accepted because, among other things, the Company has not yet raised $125 million of new equity, which is a condition to the Company’s ability to convert to common stock the new convertible preferred stock, Series G, that the Company issued to the U.S. Department of the Treasury (the “U.S. Treasury”) in March 2010 in exchange for all outstanding preferred stock, Series T, previously held by the U.S. Treasury.

 

On March 29, 2010, as a result of the Bank’s significantly undercapitalized status, the Bank consented to the issuance of a Prompt Corrective Action Directive (“PCA”) by the Federal Reserve Bank. The PCA provides that the Bank, in conjunction with the Company, must within 45 days of March 29, 2010 either: (i) increase the Bank’s capital so that it becomes adequately capitalized; (ii) enter into and close on an agreement to sell the Bank subject to regulatory approval and customary closing conditions; or (iii) take other necessary measures to make the Bank adequately capitalized. The PCA also prohibits the Bank from making any capital distributions, including dividends and from soliciting and accepting new deposits bearing an interest rate that exceeds the prevailing effective rates on deposits of comparable amounts and maturities in the Bank’s market area. The Bank must submit to the Federal

Reserve Bank within 30 days a plan and timetable for conforming the rates of interest paid on existing non-time deposit accounts to these levels.

 

The PCA also subjects the Bank to other operating restrictions, including payment of bonuses to senior executive officers and increasing their compensation, restrictions on asset growth and branching, and ensuring that all transactions between the Bank and any affiliates comply with Section 23A of the Federal Reserve Act. The Bank was already in compliance with certain of these guidelines as the Bank is already significantly undercapitalized. For example, the Bank has been complying with the FDIC’s rules relating to the payment of interest on deposits. The Company and the Bank continue to be subject to the Written Agreement entered into with the Federal Reserve Bank and the Illinois Division of Banking in December 2009 as further described under “Recent Developments — Written Agreement with Regulators.”

 

Forbearance Agreement:  On October 22, 2009, the Company entered into a Forbearance Agreement with its lender pursuant to which, among other things, the lender agreed to forbear from exercising the rights and remedies available to it as a consequence of certain existing events of default under the Company’s loan agreements (the “Loan Agreements”) through March 31, 2010 (the “Forbearance Agreement”). When the Forbearance Agreement expires on March 31, 2010, the lender could declare all amounts owed under the Loan Agreements immediately due and payable. Should the lender demand payment at that time, or any time thereafter, the Company presently would be unable to repay the amounts due. As a result, the lender could, among other remedies, foreclose on outstanding shares of the Bank’s capital stock, which would have a material adverse effect on the Company’s business, operations and ability to continue as a going concern and could result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

Although the lender has the right to foreclose on the common stock of the Bank, the Company has not received any indication from the lender through the date of filing that it intends to exercise its rights to foreclose. Should the lender exercise such rights, the Bank could become a wholly-owned subsidiary of the lender or another potential buyer, through a sale of the collateral by the lender. Such a transaction would not likely have an impact on the operations of the Bank or its customers, and customer deposits would continue to be subject to FDIC insurance. If such actions were taken by the lender to exercise its rights to the collateral, the Company’s ability to continue to generate sufficient cash flows to fund its operations and obligations would be significantly limited, which may force the Company into bankruptcy. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings.” Upon the expiration of the forbearance period, the principal and interest payments that were due under the revolving line of credit and the term note, as modified by the covenant waivers, at the time the Forbearance Agreement was entered into will once again become due and payable, along with such other amounts as may have become due during the forbearance period. Absent successful completion of all or a significant portion of the Capital Plan, the Company expects that it would not be able to meet any demands for payment of amounts then due at the expiration of the forbearance period. If the Company is unable to renegotiate, renew, replace or expand its sources of financing on acceptable terms, it may have a material adverse effect on the Company’s business and results of operations. See Note 5 — Summary of Significant Accounting Policies, Going Concern of the notes to the consolidated financial statements.

 

Capital Plan:  As announced in 2009, the Company has developed a detailed capital plan in order to, among other things, increase the Company’s common equity capital and raise additional capital. Subsequent to year end, the Company exchanged approximately 82% of its outstanding depositary shares representing interests in the Company’s Series A preferred stock for newly issued shares of common stock, thereby increasing the Company’s common equity capital, and exchanged all outstanding shares of the U.S. Treasury’s Series T preferred stock for shares of a new class of convertible preferred stock, Series G, which provides an opportunity to further increase the Company’s common equity if certain conditions are met, as further discussed under “Recent Developments — Capital Plan — Exchange Transaction with the U.S. Treasury.”

 

Raising new equity capital is also required by the Company’s and the Bank’s regulators pursuant to recent actions taken by such regulators, as more fully described under “Recent Developments — Written Agreement with Regulators.” While the Company continues to pursue new equity capital, it has not yet received any commitment for a new equity capital investment, and there can be no assurance that the Company will be able to raise a sufficient

amount of new equity capital in a timely manner, on acceptable terms or at all. If the Company ultimately is unsuccessful in raising a sufficient amount of new equity capital or, alternatively, executing another strategic initiative, the Company may become subject to a voluntary or involuntary bankruptcy filing, the Bank could be placed into FDIC receivership by its regulators, or the Bank could be acquired by a third party in a transaction in which the Company receives no value for its interest in the Bank. Any such event could be expected to result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

Going Concern:  The Company incurred net losses of $248.8 million and $162.0 million for the years ended December 31, 2009 and 2008, respectively, primarily due to provisions for credit losses and goodwill impairment charges during both years, tax charges related to a valuation allowance on deferred tax assets in 2009, and impairment charges and realized losses on the preferred stock of FNMA and FHLMC in 2008. Due to the resulting deterioration in capital levels of the Bank and the Company, combined with the current uncertainty as to the Company’s ability to raise sufficient amounts of new equity capital, recent regulatory actions with respect to the Company and the Bank, and the current inability of the Company to repay amounts owed under its Loan Agreements with its primary lender if, upon or subsequent to the expiration of the Forbearance Agreement on March 31, 2010, its primary lender were to declare the amounts outstanding thereunder immediately due and payable, there is substantial doubt about the Company’s ability to continue as a going concern.

 

The Company’s independent registered public accounting firm has included in its report on the Company’s consolidated financial statements for the year ended December 31, 2009 an explanatory paragraph with respect to the substantial doubt as to the Company’s ability to continue as a going concern. Management’s plans to address the Company’s ability to continue as a going concern are described in detail in Note 2 — Regulatory Capital of the notes to the consolidated financial statements. The Company’s financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

Existence of substantial doubt as to the Company’s ability to continue as a going concern may have a material adverse impact on the Company and the Bank’s business, financial condition and results of operations and the ability to raise necessary new equity capital. Moreover, relationships with third parties with whom the Company and the Bank do business or on whom they rely, including depositors (particularly those with deposit accounts in excess of FDIC insurance limits), customers and clients, vendors, employees and financial counter-parties could be significantly adversely impacted because these individuals and entities may react adversely to events leading to the conclusion that there is a substantial doubt about the Company’s ability to continue as a going concern, making it more difficult for the Company to address the issues giving rise to the substantial doubt about its ability to continue as a going concern.

 

Liquidity — Bank:  The Bank depends on access to a variety of funding sources, including deposits, to provide sufficient liquidity to meet its commitments and business needs and to accommodate the transaction and cash management needs of its clients, including funding loans. The Bank also must have sufficient funds available to satisfy its obligation to repay any wholesale borrowings it has outstanding, including brokered deposits and other obligations, when they come due. Although management currently believes the Bank has the ability and the available liquidity to meet its near-term potential and actual obligations, if in the future additional cost-effective funding is not available on terms satisfactory to the Bank or at all, the Bank may not be able to meet its funding obligations, which could adversely affect the Company’s results of operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity.”

 

Liquidity — Company:  As a holding company without independent operations, the Company’s liquidity (on an unconsolidated basis) is primarily dependent upon the Company’s ability to raise debt or equity capital from third parties and the receipt of dividends from its operating subsidiary. The Company is currently in default under its Loan Agreements with its primary lender, and its revolving credit facility has matured and is no longer available. Despite its recent efforts to obtain new equity capital, the Company has not yet obtained a commitment for new equity capital. As a result of recent regulatory actions, the Company’s principal operating subsidiary, the Bank, is prohibited from paying any dividends or making any loans to the Company. At December 31, 2009, the Company’s cash and cash equivalents, on an unconsolidated basis amounted to $3.4 million. Presently, the Company does not have sufficient liquidity on an unconsolidated basis to meet its short-term obligations, which include the approximately $63.6 million in outstanding debt that its lender could accelerate and demand payment for upon the

expiration of the Forbearance Agreement on March 31, 2010. Assuming continued receipt of management fees from the Bank, which are subject to approval the Bank’s regulators, the Company believes that, if the lender does not exercise its right to demand payment of amounts owed under the Loan Agreements, that it has adequate liquidity to meet its near-term commitments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity.”

 

Goodwill Impairment; Increase in Valuation Allowance:  The Company is in the process of assessing the carrying value of goodwill and it is possible that the Company may be required to recognize an impairment in the quarter ended March 31, 2010, as it believes that the events and changes in circumstances noted above represent trigger events under the authoritative guidance, indicating potential impairment of goodwill. As of December 31, 2009, the carrying amount of goodwill was $64.9 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Goodwill.” The Company is in the process of assessing the realizability of its deferred tax assets and it is possible that the Company may be required to recognize an additional impairment in the quarter ended March 31, 2010.

 

Repurchase Agreements:  The agreements with one of the Bank’s repurchase agreement counterparties could permit that counterparty to terminate the repurchase agreements if the Bank does not maintain its well-capitalized status. Because the Bank is currently not well-capitalized, there is a risk that the counterparty could exercise its option to terminate one or more of these repurchase agreements prior to maturity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings.”

 

Written Agreement with Regulators

 

As a result of a safety and soundness examination of the Bank by the Federal Reserve Bank of Chicago (the “Federal Reserve Bank”) and the Illinois Department of Financial and Professional Regulation, Division of Banking (the “Illinois Division of Banking”), the Company and the Bank entered into a written agreement (the “Written Agreement”) with the Federal Reserve Bank and the Illinois Division of Banking on December 18, 2009, that is intended to strengthen the Bank and improve the Company’s overall financial condition. As disclosed in previous documents filed with the Securities and Exchange Commission, the Company had anticipated entering into a formal supervisory action following the completion of the examination and was already taking many of the steps referenced in the Written Agreement.

 

The Written Agreement establishes timeframes for the completion of measures which have been previously identified by the Company and the regulators as important to improve the Company’s financial performance. Under the Written Agreement, the Company was required to prepare and file with the regulators within specified timeframes (generally, 60 days from the date of the Written Agreement) various specific plans designed to improve (i) board oversight over the management and operations of the Bank, (ii) credit risk management practices, (iii) management of problem loans, (iv) the allowance for loan losses, (v) the Bank’s earnings and budget, (vi) liquidity and funds management and (vii) interest rate risk management.

 

The Written Agreement requires, among other things, that the Company and the Bank obtain prior approval in order to pay dividends. In addition, the Company must obtain prior approval of the Federal Reserve Bank to (i) take any other form of payment from the Bank representing a reduction in capital of the Bank; (ii) make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities; (iii) incur, increase or guarantee any debt; or (iv) purchase or redeem any shares of the Company’s stock. Pursuant to the terms of the Written Agreement, the Company and the Bank were also required, within 60 days of the date of the Written Agreement, to submit an acceptable written plan to the regulators to maintain sufficient capital at the Company, on a consolidated basis, and at the Bank on a standalone basis. The Company submitted its written plan in February 2010. In addition, the Written Agreement also provides that the Company and the Bank must notify the Federal Reserve Bank and the Illinois Division of Banking if the capital ratios of either fall below those set forth in the capital plans that are approved by the Federal Reserve Bank and the Illinois Division of Banking. The Company must also notify the regulators before appointing any new directors or senior executive officers or changing the responsibilities of any senior executive officer position. The Written Agreement also requires the Company and the Bank to comply with certain restrictions regarding indemnification and severance payments.

The Bank must furnish periodic progress reports to the Illinois Division of Banking and the Federal Reserve Bank regarding its compliance with the Written Agreement. The Written Agreement will remain in effect until stayed, modified, terminated or suspended by the Federal Reserve Bank and the Illinois Division of Banking.

 

There can be no assurance that the Company will be able to satisfy, in a timely manner or at all, the requirements set forth in the Written Agreement, or that the plans adopted in response to the Written Agreement’s requirements will have their intended effect. The Company believes that the successful completion of all or a significant portion of its capital plan, as defined below, which includes executing transactions that seek to improve the Company’s and the Bank’s capital position, increase its common equity and Tier 1 capital and raise additional capital, will help the Bank and the Company to meet the requirements of the Written Agreement. The Company believes that a new equity raise of approximately $250 million in conjunction with the Company’s primary lender restructuring its debt to common equity will position the Company and Bank to remain well capitalized through at least December 31, 2010. However, the successful completion of all or any portion of the Capital Plan is not assured, and if the Company or the Bank is unable to timely comply with the terms of the Written Agreement or any other applicable regulations or regulatory directives, including the recently issued PCA, the Company and the Bank could become subject to additional, heightened supervisory actions and orders, which could, among other things, mandate additional capital, require the sale of certain assets and liabilities, and otherwise have a material adverse effect on the business of the Bank and the Company. Failure of the Company and the Bank to meet these conditions could lead to further enforcement action by the regulators, including the appointment of a receiver for the Bank, and any such appointment could be expected to result in a loss of the entire value of the Company’s outstanding securities. See also “Recent Developments — Outlook for 2010” for a discussion of the PCA recently issued by the Federal Reserve Bank.

 

Regulatory Capital

 

As of December 31, 2009, the Company and the Bank did not meet all regulatory capital adequacy requirements administered by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Prompt corrective action provisions are not applicable to bank holding companies.

 

Quantitative measures established to ensure capital adequacy require banks and bank holding companies to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. If a bank does not meet these minimum capital requirements, as defined, bank regulators can initiate certain actions that could have a direct material adverse effect on the bank’s financial condition and ongoing operations.

 

As of December 31, 2009, the most recent Federal Deposit Insurance Corporation notification categorized the Bank as undercapitalized under the regulatory framework for prompt corrective action. As a result of the Bank’s undercapitalized status for regulatory capital purposes as of December 31, 2009, the Bank is no longer able to accept or renew brokered deposits, whether wholesale or retail, secure deposits rates that are 75 basis points higher than the prevailing effective rates on insured deposits of comparable amounts or maturities in the Bank’s normal market area or the national rates periodically release by the FDIC, pay dividends or make other capital distributions, or obtain funds through Federal funds lines.

 

In addition, the agreements with one of the Bank’s repurchase agreement counterparties could permit that counterparty to terminate the repurchase agreements as a result of the Bank being categorized as less than well capitalized. At December 31, 2009, the Bank’s repurchase agreements with those provisions totaled $262.7 million with fixed interest rates ranging from 2.76% to 4.65%, maturities ranging from approximately 7.5 to 8.5 years, and quarterly call provisions (at the counterparty’s option). Due to the relatively high fixed rates on these borrowings as compared to currently low market rates of interest, the Bank would incur substantial costs to unwind these repurchase agreements if terminated prior to their maturities. These associated unwind costs could have a material adverse effect on the Company’s results of operations and financial condition in the period of payment. The associated unwind costs would be the difference between the fair value and carrying value of the repurchase agreements on the date of termination. Because the repurchase agreements are collateralized at an amount sufficient

to cover any such unwind costs which may be incurred, any such costs would result in a charge in the statement of operations but would not expect to have an adverse effect on the Bank’s liquidity.

 

Based on current trends, the Company projects the Bank will be critically undercapitalized at March 31, 2010. See “Recent Developments — Outlook for 2010.”

 

See Note 19 — Capital Requirements of the notes to the consolidated financial statements for a further discussion of the Company’s and Bank’s capital requirements.

 

Capital Plan

 

In July 2009, the Company announced that it had developed a detailed capital plan and timeline for execution (the “Capital Plan”). The Capital Plan was adopted in order to, among other things, improve the Company’s common equity capital and raise additional capital to enable it to better withstand and respond to adverse market conditions. Management has completed, or is in the process of completing a number of significant steps as part of the Capital Plan.

 

Steps already completed include the following:

 

 

Exchange Transaction with the U.S. Treasury.  On March 8, 2010, the U.S. Treasury exchanged the 84,784 shares of Series T preferred stock, having an aggregate approximate liquidation preference of $84.8 million, plus approximately $4.6 million in cumulative dividends not declared or paid on such preferred stock, for a new series of fixed rate cumulative mandatorily convertible preferred stock, Series G, with the same liquidation preference. The warrant dated December 5, 2008 to purchase 4,282,020 shares of common stock was also amended to re-set the strike price of the warrant to be consistent with the conversion price of the Series G preferred stock. The U.S. Treasury has the authority to convert the new preferred stock into the Company’s common stock at any time. In addition, the Company can compel a conversion of the new preferred stock into common stock, subject to the following conditions: (i) the Company receives appropriate approvals from the Federal Reserve; (ii) approximately $78.6 million principal amount of the Company’s revolving, senior, and subordinated debt shall have previously been converted into common stock on terms acceptable to the U.S. Treasury in its sole discretion; (iii) the Company shall have completed a new cash equity raise of not less than $125 million on terms acceptable to the U.S. Treasury in its sole discretion; and (iv) the Company has made the anti-dilution adjustments to the new preferred stock, if any, as required by the terms thereof. Unless earlier converted, the new preferred stock converts automatically into shares of the Company’s common stock on March 8, 2017.

 

Having successfully completed the Exchange Offer and the exchange with the U.S. Treasury, management is now concentrating on the restructuring of the Company’s outstanding senior debt and certain subordinated debt with its primary lender along with raising significant new equity capital. Accomplishing both of these components is essential to the successful completion of the overall Capital Plan because the inability to complete one of these components will significantly jeopardize the ability to realize the achievement of the other principal components. Accordingly, the Company expects that any failure to complete either one of these two final components will affect its ability to continue as a going concern.

Capital Raising Activities.  The Company is involved in discussions and information sharing with several potential strategic and financial investors that are conducting due diligence reviews of the Company and its business.

 

Restructuring of Debt with Primary Lender.  The Company continues to be in discussions with its primary lender concerning its willingness to restructure the Company’s outstanding debt or convert all or a portion of such debt into common stock. The Company currently has $8.6 million outstanding on a revolving line of credit together with $55.0 million outstanding under a separate term note with its primary lender. These loans are secured by all of the outstanding shares of stock of the Bank. On October 22, 2009, the Company entered into a forbearance agreement (the “Forbearance Agreement”) with the lender, pursuant to which, among other things, the lender agreed to forbear from exercising the rights and remedies available to it as a consequence of certain existing events of default (except for continuing to impose default rates of interest) until March 31, 2010, or earlier in the event of certain breaches or defaults or upon the occurrence of certain receivership or insolvency events. The Company has not breached or defaulted under any of its representations, warranties or obligations contained in either the Forbearance Agreement or credit agreements. The Company has received no commitment from its lender that it will pursue a debt restructuring or conversion transaction with the Company.

 

Other Recent Developments

 

The Company had a net loss of $242.7 million for the year ended December 31, 2009. Basic and diluted loss per share for the year ended December 31, 2009 were both $8.89. This loss was mainly attributed to the $170.2 million provision for credit losses as the Company continued to address credit issues, tax charges including $116.3 million related to a valuation allowance on deferred tax assets and $8.1 million related to the liquidation of bank-owned life insurance, and a goodwill impairment charge of $14.0 million. Margin was also negatively impacted by repositioning of the securities portfolio which achieved a $107.2 million reduction in risk-weighted assets along with several other liquidity preservation steps but at a cost of reduced earning asset yields for 2009. Noninterest expense was also negatively affected by higher Federal Deposit Insurance Corporation (“FDIC”) insurance costs and professional fees incurred to perform independent cumulative loan loss studies under various methodologies and assumptions, including highly stressed scenarios, in order to determine the Company’s capital needs, as well as execute the Capital Plan. Operating expenses increased further to manage impaired loans within the special assets group, and carrying costs of foreclosed properties. The increases were partially offset by the impact of staff reductions, suspension of the 401(k) match and other expense control initiatives estimated at $15.9 million on an annual basis.

 

Executive management was expanded to add additional talent with specific skills essential to work on mission critical tasks. Stephen L. Eastwood was named Executive Vice President and Chief Risk Officer of the Bank in November 2009. Alberto J. Paracchini was named Executive Vice President, Planning and Development of the Bank in January 2010. Darrin R. Bacon was named Executive Vice President, Head of Commercial and Industrial Lending of the Bank in February 2010.

 

On July 28, 2009, the Board of Directors of the Bank and the Company accepted the resignation of three directors, reducing the Boards from eleven to eight members. On September 21, 2009, the Company announced the death of director Thomas A. Rosenquist. The boards of the Company and the Bank now have seven members.

 

On May 15, 2009, Roberto R. Herencia assumed the role of president and Chief Executive Officer of the Company and the Bank, replacing J. J. Fritz, who became senior executive vice president of the Company. Mr. Herencia, who also was appointed to the board of directors of the Company, was formerly president and director of Banco Popular North America based in Chicago and executive vice president of Popular, Inc., the parent company. Under Mr. Herencia’s direction, the Company immediately tightened its loan underwriting and pricing criteria, began aggressive balance sheet repositioning activities, and developed a comprehensive capital plan. Actions the Company has taken to tighten its loan underwriting include tightening debt coverage capacity and loan to value advance rates; enhancing stress testing of new loans assuming both interest rate and credit risk changes; determining the adequacy of prior loan repayment sources in both the current market and potential future more adverse markets; increasing the focus on secondary source of repayment capacity over and above collateral; requiring increased equity for lending transactions; and strengthening credit risk review of guarantor liquidity and

financial net worth to support potential additional needs for equity or capital to support loan transactions. In addition, the Bank has identified select industries where there are perceived higher levels of increased risk or less stability to determine current loan exposure to these markets and determine proactive steps to mitigate risk or exit certain industries or credit relationships. These activities are designed to right-size the Company by reducing the loan portfolio, both in the aggregate and within the select industry portfolios noted above, thereby reducing risk-weighted assets commensurate with the decreasing amount of available capital. As a result of these activities, the Company reported asset reductions since the second quarter of 2009 and reductions in risk-weighted assets as defined for regulatory capital purposes.

 

The Company also announced on May 6, 2009, that the Board of Directors made the decision to suspend the dividend on the $43.1 million of Series A Preferred Stock; defer the dividend on the $84.8 million of Series T Preferred Stock; and defer interest payments on $60.8 million of its junior subordinated debentures as permitted by the terms of such debentures. The Written Agreement requires the Company to obtain prior approval to resume dividend payments in respect of the Series A Preferred Stock or interest payments in respect of its junior subordinated debentures.

 

In response to the financial crises affecting the overall banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”), was enacted. Under the EESA, the U.S. Treasury has the authority to, among other things, purchase mortgages, mortgage backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

 

The EESA included a provision for an increase in the amount of deposits insured by the FDIC to $250,000 until December 2009. On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program, that provides unlimited deposit insurance on funds in noninterest-bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit of $250,000. The Company has elected to participate in the Temporary Liquidity Guarantee Program and incur a 10 basis point surcharge as a cost of participation. The behavior of depositors in regard to the level of FDIC insurance could cause the Company’s existing customers to reduce the amount of deposits held at the Company, or could cause new customers to open deposit accounts. The level and composition of the Company’s deposit portfolio directly impacts its funding cost and net interest margin.

 

The EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the Securities and Exchange Commission (“SEC”) and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.

 

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in Troubled Asset Relief Program (“TARP”), including the Company, which are in addition to those previously announced by U.S. Treasury. The new limits remain in place until the participant has redeemed the preferred stock sold to U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.

 

Among the provisions in the ARRA are restrictions affecting financial institutions that are participating in the Capital Purchase Program (“CPP”). These provisions are set forth in the form of amendments to the EESA. The amendments provide that during the period in which any TARP obligation is outstanding (other than those relating to warrants), TARP recipients are subject to standards for executive compensation and corporate governance to be set forth in regulations to be issued by the U.S. Treasury. A discussion of the EESA compensation rules is set forth below at “Supervision and Regulation — Participation in Capital Purchase Program.”

Both the Federal Reserve and the FDIC have recently proposed rules which will affect incentive compensation plans of banks and bank holding companies. See “Supervision and Regulation — Compensation Guidelines.”

 

In 2009, the FDIC increased premium assessments to maintain adequate funding of the Deposit Insurance Fund. These increases in premium assessments have increased the Company’s expenses. A discussion of FDIC premium assessments is discussed below at “Supervision and Regulation — Financial Institution Regulation.”

 

2008 Developments

 

The Company recognized a non-cash, non-operating, other-than-temporary impairment charge of $47.8 million at September 30, 2008 on certain FNMA and FHLMC preferred equity securities similar to the impairment charge of $17.6 million taken in the first quarter of 2008. In September 2008, the Company sold a portion of its FNMA and FHLMC preferred equity securities recognizing a $16.7 million loss. It also recognized an $80.0 million impairment charge on its goodwill intangible asset based upon the annual test performed with the assistance of a nationally recognized third party valuation specialist. The decline in value was primarily the result of a decline in market capitalization. During 2008, the Company recognized net loan charge-offs of $54.1 million and recorded a $71.8 million loan loss provision, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions. During the first quarter of 2008, the Company also incurred a $7.1 million loss on the early extinguishment of debt arising from the prepayment of $130.0 million in FHLB advances, and recognized a $15.2 million gain on the sale of real estate.

 

On December 5, 2008, for an aggregate purchase price of $84.784 million, the Company sold 84,784 shares of Series T Preferred stock to the U.S. Treasury and issued a warrant to the U.S. Treasury which will allow it to acquire 4,282,020 shares of the Company’s common stock for $2.97 per share. The proceeds of $84.8 million were allocated between the Series T Preferred stock and the warrant based on their relative fair values. A nationally recognized independent valuation specialist was used to assist in the valuation of the Series T Preferred stock and the related warrant.

 

The Board of Directors of the Company and the Bank elected Percy L. Berger Chairman of the Board of Directors of the Company and the Bank effective December 31, 2008. Mr. Berger replaced Homer J. Livingston, Jr. who resigned as a Director and Chairman effective December 31, 2008.

 

Strategy

 

The year ended December 31, 2009 was the Company’s most challenging year. Like all other financial institutions, it faced the worst economy in 75 years. The Company entered the economic recession in a weakened financial position due to two major issues: (1) the Company suffered an $82.1 million loss in 2008 on investments in preferred stock of FNMA and FHLMC substantially reducing the Company’s capital position; and (2) the Company had financed the cash component of the bank acquisition in 2007 with bank loans secured by the Bank’s stock, subordinated debt, and a convertible preferred stock issue. These two matters left the Company with less tangible equity and financial flexibility to confront the economic recession. As the recession ensued, the Company incurred net losses of $248.8 million and $162.0 million for the years ended December 31, 2009 and 2008, respectively, primarily due to provisions for credit losses and goodwill impairment charges during both years, tax charges related to a valuation allowance on deferred tax assets in 2009, and impairment charges and realized losses on the preferred stock of FNMA and FHLMC in 2008 noted above. Due to the resulting deterioration in capital levels of the Bank and the Company, the Company and the Bank entered into a Written Agreement on December 18, 2009 and a Prompt Corrective Action on March 29, 2010, both as described in “Recent Developments — Outlook for 2010.”

 

Due to these overriding concerns, the Bank’s 2009 strategy focused on Building a New Foundation. That strategy was created and launched by the Company’s new Chief Executive Officer, Roberto R. Herencia, who joined the Bank in May 2009. The strategy for recovery and rebuilding, initiated through Mr. Herencia’s 100-Day Plan contained the following five components:

 

1. Preserve capital by optimizing the use of the Company’s balance sheet;

 

2. Ensure credit discipline and creation of stress testing the loan portfolio;

3. Reduce expenses;

 

4. Craft a comprehensive capital plan; and

 

5. Communicate, communicate, communicate — with employees, customers, and stakeholders.

 

In July 2009, the Company announced that it had developed a detailed capital plan and timeline for execution in order to, among other things, improve the Company’s common equity capital and raise additional capital to enable it to better withstand and respond to adverse market conditions. As described above in “Recent Developments — Capital Plan,” management has completed or is in the process of completing a number of significant steps as part of the Capital Plan. The Company’s immediate priorities are to comply with the terms of the PCA and Written Agreement, restore the capital ratios, and preserve the value of the Bank.

 

The Company seeks to emerge as a strong, viable community bank with minimal nonperforming assets and classified loans, high capital ratios, ample liquidity, quality performance and proven management in place. The Company is committed to building customer relationships, delivering for stockholders, partnering with its communities and engaging employees.

 

Certain information with respect to the Bank and the Company’s nonbank subsidiaries as of December 31, 2009, is set forth below:

 

 

 

 

History

 

The Bank

 

Midwest Bank and Trust Company was established in 1959 in Elmwood Park, Illinois to provide community and commercial banking services to individuals and businesses in the neighboring western suburbs of Chicago. The

Company has pursued growth opportunities for the Bank through acquisitions and the establishment of new branches. The most recent are described below.

 

 

Non-bank Subsidiaries

 

The Bank’s non-bank subsidiaries were established to support the retail and commercial banking activities of the Bank.

 

In August 2002, the Bank established MBTC Investment Company. This subsidiary was capitalized through the transfer of investment securities from the Bank and was formed to diversify management of that portion of the Company’s securities portfolio. In May 2006, MBTC Investment Company established Midwest Funding, L.L.C. This subsidiary holds real estate assets.

 

In July 2006, the Bank acquired Midwest Financial and Investment Services, Inc. (“Midwest Financial”) through the acquisition of Royal American Corporation (“Royal American”). Midwest Financial is a registered bank-affiliated securities broker-dealer and registered investment advisor and is registered with the SEC as a broker-dealer and is a member of FINRA. It operates a general securities business as an introducing broker-dealer.

 

The Company formed four statutory trusts between October 2002 and June 2005 to issue $54.0 million in floating-rate trust preferred securities. Through the Royal American merger in July 2006, the Company acquired a statutory trust that in April 2004 had issued $10.0 million in trust preferred securities which had a fixed rate until the optional redemption date of July 23, 2009 and a floating rate thereafter until maturity. Through the Northwest Suburban merger in October 2007, the Company acquired a statutory trust that in May 2004 had issued $10.0 million in floating-rate trust preferred securities. These offerings were pooled private placements exempt from registration under the Securities Act of 1933 pursuant to Section 4(2) thereunder. In November 2007, the Company redeemed $15.0 million in trust preferred securities originally issued through MBHI Capital Trust II. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of the five existing trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on its shares of common and preferred stock. See Note 16 — Junior Subordinated Debentures of the notes to the consolidated financial statements. These five trusts and their trust preferred securities are detailed below as follows:

 

 

 

 

Markets

 

The largest segments of the Company’s customer base live and work in relatively mature markets in Cook, DuPage, Kane, Lake, and McHenry Counties. The Company considers its primary market areas to be those areas immediately surrounding its offices for retail customers and generally within a 10-20 mile radius for commercial relationships. The Bank operates 26 full-service locations in the Chicago metropolitan area. The communities in which the Bank’s offices are located have a broad spectrum of demographic characteristics. These communities include a number of densely populated areas as well as suburban areas, and some extremely high-income areas as well as many middle-income and some low-to-moderate income areas.

 

Competition

 

The Company competes in the financial services industry through the Bank and Midwest Financial. The financial services business is highly competitive. The Company encounters strong direct competition for deposits, loans, and other financial services with the Company’s principal competitors including other commercial banks, savings banks, savings and loan associations, mutual funds, money market funds, finance companies, credit unions, mortgage companies, insurance companies and agencies, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms.

 

Several major multi-bank holding companies operate in the Chicago metropolitan market. Generally, these financial institutions are significantly larger than the Company and have access to greater capital and other resources. Several hundred new bank branches were opened in the Company’s marketplace between 2004 and 2007. Deposit pricing is competitive with promotional rates frequently offered by competitors. In addition, many of the Company’s non-bank competitors are not subject to the same degree of regulation as that imposed on bank holding companies, federally insured banks, and Illinois-chartered banks. As a result, such non-bank competitors have advantages over the Company in providing certain services.

 

The Company addresses these competitive challenges by creating market differentiation and by maintaining an independent community bank presence with local decision-making within its markets. The Bank competes for deposits principally by offering depositors a variety of deposit programs, convenient office locations and hours, and other services. The Bank competes for loan originations primarily through the interest rates and loan fees charged, the efficiency and quality of services provided to borrowers, the variety of loan products, and a trained staff of professional bankers.

 

The Chicago market is highly competitive making it more difficult to retain and attract customer relationships. The Company recognizes this and has initiatives to address the competition. Part of the Company’s marketing strategy is to create a performance-driven sales environment, increase activity in its branches, launch a renewed promotional image, and build and market a strong private banking program. The Company competes for qualified personnel by offering competitive levels of compensation, management and employee cash incentive programs, and by augmenting compensation with stock options and/or restricted stock grants pursuant to its stock and incentive plan. Attracting and retaining high quality employees is important in enabling the Company to compete effectively for market share.

 

Products and Services

 

Deposit Products

 

Management believes the Bank offers competitive deposit products and programs which address the needs of customers in each of the local markets served. These products include:

 

Checking and Interest-bearing Checking Accounts.  The Company has developed a range of different checking account products (e.g., Free Checking and Business Advantage Checking) designed and priced to meet specific target segments of the local markets served by each branch.

 

Savings and Money Market Accounts.  The Company offers multiple types of money market accounts and savings accounts (e.g., Relationship Savings which offers higher rates with deeper banking relationships).

Time Deposits.  The Company offers a wide range of time deposits (including traditional and Roth Individual Retirement Accounts), usually offered at premium rates with special features to protect the customer’s interest earnings in changing interest rate environments.

 

Lending Services

 

The Company’s loan portfolio consists of commercial loans, construction loans, commercial real estate loans, consumer real estate loans, and consumer loans. The Company generally requires personal guarantees of the principal except on cash secured, state or political subdivision, or not-for-profit organization loans. The Company offers lending services in the following areas:

 

Commercial Loans.  Commercial and industrial loans are made to small-to medium-sized businesses that are sole proprietorships, partnerships, and corporations. Generally, these loans are secured with collateral including accounts receivable, inventory and equipment. The personal guarantees of the principals may also be required. Frequently, these loans are further secured with real estate collateral. Owner-occupied commercial real estate loans, where repayment is not dependent on the real estate collateral, are classified as commercial loans.

 

Construction Loans.  Construction loans include loans for land development and for commercial and residential development and improvements. The majority of these loans are in-market to known and established borrowers. During the past three years, these types of loans decreased as a percentage of the loan portfolio to 13.3% at December 31, 2009 from 21.8% at December 31, 2006.

 

Commercial Real Estate Loans.  Commercial real estate loans are loans secured by real estate including farmland, multifamily residential properties, and other nonfarm-nonresidential properties. These loans are generally short-term balloon loans, with fixed or adjustable rate mortgages and terms of one to five years.

 

Consumer Real Estate Loans.  Consumer real estate loans are made to finance residential units that will house from one to four families. The Company originates both fixed and adjustable rate consumer real estate loans.

 

Home equity lines of credit, included within the Company’s consumer real estate loan portfolio, are secured by the borrower’s home and can be drawn at the discretion of the borrower. These lines of credit are generally at variable interest rates. Home equity lines, combined with the outstanding loan balance of prior mortgage loans, generally do not exceed 80% of the appraised value of the underlying real estate collateral at the time of issuance.

 

Consumer Loans.  Consumer loans (other than consumer real estate loans) are collateralized loans to individuals for various personal purposes such as automobile financing.

 

Lending officers are assigned various levels of loan approval authority based upon their respective levels of experience and expertise. Loan approval is also subject to the Company’s formal loan policy, as established by the Bank’s Board of Directors. The Bank’s loan policies establish lending authority and limits on an individual and committee basis. The loan approval process is designed to facilitate timely decisions while adhering to policy parameters and risk management targets.

 

ATMs

 

The Bank maintains a network of 30 ATM sites generally located within the Bank’s local market. All ATMs are owned by the Bank. Twenty-six of the ATM sites are located at various banking centers and four are maintained off-site. The Bank is a member of the STAR, Allpoint/STARsf, and MoneyPass networks. The Bank’s participation in the Allpoint /STARsf and MoneyPass networks allows customers to have surcharge free access to their accounts at thousands of ATMs nationwide.

 

Trust Activities

 

The Bank offers personal and corporate trust, employee benefit trust, land trust, and agencies, custody, and escrow services. As of December 31, 2009, the Bank maintained trust relationships holding an aggregate market value of $154.8 million in assets and administered 1,565 land trust accounts.

Insurance and Securities Brokerage

 

The Bank’s subsidiary, Midwest Financial is registered with the SEC as a broker-dealer and is a member of FINRA. Midwest Financial operates a general securities business as an introducing broker-dealer. The area served by Midwest Financial is the Chicago metropolitan area. It holds neither customer accounts nor customers’ securities. Licensed brokers serve all branches and provide insurance and investment-related services, including securities trading, financial planning, mutual funds sales, fixed and variable rate annuities, and tax-exempt and conventional unit trusts.

 

Employees

 

As of December 31, 2009, the Company and its subsidiaries had 416 full-time equivalent employees compared to 536 full-time equivalent employees a year ago. Management considers its relationship with its employees to be good.

 

Available Information

 

The Company’s internet address is www.midwestbanc.com. The Company is an SEC registrant and posts its SEC filings, including Forms 10-K, 10-Q, 8-K, proxy statements, and amendments thereto, on its website under Investor Relations on the day they are filed. The Company will also provide free copies of its filings upon written request to: Investor Relations, 501 West North Ave., Melrose Park, IL 60160.

 

The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company is an electronic filer. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at the SEC’s site: http://www.sec.gov.

 

The Company has a Corporate Governance webpage. The public can access information about the Company’s corporate governance at www.midwestbanc.com and by selecting About Us, then Corporate Information and then Corporate Governance. The Company posts the following on its Corporate Governance webpage:

 

 

SUPERVISION AND REGULATION

 

Bank holding companies and banks are extensively regulated under federal and state law. References under this heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations. Any change in applicable laws or regulations may have a material adverse effect on the business of commercial banks and bank holding companies, including the Company and the Bank. However, management is not aware of any current recommendations by any regulatory authority which, if implemented, would have or would be reasonably likely to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Finally, please remember that the supervision, regulation and examination of banks and bank holding companies by bank

regulatory agencies are intended primarily for the protection of depositors rather than stockholders of banks and bank holding companies.

 

Bank Holding Company Regulation

 

The Company is registered as a “bank holding company” with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and, accordingly, is subject to supervision and regulation by the Federal Reserve under the Bank Holding Company Act and the regulations issued thereunder, collectively referred to as the BHC Act. The Company is required to file with the Federal Reserve periodic reports and such additional information as the Federal Reserve may require pursuant to the BHC Act. The Federal Reserve examines the Company and the Bank, and may examine the Company’s other subsidiaries.

 

The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined, by regulation or order, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto, such as performing functions or activities that may be performed by a trust company, or acting as an investment or financial advisor. The Federal Reserve, however, expects bank holding companies to maintain strong capital positions while experiencing growth. In addition, the Federal Reserve, as a matter of policy, may require a bank holding company to be well-capitalized at the time of filing an acquisition application and upon consummation of the acquisition.

 

Under the BHC Act, the Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with an extension of credit, lease, sale of property or furnishing of services. This means that, except with respect to traditional banking products, the Company may not condition a customer’s purchase of one of its services on the purchase of another service.

 

The Gramm-Leach-Bliley Act allows bank holding companies to become financial holding companies. Financial holding companies do not face the same prohibitions against the entry into certain business transactions that bank holding companies currently face.

 

Under the Illinois Banking Act, any person (or person acting in concert) who acquires 25% or more of the Company’s stock may be required to obtain the prior approval of the Illinois Department of Financial and Professional Regulation, Division of Banking (the “Illinois Division of Banking”). Under the Change in Bank Control Act, a person may be required to obtain the prior approval of the Federal Reserve before acquiring the power to directly or indirectly control the management, operations or policies of the Company or before acquiring 10% or more of any class of its outstanding voting stock.

 

It is the policy of the Federal Reserve that the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. The Federal Reserve takes the position that in implementing this policy, it may require the Company to provide such support when the Company otherwise would not consider it advisable to do so.

 

The Federal Reserve has adopted risk-based capital requirements for assessing bank holding company capital adequacy. These standards define regulatory capital and establish minimum ratios in relation to assets, both on an aggregate basis and as adjusted for credit risks and off-balance sheet exposures. The Federal Reserve’s risk-based guidelines apply on a consolidated basis to any bank holding company with consolidated assets of $500 million or more. The risk-based guidelines also apply on a consolidated basis to any bank holding company with consolidated assets of less than $500 million if the holding company is engaged in significant non banking activities either directly or through a non bank subsidiary; conducts significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a non bank subsidiary; or has a material amount

of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission.

 

Under the Federal Reserve’s capital guidelines, bank holding companies are required to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which 4% must be in the form of Tier 1 Capital. The Federal Reserve also requires a minimum leverage ratio of Tier 1 Capital to total assets of 3% for strong bank holding companies, defined as those bank holding companies rated a composite “1” under the rating system used by the Federal Reserve. For all other bank holding companies, the minimum ratio of Tier 1 capital to total assets is 4%. Bank holding companies with supervisory, financial, operational, or managerial weaknesses, as well as those that are anticipating or experiencing significant growth, are expected to maintain capital ratios well above the minimum levels.

 

The Federal Reserve’s capital guidelines classify bank holding company capital into two categories. Tier 1, or “core capital” generally is defined as the sum of eligible core capital elements, less any amounts of goodwill and other items that are required to be deducted in accordance with the Federal Reserve capital guidelines. Eligible Tier 1 or core capital elements consist of qualifying common stockholders’ equity, qualifying noncumulative perpetual preferred stock (including related surplus), senior perpetual preferred stock issued to the U.S. Treasury under the TARP (including related surplus), minority interests related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, and restricted core capital elements (“Tier 1 Capital”). Tier 1 Capital must represent at least 50% of a bank holding company’s qualifying total capital.

 

For purposes of determining bank holding company Tier 1 Capital, restricted core capital elements include cumulative perpetual preferred stock (including related surplus), minority interests related to qualifying perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary, minority interests related to qualifying common stockholder’s equity or perpetual preferred stock issued by a consolidated subsidiary that is neither a US depository or a foreign bank, qualifying trust preferred securities and subordinated debentures issued to the Treasury under the TARP, established by the EESA by a bank holding company that has made a valid election to be taxed under Subchapter S of Chapter 1 of the U.S. Internal Revenue Code or by a bank holding company organized in mutual form.

 

Eligible Tier 2, or “supplementary capital” includes allowance for loan and lease losses (subject to limitations), perpetual preferred stock and related surplus (subject to conditions), hybrid capital instruments, perpetual debt and mandatory convertible debt securities, term subordinated debt and intermediate-term preferred stock, including related surplus (subject to limits) and unrealized holding gains on equity securities (subject to limitations). The maximum amount of Tier 2 Capital that may be included in a bank holding company’s total capital is limited to 100% of Tier 1 Capital.

 

The Federal Reserve capital guidelines limit the aggregate amount of “restricted core capital ” elements that a bank holding company may include in Tier 1 Capital. Until March 31, 2011, the aggregate amount of “restrictive core” elements consisting of cumulative perpetual preferred stock (including related surplus) and qualifying trust preferred securities that a BHC may include in Tier 1 Capital is limited to 25% of the sum of (i) qualifying common stockholder equity, (ii) qualifying noncumulative and cumulative perpetual preferred stock (including related surplus), (iii) qualifying minority interest in the equity accounts of consolidated subsidiaries and (iv) qualifying trust preferred securities.

 

After March 31, 2011, these Tier 1 “restrictive core capital” element limits will change. After that date, the aggregate amount of all restricted core capital elements that may be included by a bank holding company as Tier 1 Capital must not exceed 25% of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability.

 

The excess of restricted core capital not included in Tier 1 may generally be included in the Tier 2 Capital calculation. However, after March 31, 2011, the aggregate amount of term subordinated debt (excluding mandatory convertible debt) and limited-life preferred stock as well as excess qualifying trust preferred securities and Class C minority interest that may be included in Tier 2 capital is limited to 50 percent of Tier 1 capital (net of goodwill and other intangible assets required to be deducted). After March 31, 2011, amounts of these instruments in excess of

this limit, although not included in Tier 2 capital, will be taken into account by the Federal Reserve in its overall assessment of a banking organization’s funding and financial condition.

 

In its capital adequacy guidelines, the Federal Reserve emphasizes that the foregoing standards are supervisory minimums and that banking organizations generally are expected to operate well above the minimum ratios. These guidelines also provide that banking organizations experiencing growth, whether internally or by making acquisitions, are expected to maintain strong capital positions substantially above the minimum levels.

 

As of December 31, 2009, the Company’s regulatory capital fell below the Federal Reserve’s minimum requirements to be considered adequately capitalized. The Company had a total capital to risk-weighted assets ratio of 0.4%, a Tier 1 capital to risk-weighted assets ratio of 0.2%, and a leverage ratio of 0.1%. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources.”

 

In response to the financial crises affecting the overall banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”), was enacted. Under EESA, the U.S. Treasury has the authority to, among other things, purchase mortgages, mortgage backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

 

As indicated above, on December 5, 2008, the Company sold 84,784 shares of Series T preferred stock to the U.S. Treasury for an aggregate purchase price of $84.784 million and issued a warrant to the U.S. Treasury to acquire 4,282,020 shares of its common stock for $2.97 per share pursuant to the Letter Agreement. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources” for details regarding the exchange of all the shares of Series T preferred stock.

 

On January 12, 2009, the FDIC announced that State nonmember institutions should implement a process to monitor their use of capital injections, liquidity support and/or financing guarantees obtained through recent financial stability programs established by the Treasury, the FDIC and the Federal Reserve. In particular, the FDIC indicated that the monitoring processes should help to determine how participation in these federal programs has assisted institutions in supporting prudent lending and/or supporting efforts to work with existing borrowers to avoid unnecessary foreclosures. The FDIC has encouraged institutions to include a summary of this information in stockholder and public reports, annual reports and financial statements, as applicable. While the Company is not subject to this directive, it is foreseeable that similar requirements may be imposed on the Company by its primary banking regulator.

 

EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the SEC and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.

 

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury (see “Participation in Capital Purchase Program”). The new limits remain in place until the participant has redeemed the preferred stock sold to U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.

 

The Sarbanes-Oxley Act of 2002 implemented legislative reforms intended to prevent corporate and accounting fraud. In addition to the establishment of a new accounting oversight board which enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the legislation

and the related regulations restrict provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client require pre-approval by the company’s audit committee. In addition, audit partners must be rotated. The legislation and the related regulations require the principal chief executive officer and the principal chief financial officer to certify to the accuracy of periodic reports filed with the SEC and subject them to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

 

The Sarbanes-Oxley Act provides for disgorgement of bonuses issued to top executives prior to restatement of a company’s financial statements if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during pension fund “blackout” periods, and loans to company executives are restricted. The legislation and the related regulations accelerated the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company’s securities within two business days of the change.

 

The legislation and the related regulations also increase the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company’s registered public accounting firm. Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the company. In addition, companies must disclose whether at least one member of the committee is a “financial expert” as defined by the SEC and if not, why not. The SEC has also prescribed rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. The registered public accounting firm issues an audit report expressing an opinion on the fair presentation of the financial statements and on the effectiveness of internal control over financial reporting. See “Item 9A. Controls and Procedures” of this Annual Report on Form 10-K.

 

As a bank holding company, the Company is primarily dependent upon dividend distributions from its operating subsidiaries for its income. Federal and state statutes and regulations impose restrictions on the payment of dividends by the Company and the Bank.

 

Federal Reserve policy provides that a bank holding company should not pay dividends unless (i) the bank holding company’s net income over the prior year is sufficient to fully fund the dividends and (ii) the prospective rate of earnings retention appears consistent with the capital needs, asset quality and overall financial condition of the bank holding company and its subsidiaries.

 

Delaware law also places certain limitations on the ability of the Company to pay dividends. For example, the Company may not pay dividends to its stockholders if, after giving effect to the dividend, the Company would not be able to pay its debts as they become due. Because a major source of the Company’s cash receipts is dividends the Company receives and expects to receive from the Bank, the Company’s ability to pay dividends to stockholders is likely to be dependent on the amount of dividends paid by the Bank. No assurance can be given that the Bank can pay any such dividends to the Company on its stock. Because the Bank had a net loss of $231.0 million in 2009, the Bank will only be able to pay dividends in 2010 upon receipt of regulatory approval, though as stated in the Written Agreement, the Company and the Bank must obtain prior approval in order to pay dividends. In addition, under the terms of the Company’s Series T preferred stock sold to the U.S. Treasury, the Company will only be able to pay dividends with the approval of the U.S. Treasury. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources” for details regarding the exchange of all the shares of Series T preferred stock.

 

Participation in Capital Purchase Program

 

On December 5, 2008, the Company issued $84.8 million of its Series T Preferred Stock to the U.S. Treasury under the CPP. In order to participate in the CPP, the Company has to comply with certain executive compensation rules contained in EESA. The ARRA includes provisions that further regulate the executive compensation of

financial institutions participating in the CPP. The Treasury has adopted regulations to implement the EESA compensation rules as amended by ARRA.

 

On March 8, 2010, the Series T Preferred Stock held by the U.S. Treasury was exchanged for a new series of Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, Series G (the “Series G Preferred Stock”). For a further, discussion of the Exchange Agreement and the Series G Preferred Stock, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources.”

 

Persons Subject to the Rules.  Pursuant to the terms of the Exchange Agreement, the Company will have to continue to comply with the EESA compensation rules. These rules, described below, apply to the senior executive officers (the “SEOs”), and certain most highly compensated employees of the Company. SEOs are the principal executive officer, the PEO, the principal financial officer, the PFO, and the three most highly compensated executive officers (other than the PEO and the PFO). The determination of the three most highly compensated executive officers and the most highly compensated employees for a particular year is based on their annual compensation for the last completed fiscal year (as it is determined pursuant to Item 402(a) of Regulation S-K). The Company’s SEOs subject to the EESA compensation rules for 2010 are: Roberto R. Herencia, JoAnn Sannasardo Lilek, J.J. Fritz, Jonathan P. Gilfillan, and Stephan L. Markovits.

 

Compensation Committee Duties — Semi-annual Reviews.  The compensation committee must review at least every six months with senior risk officers the SEO compensation plans and all employee compensation plans and the risks these plans pose to the Company. In this review, the committee must identify and limit:

 

 

Annual Narrative.  The compensation committee must annually prepare a narrative description of how it limited the features in:

 

 

Annual Certification.  The compensation committee must certify annually that the committee has reviewed:

 

 

Reporting of Narrative and Certification.  The Company must provide the narrative disclosure and the certification in its annual compensation committee report included in its annual meeting proxy statement and file a copy of the certification with the U.S. Treasury.

 

Stockholder Non-Binding “Say on Pay.”  The Company must allow its stockholders the opportunity to participate annually in a non-binding vote on senior executive compensation. The stockholder vote will not be construed as overruling a decision by the board of directors nor does it create or imply any additional fiduciary duty by the board. Furthermore, it does not restrict or limit the ability of stockholders to make other proposals related to executive compensation.

 

Compliance Certifications.  The Company’s PEO and PFO must provide a written certification of compliance with the provisions of Section 111 of EESA, as amended by ARRA. The certification must be filed within 90 days of the end of any fiscal year. The Company must include these certifications in its annual report on Form 10-K and must file them with the U.S. Treasury.

 

Limitation on the Company’s Compensation Tax Deduction.  The Company is subject to the provisions of Section 162(m)(5) of the Internal Revenue Code of 1986, as amended; this provision limits the deduction for compensation paid to SEOs to $500,000 (including performance based compensation).

 

Clawback.  The Company must recover any bonus, retention award or incentive compensation paid to (or accrued for) SEOs and the next 20 most highly compensated employees if the payments or accruals were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria, the Clawback. The Company must exercise its Clawback rights unless it determines that it is unreasonable to do so (e.g., the costs of recovery exceed the amount involved).

 

Severance Prohibited.  The Company may not make golden parachute payments (defined as any payment for “departure from a company for any reason, except for payments for services performed or benefits accrued”) to its SEOs or any of the next five most highly compensated employees. A golden parachute payment includes a payment for departure from the Company for any reason, other than a payment for services performed or benefits accrued, including an amount due upon a change in control of the Company.

 

Limits on Bonuses, Retention Awards and Incentive Compensation.  The Company may not pay or accrue any bonus, retention award, or incentive compensation to or for the Company’s SEOs unless the amounts are payable as long-term restricted stock, provided that the stock does not fully vest until the repayment of TARP assistance and has a value that is no greater than one-third of the total annual compensation.

 

Long-Term Restricted Stock.  The value of the long-term restricted stock can be no greater than one-third of the employee’s total annual compensation. For purposes of determining annual compensation, each equity-based compensation (including the long-term restricted stock grant ) will be included in this calculation in the year in which it is granted at its total fair market value on the grant date.

 

Except as described below, the long-term restricted stock cannot fully vest until the repayment of all financial assistance by the Company.

 

Furthermore, an employee must provide services to the Company for at least two years after the grant date of the long-term restricted stock (or stock unit) in order to vest in this stock (or stock unit). However, the award may vest prior to this two year period (but after the TARP funds have been repaid) due to the death, disability or a change in control.

 

Restricted stock may become transferable (or in the case of a restricted stock unit, payable) earlier. For each 25% of the TARP financial assistance which is repaid, 25% of the total long-term restricted stock may become transferable (or 25% of the restricted stock unit may be payable).

 

In the case of restricted stock (but not a restricted stock unit), the fair market value of the stock may be subject to inclusion in income for income tax purposes before the stock becomes transferable. As a consequence, if this occurs, the rule permits sales to the extent necessary to pay the applicable taxes.

 

Perquisites.  The Company must disclose annually to the U.S. Treasury and the Federal Reserve any perquisites (as defined in Item 402(c)(2) of Regulation S-K) whose total value exceeds $25,000 provided to

the SEOs and next 20 most highly compensated employees. The filing must include the amount and nature of the perquisite and a justification for offering the perquisite (including a justification for all perquisites offered to the individual). The filing must be made within 120 days of the end of the fiscal year.

 

Tax Gross-Ups.  The Company is prohibited from providing tax gross-ups or other reimbursements for the payment of taxes to any of the SEOs and next twenty most highly compensated employees relating to any form of compensation, including severance payments and perquisites.

 

Compensation Consultant.  The Company must disclose annually to the U.S. Treasury and the Federal Reserve whether the Company, the board, or the compensation committee has engaged a compensation consultant. This disclosure must include all of the types of services the compensation consultant has provided during the past three years, including any “benchmarking” or comparisons employed to identify certain percentile levels of compensation (for example, other peer group companies used for benchmarking and a justification for using these companies, and the lowest percentile level of other companies’ employee compensation considered for compensation proposals). The filing must be made within 120 days of the end of the fiscal year.

 

Limits on Luxury Expenditures.  The board of directors of the Company must adopt an excessive or luxury expenditures policy, file this policy with the U.S. Treasury and the Federal Reserve, and post the text of this policy on its Internet website. The policy must cover, among other things (i) entertainment or events; (ii) office and facility renovations; (iii) aviation or other transportation services; and (iv) other similar items, activities or events. The policy (1) must identify the types and categories of expenses prohibited or requiring prior approval; (2) include approval procedures for those expenses requiring prior approval; (3) mandate PEO and PFO certification of the prior approval of any expenditures requiring the prior approval of any SEO, other similar executive officers, or the board of directors; (4) mandate prompt internal reporting of any violation of this policy; and (5) require accountability for adherence to this policy.

 

This policy was adopted in August 2009 and is posted on the Company’s website at www.midwestbanc.com. If a material amendment is made to the policy it must be provided to the U.S. Treasury and Federal Reserve and it must be posted on the Company’s website within ninety days.

 

Compensation Guidelines

 

In October 2009, the Federal Reserve issued a comprehensive proposal on incentive compensation policies (the “Incentive Compensation Proposal”) intended to ensure that the incentive compensation policies of banking organizations do not undermine their safety and soundness by encouraging excessive risk-taking. The Incentive Compensation Proposal, which covers all employees that have the ability to materially affect a bank’s risk profile, either individually or as part of a group, is based upon the key principles that incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the board of directors. Banks were instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-taking and implement corrective programs as needed. Where deficiencies in incentive compensation arrangements exist, they must be immediately addressed.

 

The Federal Reserve will review, as part of its regular, risk-focused examination process, the incentive compensation of banks, such as the Bank, that are not “large, complex banking organizations.” These reviews will be tailored based on the scope and complexity of the bank’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in its examination reports and deficiencies will be incorporated into the bank’s supervisory ratings, which can affect the bank’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a bank if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and it is not taking prompt and effective measures to correct the deficiencies.

 

In January 2010, the FDIC announced that it would seek public comment on whether banks with compensation plans that encourage risky behavior should be charged with higher deposit assessment rates than such banks would otherwise be charged. The scope and content of the U.S. banking regulators’ policies on executive compensation are

continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whether compliance with such policies will adversely affect the Company’s ability to hire, retain and motivate its key employees.

 

Bank Regulation

 

Under Illinois law, the Bank is subject to supervision and examination by Illinois Division of Banking. The Bank is a member of the Federal Reserve System and as such is also subject to examination by the Federal Reserve. The Federal Reserve also supervises compliance with the provisions of federal law and regulations, which place restrictions on loans by member banks to their directors, executive officers and other controlling persons. The Bank is also a member of the FHLB of Chicago and may be subject to examination by the FHLB of Chicago. Any affiliates of the Bank and the Company are also subject to examination by the Federal Reserve and the Illinois Division of Banking.

 

The deposits of the Bank are insured by the Deposit Insurance Fund (the “DIF”), under the provisions of the Federal Deposit Insurance Act (the “FDIA”), and the Bank is, therefore, also subject to supervision and examination by the FDIC. The FDIA requires that the appropriate federal regulatory authority approve any merger and/or consolidation by or with an insured bank, as well as the establishment or relocation of any bank or branch office. The FDIA also gives the Federal Reserve and other federal bank regulatory agencies power to issue cease and desist orders against banks, holding companies or persons regarded as “institution affiliated parties.” A cease and desist order can either prohibit such entities from engaging in certain unsafe and unsound bank activity or can require them to take certain affirmative action.

 

Furthermore, banks are affected by the credit policies of the Federal Reserve, which regulates the national supply of bank credit. Such regulation influences overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans and paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

 

As discussed above, under Illinois law, the Bank is subject to supervision and examination by Illinois Division of Banking, and, as a member of the Federal Reserve System, by the Federal Reserve. Each of these regulatory agencies conducts routine, periodic examinations of the Bank and the Company.

 

Financial Institution Regulation

 

Transactions with Affiliates.  Transactions between a bank and its holding company or other affiliates are subject to various restrictions imposed by state and federal regulatory agencies. Such transactions include loans and other extensions of credit, purchases of securities and other assets and payments of fees or other distributions. In general, these restrictions limit the amount of transactions between a bank and an affiliate of such bank, as well as the aggregate amount of transactions between a bank and all of its affiliates, impose collateral requirements in some cases and require transactions with affiliates to be on terms comparable to those for transactions with unaffiliated entities.

 

Dividend Limitations.  As a state member bank, the Bank may not declare or pay a dividend if the total of all dividends declared during the calendar year, including the proposed dividend, exceeds the sum of the Bank’s net income (as reportable in its Reports of Condition and Income) during the current calendar year and the retained net income of the prior two calendar years, unless the dividend has been approved by the Federal Reserve. Under Illinois law, the Bank may not pay dividends in an amount greater than its net profits then on hand, after deducting losses and bad debts. For the purpose of determining the amount of dividends that an Illinois state-chartered bank may pay, bad debts are defined as debts upon which interest is past due and unpaid for a period of six months or more, unless such debts are well-secured and in the process of collection.

 

In addition to the foregoing, the ability of the Company and the Bank to pay dividends may be affected by the various minimum capital requirements and the capital and noncapital standards established under the Federal Deposit Insurance Corporation Improvements Act of 1991 (“FDICIA”) as described below. The right of the Company, its stockholders and its creditors to participate in any distribution of the assets or earnings of its subsidiaries is further subject to the prior claims of creditors of the respective subsidiaries.

Capital Requirements.  State member banks are required by the Federal Reserve to maintain certain minimum capital levels. The Federal Reserve’s capital guidelines for state member banks require state member banks to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. In addition, the Federal Reserve requires a minimum leverage ratio of Tier 1 Capital to total assets of 3% for strong banking institutions (those rated a composite “1” under the Federal Reserve’s rating system) and a minimum leverage ratio of Tier 1 Capital to total assets of 4% for all other banks.

 

At December 31, 2009, the Bank has a Tier 1 capital to risk-weighted assets ratio and a total capital to risk-weighted assets ratio which fall below the above requirements. The Bank has a total capital to risk-weighted assets ratio of 6.4%, a Tier 1 capital to risk-weighted assets ratio of 5.1%, and a Tier 1 leverage ratio of 3.4%. See “Capital Resources” for additional details including the impact on the Bank.

 

Standards for Safety and Soundness.  The Federal Reserve and the other federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards pursuant to FDICIA. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the Federal Reserve adopted regulations that authorize, but do not require, the Federal Reserve to order an institution that has been given notice by the Federal Reserve that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the Federal Reserve must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the “prompt corrective action” provisions of FDICIA. If an institution fails to comply with such an order, the Federal Reserve may seek to enforce such order in judicial proceedings and to impose civil money penalties. The Federal Reserve and the other federal bank regulatory agencies also adopted guidelines for asset quality and earnings standards.

 

A range of other provisions in FDICIA include requirements applicable to closure of branches; additional disclosures to depositors with respect to terms and interest rates applicable to deposit accounts; uniform regulations for extensions of credit secured by real estate; restrictions on activities of and investments by state-chartered banks; modification of accounting standards to conform to generally accepted accounting principles including the reporting of off-balance-sheet items and supplemental disclosure of estimated fair market value of assets and liabilities in financial statements filed with the banking regulators; increased penalties in making or failing to file assessment reports with the FDIC; greater restrictions on extensions of credit to directors, officers and principal stockholders; and increased reporting requirements on agricultural loans and loans to small businesses.

 

In addition, the federal banking agencies adopted a final rule, which modified the risk-based capital standards to provide for consideration of interest rate risk when assessing the capital adequacy of a bank. Under this rule, the Federal Reserve and the FDIC must explicitly include a bank’s exposure to declines in the economic value of its capital due to changes in interest rates as a factor in evaluating a bank’s capital adequacy. On January 7, 2010, the federal banking agencies adopted a joint agency policy statement providing guidance to banks for managing interest rate risk. The policy statement emphasizes the importance of adequate oversight by management and a sound risk management process. The assessment of interest rate risk management made by the bank’s examiners will be incorporated into the bank’s overall risk management rating and used to determine the effectiveness of management.

 

As part of their ongoing supervisory monitoring process, the federal regulatory agencies use certain criteria to identify institutions that are potentially exposed to significant loan concentration risks. In 2007, the regulatory agencies issued new guidelines relating to commercial real estate (“CRE”) lending risks. An institution experiencing rapid growth in CRE lending, having notable exposure to a specific type of CRE, or approaching or exceeding the specified CRE supervisory criteria may be subjected to further supervisory analysis. Because these are guidelines, the supervisory monitoring criteria do not constitute limits on an institution’s lending activity but rather serve as high-level

indicators to identify institutions potentially exposed to CRE concentration risk. The criteria do not constitute a “safe harbor” for institutions if other risk indicators are present. Existing capital adequacy guidelines require an institution to hold capital commensurate with the level and nature of the risks to which it is exposed. Regulatory agencies may consider the level and nature of inherent risk in an institution’s CRE portfolio along with other factors to determine if an institution is maintaining an adequate capital level to serve as a buffer against unexpected losses and can require such an institution to develop a plan for reducing its CRE concentrations or for increasing or maintaining capital appropriate to the level and nature of its lending concentration risk.

 

Prompt Corrective Action.  Pursuant to the Federal Reserve regulations implementing the prompt corrective action provisions of FDICIA, a bank will be deemed to be: (i) well-capitalized if the bank has a total risk-based capital ratio of 10% or greater, Tier 1 risk-based capital ratio of 6% or greater and leverage ratio of 5% or greater; (ii) adequately capitalized if the bank has a total risk-based capital ratio of 8% or greater, Tier 1 risk-based capital ratio of 4% or greater and leverage ratio of 4% or greater (3% for the most highly rated banks); (iii) undercapitalized if the bank has a total risk-based capital ratio of less than 8%, Tier 1 risk-based capital ratio of less than 4% or leverage ratio of less than 4% (less than 3% for the most highly rated banks); (iv) significantly undercapitalized if the bank has a total risk-based capital ratio of less than 6%, Tier 1 risk-based capital ratio of less than 3% or leverage ratio of less than 3%; and (v) critically undercapitalized if the bank has a ratio of tangible equity to total assets of 2% or less.

 

Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well-capitalized cannot accept, renew or rollover brokered deposits except with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or rollover brokered deposits.

 

The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institution’s capital, the agencies’ corrective powers include, among other things:

 

 

A banking institution that is in any of the three undercapitalized categories is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institution’s holding company guarantees the plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.

 

FDICIA also contains a variety of other provisions that may affect the Company’s operations, including reporting requirements, regulatory standards for real estate lending, “truth in savings” provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.

 

The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions. However, federal banking agencies have indicated that, in regulating bank holding companies, the agencies may take appropriate action at the holding company level based on their

assessment of the effectiveness of supervisory actions imposed upon subsidiary insured depository institutions pursuant to the prompt corrective action provisions of FDICIA.

 

FDIC Insurance Premiums on Deposit Accounts.  The Bank is required to pay deposit insurance premiums based on the risk it poses to the DIF. The FDIC has authority to raise or lower assessment rates on insured deposits in order to achieve statutorily required reserve ratios in the insurance funds and to impose special additional assessments.

 

On February 8, 2006, President Bush signed into law the Federal Deposit Insurance Reform Act of 2005, the Reform Act.

 

The FDIC merged the Bank Insurance Fund and the Savings Association Insurance fund to form the DIF on March 31, 2006 in accordance with the Reform Act. The FDIC maintains the DIF by assessing depository institutions an insurance premium. The FDIC annually sets the reserve level of the DIF within a statutory range between 1.15% and 1.50% of insured deposits. If the reserve level of the insurance fund falls below 1.15%, or is expected to do so within six months, the FDIC must adopt a restoration plan that will restore the DIF to a 1.15% ratio generally within five years. If the reserve level exceeds 1.35%, the FDIC may return some of the excess in the form of dividends to insured institutions.

 

Effective January 1, 2007 the FDIC introduced a new risk based system for deposit insurance premium assessments. This risk based assessment system established four Risk Categories. Risk Category I includes well-capitalized institutions that are financially sound with only a few minor weaknesses.

 

Due to disruptions in the financial markets and the large numbers of bank failures in the last several years, the DIF reserve ratio has fallen below 1.15%. In response to these circumstances, the FDIC on October 7, 2008 established a Restoration Plan for the DIF which was implemented immediately. The 2008 Restoration Plan called for the FDIC to set assessment rates such that the reserve ratio would return to 1.15% within five years. On February, 27, 2009, the FDIC Board of Directors adopted a new final rule that modified the risk-based assessment fee system applied to FDIC insured financial institutions. The final rule established new base assessment rates beginning on April 1, 2009. The new initial base assessment rates are as follows:

 

Initial Base Assessment Rates (in basis points)

 

 

In addition, the final rule introduced three possible adjustments to the base assessment rates. The final rule provided for adjustments that decrease the base assessment rate up to five basis points for long term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt and, for small institutions, a portion of Tier 1 capital. The new rule also provides for a potential adjusted increase of the base assessment rate in an amount of up to 50% of an institution’s prior assessment rate for secured liabilities that exceed 25% of its domestic deposits. In addition, a possible adjustment to the base rate assessment was provided under the final rule based upon brokered deposits in excess of 10% of domestic deposits.

After applying all possible adjustments, minimum and maximum total assessment rates under the final rule for each risk category are as follows:

 

Total Base Assessment Rates

 

 

On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution will not exceed 10 basis points times the institution’s assessment base for the second quarter 2009. The special assessment was collected on September 30, 2009. At that time, an additional special assessment of up to 5 basis points to be assessed later in 2009 was identified as probable.

 

On October 2, 2009, the FDIC amended the DIF Restoration Plan adopted on February 27, 2009. The October 2009 amendments provided that the time period to restore the DIF to the statutory range between 1.15% and 1.50% of insured deposits was extended to eight years. Further, the FDIC determined that it would not impose any further special assessments under the authority of the final rule adopted in May 2009 and that the assessment rates would remain at their current levels through the end of 2010. Further the FDIC adopted a uniform 3 basis point increase in assessment rates effective January 1, 2011, to ensure that the fund returns to 1.15 percent within the Amended Restoration Plan period of eight years.

 

On November 17, 2009 the FDIC issued a final rule requiring insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012. Under the FDIC final rule, assessments for these periods were collected on December 30, 2009, along with each institution’s regular quarterly risk-based deposit insurance assessment for the third quarter of 2009. For purposes of estimating an institution’s assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, and calculating the amount that an institution would prepay on December 30, 2009, the institution’s assessment rate was based on its total base assessment rate in effect on September 30, 2009. However certain financial institutions, including the Bank, were exempted from the new prepayment regulations and will continue to pay their risk-based assessments on a quarterly basis.

 

In addition to the FDIC insurance program, the Bank is required to pay a Financing Corporation (“FICO”) assessment (on a semi-annual basis) in order to share in the payment of interest due on bonds used to provide liquidity to the savings and loan industry in the 1980s. During 2009, the Bank’s FICO assessment totaled $266,000, or 1.04 basis points of its insured deposits.

 

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. There are no pending proceedings to terminate the deposit insurance of the Bank. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.

 

On October 3, 2008, EESA was signed into law and included a provision for an increase in the amount of deposits insured by the FDIC to $250,000 until December 2009. On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program (the “TLGP”) where all noninterest-bearing transaction

deposit accounts, including all personal and business checking deposit accounts, and NOW accounts, which are capped at a rate no higher than 0.50%, are fully guaranteed, through June 30, 2010, regardless of dollar amount. The Company has elected to participate in the program and has been assessed a 10 basis point surcharge.

 

On May 20, 2009, the Helping Families Save Their Homes Act was signed into law. Provisions of this act extended the dates for the increase in the amount of deposits insured by the FDIC to $250,000 until December 2013. The act also extended the TLGP coverage until June 30, 2010, for those institutions that had previously agreed to participate and who have made an election to not opt out from the program as of December 31, 2009. The Company has elected to continue participating in the extended TLGP coverage.

 

Another component of the TLGP is a voluntary program whereby the FDIC will temporarily guarantee newly issued senior unsecured debt of an eligible financial institution up to 125% of the par or face value of a debt that is scheduled to mature before June 30, 2009. The FDIC implemented an additional assessment for institutions that elected to participate in the Debt Guarantee program. The Debt Guarantee Program also allowed for financial institutions to opt out from coverage. The Company elected to participate in the Debt Guarantee Program. The Company has not issued any such debt and currently does not plan to issue, any such debt.

 

Federal Reserve System.  The Bank is subject to Federal Reserve regulations requiring depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve regulations generally require 3% reserves on the first $44.4 million of transaction accounts and 10% on the remainder. The first $10.3 million of otherwise reservable balances (subject to adjustments by the Federal Reserve) are exempted from the reserve requirements. The Bank is in compliance with the foregoing requirements.

 

Community Reinvestment.  Under the Community Reinvestment Act (“CRA”), a financial institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to help meet the credit needs of its entire community, including low-and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. However, institutions are rated on their performance in meeting the needs of their communities. Performance is judged in three areas: (a) a lending test, to evaluate the institution’s record of making loans in its assessment areas; (b) an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing and programs benefiting low or moderate income individuals and business; and (c) a service test to evaluate the institution’s delivery of services through its branches, ATMs and other offices. The CRA requires each federal banking agency, in connection with its examination of a financial institution, to assess and assign one of four ratings to the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the institution, including applications for charters, branches and other deposit facilities, relocations, mergers, consolidations, acquisitions of assets or assumptions of liabilities and savings and loan holding company acquisitions. The CRA also requires that all institutions make public disclosure of their CRA ratings. The Bank received a “satisfactory” rating on its most recent CRA performance evaluation.

 

Brokered Deposits.  Well-capitalized institutions are not subject to limitations on brokered deposits, while an adequately capitalized institution is able to accept, renew or rollover brokered deposits only with a waiver from the FDIC and subject to certain restrictions on the yield paid on such deposits. Undercapitalized institutions are not permitted to accept or renew brokered deposits.

 

Enforcement Actions.  Federal and state statutes and regulations provide financial institution regulatory agencies with great flexibility to undertake enforcement action against an institution that fails to comply with regulatory requirements, particularly capital requirements. Possible enforcement actions range from the imposition of a capital plan and capital directive to civil money penalties, cease and desist orders, receivership, conservatorship or the termination of deposit insurance.

 

Bank Secrecy Act and USA Patriot Act.  In 1970, Congress enacted the Currency and Foreign Transactions Reporting Act, commonly known as the Bank Secrecy Act (the “BSA”). The BSA requires financial institutions to maintain records of certain customers and currency transactions and to report certain domestic and foreign currency

transactions, which may have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. Under this law, financial institutions are required to develop a BSA compliance program. In 2001, the President signed into law comprehensive anti-terrorism legislation commonly known as the USA Patriot Act. The USA Patriot Act requires financial institutions to assist in detecting and preventing international money laundering and the financing of terrorism.

 

The U.S. Treasury has adopted additional rules and regulations in order to implement the USA Patriot Act. Under these regulations, law enforcement officials communicate names of suspected terrorists and money launderers to financial institutions so as to enable financial institutions to promptly locate accounts and transactions involving those suspects. Financial institutions receiving names of suspects must search their account and transaction records for potential matches and report positive results to the U.S. Department of the Treasury Financial Crimes Enforcement Network (“FinCEN”). Each financial institution must designate a point of contact to receive information requests. These regulations outline how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of a statutory safe harbor if each financial institution notifies FinCEN of its intent to share information.

 

The U.S. Treasury has also adopted regulations intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Financial institutions are required to take reasonable steps to ensure that they are not providing banking services directly or indirectly to foreign shell banks. In addition, banks must have procedures in place to verify the identity of the persons with whom they deal, and financial institutions must undertake additional due diligence when circumstances warrant and in the case of money service businesses.

 

Interstate Banking and Branching Legislation.  Under the Interstate Banking and Efficiency Act of 1994 (the“Interstate Banking Act”), bank holding companies are allowed to acquire banks across state lines subject to various requirements of the Federal Reserve. In addition, under the Interstate Banking Act, banks are permitted, under some circumstances, to merge with one another across state lines and thereby create a main bank with branches in separate states. After establishing branches in a state through an interstate merger transaction, a bank may establish and acquire additional branches at any location in the state where any bank involved in the interstate merger could have established or acquired branches under applicable federal and state law.

 

The State of Illinois has adopted legislation “opting in” to interstate bank mergers, and allows out of state banks to enter the Illinois market through de novo branching or through branch-only acquisitions if Illinois state banks are afforded reciprocal treatment in the other state. It is anticipated that this interstate merger and branching ability will increase competition and further consolidate the financial institutions industry.

 

Insurance Powers.  Under state law, a state bank is authorized to act as agent for any fire, life or other insurance company authorized to do business in the State of Illinois. Similarly, the Illinois Insurance Code was amended to allow a state bank to form a subsidiary for the purpose of becoming a firm registered to sell insurance. Such sales of insurance by a state bank may only take place through individuals who have been issued and maintain an insurance producer’s license pursuant to the Illinois Insurance Code.

 

State banks are prohibited from assuming or guaranteeing any premium on an insurance policy issued through the bank. Moreover, state law expressly prohibits tying the provision of any insurance product to the making of any loan or extension of credit and requires state banks to make disclosures of this fact in some instances. Other consumer oriented safeguards are also required.

 

Insurance products are sold through Midwest Financial, a subsidiary of the Bank acquired in 2006 through the acquisition of Royal American Corporation. Midwest Financial is registered with, and subject to examination by, the Illinois Department of Insurance.

 

Securities Brokerage.  Midwest Financial, a registered bank-affiliated securities broker-dealer and registered investment advisor, operates a general securities business as an introducing broker-dealer. It is registered with the SEC as a broker-dealer and is a member of FINRA.

 

Consumer Compliance.  The Bank has been examined for consumer compliance on a regular basis. The Bank is subject to many federal consumer protection statutes and regulations including the Equal Credit Opportunity Act,

the Fair Housing Act, the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act. Among other things, these acts:

 

 

Federal Fair Lending Laws.  The federal fair lending laws prohibit discriminatory lending practices. The Equal Credit Opportunity Act prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief for alleged violations.

 

Home Mortgage Disclosure Act.  The Federal Home Mortgage Disclosure Act (“HMDA”), grew out of public concern over credit shortages in certain urban neighborhoods. One purpose of the HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. The HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. The HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of one-to four-family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under the HMDA to determine whether depository institutions engage in discriminatory lending practices.

 

The appropriate federal banking agency, or in some cases, U.S. Department of Housing and Urban Development, enforces compliance with the HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of this act.

 

Real Estate Settlement Procedures Act.  The Federal Real Estate Settlement Procedures Act (“RESPA”), requires lenders to provide borrowers with disclosures and a written good faith estimate regarding the nature and cost of real estate settlements. RESPA also prohibits certain abusive practices, such as kickbacks, places limitations on the amount that certain settlement charges can exceed the written good faith estimate of those charges and limits the amount of escrow accounts. Violations of RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant, depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.

Truth in Lending Act.  The federal Truth in Lending Act is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of the act, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan.

 

On July 14, 2008, the Federal Reserve Board approved a final rule, which was effective on October 1, 2009, amending Regulation Z (Truth in Lending) to prohibit unfair, abusive or deceptive home mortgage lending practices and restricts certain other mortgage practices. The final rule also establishes advertising standards and requires certain mortgage disclosures to be given to consumers earlier in the transaction.

 

The final rule adds four new protections for a newly defined category of “higher-priced mortgage loans” secured by a consumer’s principal dwelling. For loans in this category, these protections will: (1) prohibit a lender from making a loan without regard to borrowers’ ability to repay the loan from income and assets other than the home’s value; (2) require creditors to verify the income and assets they rely upon to determine repayment ability; (3) ban any prepayment penalty if the payment can change in the initial four years (and for certain other higher-priced loans, the prepayment penalty period cannot last for more than two years); and (4) require creditors to establish escrow accounts for property taxes and homeowner’s insurance for all first-lien mortgage loans.

 

In addition to the rules governing higher-priced loans, the rules adopted the new protections for loans secured by a consumer’s principal dwelling, regardless of whether the loan is considered to be a “higher-priced mortgage loan”. Under the new rules: (1) creditors and mortgage brokers are prohibited from coercing a real estate appraiser to misstate a home’s value; (2) companies that service mortgage loans are prohibited from engaging in certain practices, such as pyramiding late fees; (3) servicers are required to credit consumers’ loan payments as of the date of receipt and provide a payoff statement within a reasonable time of request; (4) creditors must provide a good faith estimate of the loan costs, including a schedule of payments, within three days after a consumer applies for any mortgage loan secured by a consumer’s principal dwelling, such as a home improvement loan or a loan to refinance an existing loan; and (5) consumers cannot be charged any fee until after they receive the early disclosures, except a reasonable fee for obtaining the consumer’s credit history.

 

For all mortgages, the new rules also set additional advertising standards. Advertising rules now require additional information about rates, monthly payments, and other loan features. The final rule bans seven deceptive or misleading advertising practices, including representing that a rate or payment is “fixed” when it can change.

 

The new rules took effect on October 1, 2009. The single exception is the escrow requirement, which will be phased in during 2010 to allow lenders to establish new systems as needed.

 

Violations of the Truth in Lending Act may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. Under certain circumstances, the Truth in Lending Act and Regulation Z of the Federal Reserve Act also provide a consumer with a right of rescission, which if exercised would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the offending transaction, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of the Truth in Lending Act.

 

Fair and Accurate Credit Transactions Act.  In connection with the passage of the Fair and Accurate Credit Transactions (“FACT”) Act, the Bank’s financial regulator issued final rules and guidelines, effective November 1, 2008, requiring the Bank to adopt and implement a written identity theft prevention program, paying particular attention to 26 identified “red flag” events. The program must also assess the validity of address change requests for card issuers and for users of consumer reports to verify the subject of a consumer report in the event of notice of an address discrepancy.

 

The FACT Act gives consumers the ability to challenge the Bank with respect to credit reporting information provided by the Bank. The new rule also prohibits the Bank from using certain information it may acquire from an affiliate to solicit the consumer for marketing purposes unless the consumer has been give notice and an opportunity to opt out of such solicitation for a period of five years.

Federal Home Loan Bank System.  The Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional FHLBs. The FHLB system provides a central credit facility primarily for member institutions. The Bank, as a member of the FHLB of Chicago (“FHLBC”) is required to acquire and hold shares of capital stock in the FHLBC in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLBC, whichever is greater. At December 31, 2009, the Bank had advances from the FHLBC with aggregate outstanding principal balances of $340.0 million, and the Bank’s investment in the FHLBC stock of $17.0 million was at its minimum requirement. FHLB advances must be secured by specified types of collateral and are available to member institutions primarily for funding purposes.

 

Regulatory directives, capital requirements and net income of the FHLBs affect their ability to pay dividends to the Bank. In addition, FHLBs are required to provide funds to cover certain obligations and to fund the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members.

 

In October 2007, the FHLBC announced that it entered into a consensual cease and desist order with its regulator which prohibits it from redeeming or repurchasing any capital stock from members or declaring dividends on its capital stock without prior approval. The FHLBC announced in October 2007 that it would suspend dividends on its stock and no dividends have been declared or paid since that time. In July 2008, the FHLBC announced that it had received regulatory approval to make limited redemptions of its capital stock. The redemptions are limited to capital stock purchased in connection with member borrowing advances which will be redeemed when the advances are paid.

 

Monetary Policy and Economic Conditions

 

The earnings of banks and bank holding companies are affected by general economic conditions and by the fiscal and monetary policies of federal regulatory agencies, including the Federal Reserve. Through open market transactions, variations in the discount rate and the establishment of reserve requirements, the Federal Reserve exerts considerable influence over the cost and availability of funds obtainable for lending or investing.

 

The above monetary and fiscal policies and resulting changes in interest rates have affected the operating results of all commercial banks in the past and are expected to do so in the future. Banks and their respective holding company cannot fully predict the nature or the extent of any effects which fiscal or monetary policies may have on their business and earnings.

EXECUTIVE OFFICERS OF THE REGISTRANT

 

Listed below are the executive officers of the Company as of March 30, 2010.

 

Roberto R. Herencia (50) assumed the roles of President and Chief Executive Officer of the Company and the Bank, and was appointed to the board of directors of the Company on May 15, 2009. He was formerly president and director of Banco Popular North America based in Chicago and executive vice president of Popular, Inc., the parent company. Mr. Herencia spent 17 years at Banco Popular. In addition to serving as executive vice president of Popular, Inc. since 1997, and president and director of Banco Popular North America since December 2001, he served as chief operating officer, senior credit officer and reported to Popular’s CFO in charge of capital markets, M&A and rating agencies between 1991 and 2001. Prior to joining Popular, Mr. Herencia spent 10 years in a variety of senior positions at The First National Bank of Chicago, including serving as head of the emerging markets division and operations in Latin America. He was directly involved in the restructure, workout and debt for equity swaps of public and private sector credits in Latin America.

 

JoAnn Sannasardo Lilek (53) was named Executive Vice President and Chief Financial Officer of the Company and the Bank in March 2008. Ms. Lilek was chief financial officer for DSC Logistics, a Chicago-based national supply chain management firm. Before joining DSC, Lilek had a 23 year career at ABNAmro North American Inc. where her positions included executive vice president reporting directly to the chairman, executive vice president and chief financial officer Wholesale Banking North America and group senior vice president and corporate controller.

 

Jan R. Thiry, CPA (57) was named Chief Accounting Officer of the Company and the Bank in March 2007. Mr. Thiry has been a director of Midwest Financial since June 2007., He has been director and secretary of MBTC Investment Company since March 2008 and president since February 2009. Mr. Thiry was hired in December 2006 as Senior Vice President and Controller of the Company and the Bank. He served as senior vice president and controller of CIB Marine Bancshares in Pewaukee, Wisconsin from 1999 to 2006. Mr. Thiry has also held senior positions at M&I Corporation and Security Bank in Milwaukee, Wisconsin. Additionally, he was a senior auditor at KPMG LLP.

 

Darrin R. Bacon (46) was named Executive Vice President Head of Commercial and Industrial Lending of the Bank in February 2010. Mr. Bacon has been in commercial banking for 23 years. He joined the Bank in 2006 as Senior Vice President running the Naperville commercial banking group. Mr. Bacon came to the Bank through the acquisition of Royal American where he served as senior vice president since 2001. Prior to this, he spent 10 years with First Chicago Bank/American National Bank. The latter three years he ran a commercial banking division out of American National Bank’s Wheaton office. Mr. Bacon began his banking career in 1986 with Boulevard Bank, N.A. in Chicago, IL. He completed his formal credit training during his four years at Boulevard Bank, N.A.

 

Sheldon Bernstein (63) was named Executive Vice President of the Bank in January 2005. He previously served as Senior Vice President of the Company from 2001 to 2005. Mr. Bernstein has served as President of the Bank, Cook County Region from 2000 to 2004. From 2000 through 2002, he served as Chief Operating Officer of the Bank. Previously, Mr. Bernstein served as Executive Vice President-Lending of the Bank since 1993. He was also served as director of Midwest Financial and Investment Services, Inc. from 2002 to 2005. Mr. Bernstein was a director of First Midwest Data Corp from 2001 to 2002.

 

Thomas J. Bell, III (43) was named Executive Vice President and Chief Investment Officer of the Company and the Bank in December 2008. He was named Treasurer of the Bank in September 2009. Mr. Bell previously served as Senior Vice President for ABN AMRO North America Inc., a Chicago-based bank holding company for the LaSalle Banks. In his fourteen years of service at ABN AMRO, Mr. Bell contributed to multiple disciplines within the asset and liability management, capital markets and treasury functions. Prior to ABN AMRO/LaSalle, Mr. Bell spent several years with the Federal Reserve Bank of Chicago.

 

Thomas A. Caravello (61) was named Executive Vice President and Chief Credit Officer of the Bank in January 2005. Mr. Caravello was named manager, president, and chief executive officer of Midwest Funding, L.L.C. in May 2006. He has served as Senior Vice President — Credit Administration from 2003 to 2005. Previously he served as Vice President — Credit Administration from 1998 to 2003.

Mary C. Ceas, SPHR, (52) was named Senior Vice President — Human Resources of the Company and the Bank in 2000. Previously, Ms. Ceas was Vice President — Human Resources since 1997 and served as Director — Training and Development from 1995 to 1997.

 

Bruno P. Costa (49) was named Executive Vice President and Chief Operations and Technology Officer of the Bank in January 2005. He served as President of the Information Services Division of the Bank from 2002 to 2005. Mr. Costa served as President and Chief Executive Officer of First Midwest Data Corp. from 1995 to 2002. He held various management positions at the Bank since 1983.

 

Stephen L. Eastwood (61) was named Executive Vice President and Chief Risk Officer of the Bank in November 2009. Prior, Mr. Eastwood was an independent consultant specializing in financial reorganizations. From 2004 to 2006, Mr. Eastwood served as the deputy chief education officer of the Chicago Public Schools. Prior to 2004, Mr. Eastwood held a variety of leadership positions over a 32-year career in Chicago banking units that merged with JPMorgan Chase. While at JPMorgan Chase he served as president of Banc One Capital Holdings Corporation and as chief credit officer of American National Bank.

 

J. J. Fritz (61) was named Senior Executive Vice President of the Company and the Bank in May 2009. He previously served as President and Chief Executive Officer of the Company and Chief Executive Officer of the Bank since January 29, 2009. He was named Director and Executive Vice President of the Company and Director, President, and Chief Operating Officer of the Bank in July 2006. Mr. Fritz was also named director, president, and chief executive officer of Midwest Financial in July 2006. Mr. Fritz and other investors founded Royal American in 1991, where he served as chairman and chief executive officer, after he served as chief executive officer of First Chicago Bank of Mt. Prospect. His lengthy career in the Chicago metropolitan area also includes positions at Northern Trust, First National Bank of Libertyville and Continental Illinois National Bank.

 

Jonathan P. Gilfillan (49) was named Executive Vice President and Division Head of Commercial Real Estate Lending of the Bank in July 2008. Mr. Gilfillan previously served as Senior Vice President for Park National Bank since 2007. Prior to joining Park National, Mr. Gilfillan spent his career at LaSalle Bank NA, where he had been specializing in CRE lending since 1992.

 

Thomas H. Hackett (62) was named Executive Vice President of the Bank in November 2003. Mr. Hackett was named manager and vice president of Midwest Funding, L.L.C. in May 2006. He previously was division manager at Banc One, Chicago, Illinois from 2002 to 2003. Prior, he was first vice president of American National Bank of Chicago from 1997 to 2002. He has also served in similar capacities at First Chicago/NBD, Park Ridge, IL, NBD of Woodridge and Heritage Bank of Woodridge, Illinois.

 

Stephan L. Markovits (60) was named Executive Vice President of the Bank in October 2007. Mr. Markovits previously was president of Northwest Suburban Bancorp, Inc. from 2003 to 2007. He also held various management positions at Plains Bank of Illinois from 1998 to 2003.

 

Dennis M. Motyka (60) was named Executive Vice President of the Bank and director of Midwest Financial in October 2005. He previously was senior vice president and director of banking centers for Cole Taylor Bank in Rosemont from 2002 to 2005. He served as senior vice president and Illinois regional manager for LaSalle Bank in Chicago from 1996 to 2002. He also held positions with Comerica Bank and Affiliated Bank, both in Franklin Park, as well as with Western National Bank in Cicero.

 

Alberto J. Paracchini (39) was named Executive Vice President and Head of Planning and Development of the Bank in January 2010. Prior, Mr. Paracchini spent 16 years at Popular, Inc. where he held leadership positions in both banking and mortgage subsidiaries. From 2006 through 2008, Mr. Paracchini served as president and chief financial officer of Popular Financial Holdings and chief financial officer of E-Loan, an internet banking and mortgage company. Prior to 2006, Mr. Paracchini headed all operational and technology functions at Banco Popular North America and also served as chief financial officer where he was responsible for all financial and treasury activities.

 

David Taylor (44) was named Executive Vice President of the Bank’s wealth management group in August 2008. Mr. Taylor was named chief executive officer of Midwest Financial and Investment Services, Inc. in November 2009. Mr. Taylor previously held management positions at Bank of America US Trust Wealth Management (formerly LaSalle Bank) for 11 years. Mr. Taylor began his career in 1989 with Pioneer Bank & Trust Company.

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995

 

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended The Company and its representatives may, from time to time, make written or oral statements that are “forward-looking” and provide information other than historical information, including statements contained in the Form 10-K, the Company’s other reports and documents filed with the Securities and Exchange Commission or in communications to its stockholders. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement. These factors include, among other things, the factors listed below.

 

In some cases, the Company has identified forward-looking statements by such words or phrases as “will likely result,” “is confident that,” “expects,” “should,” “could,” “may,” “will continue to,” “believes,” “anticipates,” “predicts,” “forecasts,” “estimates,” “projects,” “potential,” “intends,” or similar expressions identifying “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. These forward-looking statements are based on management’s current views and assumptions regarding future events, future business conditions, and the outlook for the Company based on currently available information. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, these statements. The Company cautions readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.

 

In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the Company is hereby identifying important factors that could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any forward-looking statements.

 

Among the factors that could have an impact on the Company’s ability to achieve the plans, goals, and future events and conditions expressed or implied in forward-looking statements are:

 

 

 

 

The Company wishes to caution that the foregoing list of important factors may not be all-inclusive and specifically declines to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

With respect to forward-looking statements set forth in the notes to consolidated financial statements, including those relating to contingent liabilities and legal proceedings, some of the factors that could affect the ultimate disposition of those contingencies are changes in applicable laws, the development of facts in individual cases, settlement opportunities, and the actions of plaintiffs, judges, and juries.

 

 

The Company’s business, financial condition or results of operations could be materially adversely affected by any of these risks.

 

The Bank was undercapitalized under regulatory guidelines at December 31, 2009, and continued losses and deterioration in credit quality are likely to cause the Bank’s capital levels to further decline in the near term.

 

The Bank was “undercapitalized” for regulatory capital ratio purposes at December 31, 2009 as compared to “well-capitalized” at September 30, 2009. Credit quality continued to deteriorate in early 2010 and, as a result, the Bank’s interim capital position was “significantly undercapitalized” as of January 31, 2010, and the Company

expects the Bank to be “critically undercapitalized” at March 31, 2010. A bank is considered critically undercapitalized when it has a tangible equity to total assets ratio of equal to or less than 2.00%. See Item 1. “Business — Supervision and Regulation — Capital Requirements.” In addition, the Company was “undercapitalized” at December 31, 2009 and is expected to remain undercapitalized at March 31, 2010. Failure by the Company to improve the Bank’s regulatory capital ratios within the timeframe required under the Prompt Correction Act discussed below will result in material adverse consequences, including the possibility that the Company may become subject to a voluntary or involuntary bankruptcy filing, the Bank could be placed into FDIC receivership by its regulators, or the Bank could be acquired by a third party in a transaction in which the Company receives no value for its interest in the Bank, any of which events would be expected to result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

Due to the Bank’s significantly undercapitalized status, the Federal Reserve Bank has issued a Prompt Corrective Action Directive (“PCA”) pursuant to which the Bank must either become adequately capitalized or be sold within 45 days of the PCA. Any failure to comply with the terms of the PCA will have a material adverse effect on the business of the Company.

 

The PCA consented to by the Bank provides that the Bank, in conjunction with the Company, must within 45 days of March 29, 2010 either: (i) increase the Bank’s capital so that it becomes adequately capitalized; (ii) enter into and close an agreement to sell the Bank subject to regulatory approval and customary closing conditions; or (iii) take other necessary measures to make the Bank adequately capitalized. The PCA also prohibits or restricts the Bank from taking certain other actions and subjects the Bank to other operating restrictions. In addition, the Company and the Bank continue to be subject to the written agreement (the “Written Agreement”) with the Federal Reserve Bank and the Illinois Division of Banking that requires the Company and the Bank to take certain steps intended to improve their overall condition, as further described under “Business — Recent Developments — Written Agreement with Regulators.”

 

There can be no assurance that the Company or the Bank will be able to satisfy, in a timely manner or at all, the requirements set forth in the PCA and the Written Agreement, or that the plans adopted in response to the requirements of the PCA and the Written Agreement will have their intended effect. As further described under “Business — Recent Developments — Outlook for 2010,” the Company and the Bank were notified on March 25, 2010 by the Federal Reserve Bank that the Bank’s capital plan previously submitted as required under the Written Agreement was not accepted. Moreover, the PCA does not prevent bank regulators from increasing the amount or composition of capital required to be raised, denying any sale of the Bank or imposing other directives restricting the Company’s or the Bank’s business.

 

If the Company or the Bank is unable to comply with the terms of the PCA, the Written Agreement or any other applicable regulations, the Company and the Bank will become subject to additional, heightened supervisory actions and orders, including further enforcement action by the regulators that may, among other things, result in the appointment of a receiver for the Bank or the acquisition of the Bank in a transaction in which the Company receives no value. Any such appointment or sale of the Bank could be expected to result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

The Company does not have the ability to pay amounts that will become immediately due and payable upon the expiration of the Forbearance Agreement with the Company’s primary lender on March 31, 2010.

 

The Company has been in violation of certain financial covenants under its revolving line of credit and term note and the related loan documents (collectively, the “Loan Agreements”) since September 30, 2009. The lender under the Loan Agreements advised the Company that such noncompliance constituted a continuing event of default. As a result, the lender possesses certain rights and remedies, including the ability to demand immediate payment of amounts owed under the Loan Agreements totaling approximately $63.6 million plus accrued interest or to foreclose on 100% of the stock of the Bank which was pledged as collateral to support the Company’s obligations under the Loan Agreements. On October 22, 2009, the Company entered into a Forbearance Agreement with its lender under the Loan Agreements, pursuant to which, among other things, the lender agreed to forbear from exercising the rights and remedies available to it as a consequence of certain existing events of default, other than

continuing to impose default rates of interest (the “Forbearance Agreement”). The Forbearance Agreement expires on March 31, 2010, at which time the lender could declare immediately due and payable all amounts owed under the Loan Agreements. Should the lender demand payment at or after that time, the Company presently would be unable to repay the amounts due. As a result, the lender could, among other remedies, foreclose on outstanding shares of the Bank’s capital stock, which would have a material adverse effect on the Company’s business, operations and ability to continue as a going concern and could result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

If the Company fails to raise additional capital in a timely manner, the Company may be forced to seek bankruptcy protection and/or the Bank could be placed under FDIC receivership.

 

A principal component of the Company’s overall capital plan has been to raise new equity capital necessary in order to improve the regulatory capital ratios of the Company and the Bank. The timely raising of new equity capital is also critical in order to increase the Bank’s capital as required by the PCA. While the Company continues to pursue new equity capital, it has not received any commitment for a new equity capital investment, and there can be no assurance that the Company will be able to raise a sufficient amount of new equity capital in a timely manner, on acceptable terms or at all. If the Company ultimately is unsuccessful in raising a sufficient amount of new equity capital or, alternatively, executing another strategic initiative, the Company may become subject to a voluntary or involuntary bankruptcy filing, the Bank could be placed into FDIC receivership by its regulators, or the Bank could be acquired by a third party in a transaction in which the Company receives no value for its interest in the Bank. Any such event could be expected to result in a loss of all or a substantial portion of the value of the Company’s outstanding securities.

 

As a result of the above-described events and circumstances, the Company has determined that there is substantial doubt as to the Company’s ability to continue as a going concern.

 

Due to the deterioration in the capital ratios of the Bank and the Company, the uncertainty as to the Company’s ability to raise sufficient amounts of new equity capital, recent regulatory actions with respect to the Company and the Bank, including the PCA, and the current inability of the Company to repay amounts owed under the Loan Agreements if, after the expiration of the Forbearance Agreement, its lender were to declare the amounts owed thereunder immediately due and payable, the Company has determined that there is substantial doubt as to the Company’s ability to continue as a going concern. Although the Company believes that the raising of additional capital, if timely achieved, will alleviate the substantial doubt about the Company’s ability to continue as a going-concern, there can be no assurance that such actions will be achieved in a timely manner or at all, or if achieved, that they will be sufficient to alleviate the uncertainty about the Company’s ability to continue as a going concern. The Company’s independent registered public accounting firm has included in its report on the Company’s consolidated financial statements for the year ended December 31, 2009 an explanatory paragraph with respect to the substantial doubt as to the Company’s ability to continue as a going concern. The Company is undercapitalized at December 31, 2009, as defined by the regulatory capital requirements administered by the federal banking agencies, and does not have sufficient liquidity to meet the potential demand for all amounts due under its lending arrangements upon termination of the Forbearance Agreement that expires on March 31, 2010. The Company’s financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

A substantial doubt as to the Company’s ability to continue as a going concern may have a material adverse impact on the Company and the Bank’s business, financial condition and results of operations and the ability to raise necessary new equity capital. Moreover, relationships with third parties with whom the Company and the Bank do business or on whom they rely, including depositors (particularly those with deposit accounts in excess of FDIC insurance limits), customers and clients, vendors, employees and financial counter-parties could be significantly adversely impacted because these individuals and entities may react adversely to the going concern issue, making it more difficult for the Company to address the issues giving rise to the going concern.

The Company has incurred cumulative losses since January 1, 2008 and expect to incur losses in the future.

 

Since January 1, 2008, the Company has incurred losses of $401.0 million through December 31, 2009. These losses are due to the goodwill impairment charges, a substantial increase in provision for credit losses, and the losses on the preferred stock of FNMA and GNMA.

 

The Company expects to incur losses through 2010. The Company cannot provide any assurances that it will not incur additional losses, especially in light of economic conditions that continue to adversely affect the Company’s borrowers and local markets. Further losses in 2010 could require the Company to access additional capital, which may or may not be available. Losses subsequent to December 31, 2009, will reduce the Company’s capital and may require it to write down or write off its deferred tax assets and goodwill.

 

The Company’s results of operations, financial condition and business may be materially, adversely affected if it fails to successfully implement the Capital Plan.

 

The Company’s Capital Plan it announced in July 2009 contemplates a number of different strategies intended to increase common equity capital and raise additional capital as further described under “Capital Plan” of Part I Item 1 above. There can be no assurances, however, that the Company will be able to successfully execute on each or every component of the Capital Plan, in a timely manner or at all, and a number of events and conditions must occur in order for the plan to achieve its intended effect. For instance, one of the key elements of the Capital Plan is to raise a significant amount of new equity capital. The Company’s ability to raise additional equity capital is subject to a number of factors and there can be no assurance that the Company can raise additional capital in a timely manner, on acceptable terms or at all.

 

If the Company is not able to successfully complete the Capital Plan, the Company could be adversely impacted by negative assessments regarding its ability to withstand continued adverse economic conditions. Moreover, the Company’s business, and the value of its securities would be materially and adversely affected, it would be more difficult for the Company to meet the capital requirements of the Company’s primary banking regulators, it would likely become increasingly difficult to seek further forbearance or waivers from the Company’s primary lender for continuing or any new events of default and it would be difficult to obtain forbearance or waivers, if necessary, from the counterparties to the repurchase agreements, any of which circumstances may make it difficult for the Company in the future to demonstrate its ability to continue as a going concern. If the Company is unable to successfully complete its Capital Plan and were to continue to suffer further deterioration of its loan portfolio, the Company may consider with a strategic or financial partner a plan of reorganization to recapitalize the Bank pursuant to chapter 11 of the bankruptcy code or become subject to an involuntary bankruptcy petition and/or the Bank could be placed into FDIC receivership by its regulators. Any such event could be expected to result in a loss of the entire value of the Company’s outstanding common stock and all or substantially all of the value of any depositary shares outstanding.

 

Changes in economic conditions, in particular a continued economic slowdown in Chicago, Illinois, has hurt and could continue to hurt the Company’s business materially.

 

The Company’s business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond its control. A continued deterioration in economic conditions, in particular a continuing economic slowdown in Chicago, Illinois, and surrounding areas, has resulted and may continue to result in the following consequences, any of which could hurt or continue to hurt the Company’s business materially:

 

 

 

A large percentage of the Company’s loans are collateralized by real estate, including construction loans, and adverse changes in the real estate market may result in continued or increased losses and continue adversely affect the Company’s profitability.

 

A majority of the Company’s loan portfolio is comprised of loans at least partially collateralized by real estate; a substantial portion of this real estate collateral is located in the Chicago market.

 

As of December 31, 2009, collateral-based classification basis, commercial real estate loans totaled $1.2 billion, or 52.5% of the Company’s total loan portfolio, and construction loans, including land acquisition and development, totaled an additional $308.6 million, or 13.3% of its total loan portfolio.

 

Adverse changes in the economy affecting real estate values generally or in the Chicago market specifically could significantly impair the value of the Company’s collateral and its ability to sell the collateral upon foreclosure. In the event of a default with respect to any of these loans, amounts received upon sale of the collateral may be insufficient to recover outstanding principal and interest on the loans. As a result, the Company’s profitability could be negatively impacted by an adverse change in the real estate market.

 

Construction and land acquisition and development lending involve additional risks because funds may be advanced based upon values associated with the completed project, which is uncertain. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If the appraisal of the anticipated value of the completed project proves to be overstated, the Company may have inadequate security for the loan.

 

Nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition.

 

At December 31, 2009, the Company’s nonperforming loans were $285.5 million, or 12.3% of its loan portfolio, and the nonperforming assets (which include nonperforming loans, troubled-debt restructured loans, and foreclosed properties) were $312.4 million, or 9.06% of total assets. In addition, the Company had approximately $62.9 million in accruing loans that were 30 to 89 days delinquent at December 31, 2009.

 

The Company’s nonperforming assets adversely affect its net income in various ways. Until economic and market conditions improve, the Company expects to continue to incur additional losses relating to an increase in nonperforming loans. The Company does not record interest income on nonaccrual loans, thereby adversely affecting its income, and increasing its loan administration costs. The Company does incur the costs of funding problem assets and foreclosed properties, however. When the Company takes collateral in foreclosures and similar proceedings, its is required to mark the collateral to its then fair value less expected selling costs, which, when compared to the principal amount of the loan, may result in a loss. These nonperforming loans and foreclosed properties also increase the Company’s risk profile. There can be no assurance that: (i) the Company will be able to reduce its nonperforming assets timely; or (ii) that it will not experience further increases in nonperforming loans in the future. Any of these actions may result in additional future credit losses and additional regulatory enforcement actions.

The Company’s allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect its results of operations or its financial condition.

 

As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to their terms and that the collateral securing the payment of these loans may be insufficient to assure repayment. The Company has and may continue to experience significant loan losses, which could continue to have a material adverse effect on its operating results. Management makes various assumptions and judgments about the collectibility of the Company’s loan portfolio, which are based in part on:

 

 

The Company maintains an allowance for loan losses in an attempt to cover probable incurred loan losses inherent in its loan portfolio. Additional loan losses will likely continue to occur in the future and may occur at a rate greater than experienced historically. In determining the amount of the allowance, the Company relies on an analysis of its loan portfolio, experience, and evaluation of general economic conditions. If the Company’s assumptions and analysis prove to be incorrect, its current allowance may not be sufficient. In addition, adjustments may be necessary to allow for unexpected volatility or deterioration in the local or national economy or other factors such as changes in interest rates that may be beyond its control. The results of examination from regulatory agencies are also considered. Any increase in the Company’s loan allowance or loan charge-offs could have a material adverse effect on its results of operations.

 

The level of the Company’s nonperforming assets, which consist of nonaccrual loans, troubled debt restructured loans, foreclosed real estate and other repossessed assets, may also impact the sufficiency of the Company’s allowance for loan losses. Nonperforming assets totaled $312.4 million as of December 31, 2009, an increase of $228.3 million, or 271.3%, from $84.1 million at December 31, 2008.

 

In addition to those loans currently identified and classified as nonperforming loans, management is aware that other possible credit problems may exist with some borrowers. These include loans that are migrating from grades with lower risk of loss probabilities into grades with higher risk of loss probabilities as performance and potential repayment issues surface. The Company monitors these loans and adjusts loss rates in its allowance for loan losses accordingly. The most severe of these loans are credits that are classified as substandard assets due to either less than satisfactory performance history, lack of borrower’s paying capacity, or inadequate collateral.

 

While the Company attempts to manage the risk from changes in market interest rates, interest rate risk management techniques are not exact. In addition, the Company may not be able to economically hedge its interest rate risk. A rapid or substantial increase or decrease in interest rates could adversely affect its net interest income and results of operations.

 

The Company’s net income depends primarily upon its net interest income. Net interest income is income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors, including the volume of earning assets, the general level of interest rates, the dynamics of changes in interest rates and the level of nonperforming loans. The cost of funds varies with the amount of funds required to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of non-interest-bearing demand deposits and equity capital.

 

Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. The Company expects that it will periodically experience “gaps” in the interest rate sensitivities of its assets and liabilities. That means either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest earning assets, or vice versa. When interest-bearing liabilities mature or reprice more

quickly than interest earning assets, an increase in market rates of interest could reduce the Company’s net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce net interest income. The Company is unable to predict changes in market interest rates which are affected by many factors beyond its control including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets. Based on its net interest income simulation model, if market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift of the yield curve) net interest income would be expected to increase by 8.29% and 18.12%, respectively, from what it would be if rates were to remain at December 31, 2009 levels. The actual amount of any increase or decrease may be higher or lower than that predicted by the Company’s simulation model. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, credit spreads, relationships between interest sensitive instruments and key driver rates, balance sheet growth, client loan and deposit preferences and the timing of changes in these variables.

 

As result of current market conditions, the Company’s net interest income simulation model did not test the effects of 100 and 200 basis point decreases in market interest rates at December 31, 2008 or December 31, 2009 as those decreases would result in some deposit interest rate assumptions falling below zero. Nonetheless, the Company’s net interest income could decline in those scenarios as yields on earning assets could continue to adjust downward. Although the Company is seeking to mitigate this risk by instituting interest rate floors into its variable-rate loan products, continuation of the existing interest rate environment, featuring an historically low absolute level of market rates of interest, could have a material adverse effect on the Company.

 

The Company attempts to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. The Company continually reviews its interest rate risk position and modifies its strategies based on projections to minimize the impact of future interest rate changes. The Company also uses financial instruments with optionality to modify its exposure to changes in interest rates. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect results of operations and financial performance.

 

The Company and the Bank may not be able to access sufficient and cost-effective sources of liquidity necessary to fund operations and meet payment obligations under their existing funding commitments, including the repayment of brokered deposits.

 

The Bank depends on access to a variety of funding sources, including deposits, to provide sufficient liquidity to meet its commitments and business needs and to accommodate the transaction and cash management needs of its clients, including funding loans. The Bank also must have sufficient funds available to satisfy its obligation to repay any wholesale borrowings its has outstanding, including brokered deposits and other obligations, when they come due. Currently, the Bank’s primary sources of liquidity are clients’ deposits, as well as brokered deposits, Federal Home Loan Bank advances, and repayments and maturities of loans and securities.

 

To the extent deposit growth is not commensurate with its funding needs, the Bank may need to access alternative, more expensive funding sources. Addressing these funding needs in the future will be even more challenging given that the Bank is undercapitalized for regulatory capital purposes, and as a result, the Bank is no longer able to accept or renew brokered deposits, whether wholesale or retail, secure deposits at rates that are 75 basis points higher than the prevailing effective rates on insured deposits of comparable amounts or maturities in the Bank’s normal market area or the national rates periodically release by the FDIC. In addition, the Bank is not knowingly accepting deposits in excess of FDIC insurance coverage limits, and believes it has sufficient liquidity to fund its near-term potential and actual obligations. Scheduled maturities of brokered deposits are $60.1 million in the first quarter 2010, $64.9 million in the second quarter 2010, $206.4 million in the third quarter 2010, $76.5 million in the fourth quarter 2010 and $46.6 million thereafter.

 

Although the Bank experienced an increase in deposits that has allowed it to reduce to some extent its reliance on wholesale funding sources during 2009, there can be no assurance that this level of deposit growth will continue. There is also no way to determine with any degree of certainty whether these deposits are, in whole or in part, permanent or transitory. If the returns in the equity markets continue to improve or FDIC insurance coverage is reduced, some of the Bank’s deposits could move to higher yielding investment alternatives outside of the Bank,

thus causing a reduction in the Bank’s deposits and increased reliance on wholesale funding sources. Although management currently believes the Bank has the ability and the available liquidity to meet its near-term potential and actual obligations, if in the future additional cost-effective funding is not available on terms satisfactory to the Bank or at all, the Bank may not be able to meet its funding obligations, which could adversely affect the Company’s results of operations and earnings.

 

In addition, as further described below, several of the Bank’s repurchase agreements could permit the counterparty to terminate the repurchase agreements prior to maturity because the Bank is not currently well-capitalized. Due to the relatively high fixed rates on these borrowings as compared to currently low market rates of interest, the Bank would incur substantial costs to unwind these repurchase agreements if terminated prior to their maturities, which could have a material adverse effect on the Company’s results of operations and financial condition in the period of payment. As a result of the Bank’s capital position, it had to increase the amount of collateral securing the existing FHLBC advances, and the wholesale funding market is no longer available to the Bank.

 

As a holding company without independent operations, the Company’s liquidity (on an unconsolidated basis) is primarily dependent upon the Company’s ability to raise debt or equity capital from third parties and the receipt of dividends from its operating subsidiaries. The Company is currently in default under its Loan Agreements and its revolving credit facility has matured and is no longer available. Despite its recent efforts to obtain new equity capital, the Company has not yet obtained a commitment for new equity capital. As a result of recent regulatory actions, the Company’s principal operating subsidiary, the Bank, is prohibited from paying any dividends or making any loans to the Company. At December 31, 2009, the Company’s cash and cash equivalents on an unconsolidated basis amounted to $3.4 million. The Company’s liquidity position on an unconsolidated basis can be adversely affected by, among other things, decreases in the amount of cash and other liquid assets on hand due to increased expenses or otherwise; the payment of interest or principal on debt issued by the Company (including any amounts demanded upon expiration of the Forbearance Agreement); any payment of dividends on equity securities issued by the holding company (all of which have been suspended or deferred); any capital it injects into the Bank; and any redemption of debt for cash issued by the holding company. The Company’s unconsolidated liquidity position also may be adversely affected if the Bank continues to be unable or prohibited by its regulators to pay a dividend to the Company sufficient to satisfy the Company’s cash flow needs; if it is required by the Federal Reserve to use cash at the holding company to support the capital position of the Bank; or if it continues to have difficulty raising cash at the holding company level through the issuance of debt or equity instruments or accessing additional sources of credit. Although the Company receives a management fee from the Bank for services provided by the Company in support of the Bank’s operations, the timing and amount of such management fees are subject to approval by the Bank’s regulators, and there can be no assurances that such fees will be approved in the future or that the amounts of such fees will be sufficient to meet the Company’s costs of providing services to the Bank.

 

Presently, the Company does not have sufficient liquidity on an unconsolidated basis to meet its short-term obligations, which include the approximately $63.6 million in outstanding debt that its lender could accelerate and demand payment for upon the expiration of the Forbearance Agreement on March 31, 2010. The Company believes that, if the lender does not exercise its right to demand payment of amounts owed under the Loan Agreements, that it has adequate liquidity to meet its near-term commitments.

 

The Company’s cost of funds for banking operations may increase as a result of general economic conditions, interest rates and competitive pressures.

 

The Bank has traditionally obtained funds principally through deposits and borrowings. As a general matter, deposits are a cheaper source of funds than borrowings, because interest rates paid for deposits are typically less than interest rates charged for borrowings. Historically and in comparison to commercial banking averages, the Bank has had a higher percentage of its time deposits in denominations of $100,000 or more and brokered certificates of deposit. Within the banking industry, the amounts of such deposits are generally considered more likely to fluctuate than deposits of smaller denominations. If, as a result of general economic conditions, market interest rates, competitive pressures or otherwise, the value of deposits at the Bank decrease relative to its overall banking operations, the Bank may have to rely more heavily on borrowings as a source of funds in the future.

Changes in the mix of the Company’s funding sources could have an adverse effect on its income. 33.7% of the Company’s funding sources as of December 31, 2009 are in lower-rate transactional deposit accounts. Market rate increases or competitive pricing could heighten the risk of moving to higher-rate funding sources, which would cause an adverse impact on the Company’s results of operations.

 

The Company is in breach of certain financial covenants under its Loan Agreements and its lender has the right to take certain courses of action that would, if exercised, have a material adverse effect on the Company’s operations and ability to continue as a going concern.

 

At December 31, 2009, the Company had approximately $78.6 million outstanding under the Loan Agreements. Approximately $63.6 million of the amounts outstanding under the Loan Agreements are secured by all of the outstanding shares of stock of the Bank. The Company has breached certain financial covenants under the Loan Agreements, certain of which breaches constitute events of default. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings.” Due to the occurrence and the continuance of such events of default, the interest rate on the revolving line of credit increased to the default interest rate of 7.25%, and the interest rate under the term loan agreement increased to the default interest rate of 30 day LIBOR plus 455 basis points.

 

On October 22, 2009, the Company entered into the Forbearance Agreement with the lender, pursuant to which, among other things, the lender agreed to forbear from exercising the rights and remedies available to it as a consequence of the existing events of default, except for continuing to impose default rates of interest. The Forbearance Agreement expires on March 31, 2010, or earlier if, among other things, the Company breaches representations and warranties contained in, or defaults on its obligations under, the Forbearance Agreement, or the Company defaults on certain obligations under its loan agreements (other than with respect to certain financial and regulatory covenants) or the Bank becomes subject to receivership by the FDIC or the Company becomes subject to other bankruptcy or insolvency type proceedings. The Forbearance Agreement did not waive any of the Company’s events of default or any other default or event of default, and the lender has not committed to waive any of the existing and continuing events of default following the expiration of the Forbearance Agreement.

 

Upon the expiration of the Forbearance Agreement, the principal and interest amounts that were owed under the Loan Agreements, as modified by earlier covenant waivers, at the time the Forbearance Agreement was entered into will once again become due and payable, along with such other amounts as may have become due during the forbearance period. The Company will not be able to meet any demands for payment of amounts then due at the expiration of the Forbearance Agreement. As a result of the events of default, the lender may, among other remedies, seize the outstanding shares of the Bank’s capital stock held by the Company that have been pledged as collateral for borrowings under the Loan Agreements.

 

If the lender were to take one or more of the above actions, or if the Company is unable to renegotiate, renew, replace or expand its sources of financing on acceptable terms, it could have a material adverse effect on the Company’s business, operations and ability to continue as a going concern, and investors could lose all or a substantial portion of their investment in the securities of the Company they hold. Upon a liquidation, holders of the Company’s debt securities (including subordinated debt securities underlying the Company’s trust preferred securities) and lenders with respect to other borrowings would be entitled to receive a distribution of the available assets, if any, prior to holders of the Company’s preferred stock and common stock, and holders of preferred stock would be entitled to receive distribution of the available assets, if any, prior to holders of the Company’s common stock. Any decisions by investors and lenders to enter into equity and financing and refinancing transactions with the Company will depend upon a number of factors, including the Company’s historical and projected financial performance, the degree of non-compliance with the terms of its current loan arrangements, industry and market trends, the availability of capital and its investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. There can be no assurance that the Company will be able to raise sufficient capital to return to compliance under its existing debt arrangements or pay the loans in full.

There is a risk that the counterparty to certain of the Bank’s existing repurchase agreements may have the right to terminate the repurchase agreements, which could materially and adversely affect the Company’s financial position and earnings in the period of termination.

 

The agreements with one of the Bank’s repurchase agreement counterparty could permit that counterparty to terminate the repurchase agreements if the Bank does not maintain its well-capitalized status. Because the Bank is not well-capitalized, there is a risk that the counterparty could exercise its option to terminate one or more of these repurchase agreements prior to maturity. At December 31, 2009, the Bank’s repurchase agreements with those provisions totaled $262.7 million with fixed interest rates ranging from 2.76% to 4.65%, maturities ranging from approximately 7.5 to 8.5 years, and quarterly call provisions (at the counterparty’s option). Due to the relatively high fixed rates on these borrowings as compared to currently low market rates of interest, the Bank would incur substantial costs to unwind these repurchase agreements if terminated prior to their maturities, which could have a material adverse effect on the Company’s results of operations and financial condition in the period of payment. The associated unwind costs would be the difference between the fair value and carrying value of the repurchase agreements on the date of termination. Because the repurchase agreements are collateralized at an amount sufficient to cover any such unwind costs which may be incurred, any such costs would result in a charge in the statement of operations but would not be expected to have a material adverse effect on the Bank’s liquidity.

 

The Company’s common stock could be delisted from Nasdaq.

 

The Company’s common stock is currently listed on Nasdaq. On September 15, 2009, the Company received a letter notifying the Company of failure to maintain a minimum closing bid price of $1.00 per share on Company common stock over the preceding 30 consecutive business days as required by Nasdaq rules. The letter stated that the Company had until March 15, 2010 to demonstrate compliance by maintaining a minimum closing bid price of at least $1.00 for a minimum of ten consecutive business days. The Company was not able to satisfy this requirement.

 

On March 11, 2010, Nasdaq notified the Company that it had approved the Company’s application to transfer its common stock from the Nasdaq Global Market to the Nasdaq Capital Market effective March 16, 2010. Nasdaq has advised the Company that it has been granted an additional 180 calendar-day compliance period which will end on September 13, 2010.

 

If the Company does not maintain a minimum closing bid price of at least $1.00 for a minimum of ten consecutive business days by September 13, 2010, Nasdaq will notify the Company that its common stock is subject to delisting from Nasdaq. At that time, the Company may appeal Nasdaq’s determination to delist its common stock to a Listing Qualifications Panel.

 

Although the Company was allowed to transfer to the Nasdaq Capital Market, the perception or possibility that the Company’s common stock could be delisted in the future could negatively affect the liquidity and price of its common stock. Delisting would have an adverse effect on the liquidity of the common stock and, as a result, the market price for the common stock might become more volatile. Delisting could also make it more difficult for the Company to raise additional capital. Although the Company expects that quotes for its common stock would continue to be available on the OTC Bulletin Board or, if it were delisted from Nasdaq, on the “Pink Sheets,” such alternatives are generally considered to be less efficient markets, and the stock price, as well as the liquidity of the common stock, may be adversely impacted as a result.

 

Also, in the future the Company could fall out of compliance with other minimum criteria for continued listing, including minimum market capitalization, minimum stockholders’ equity and minimum public float. A failure to meet any of these other continued listing requirements could result in delisting of the Company’s common stock.

 

Markets have experienced, and may continue to experience, periods of high volatility accompanied by reduced liquidity.

 

Financial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Under these extreme conditions, hedging and other risk management strategies may not be as effective at mitigating trading losses as they would be under more normal market

conditions. Moreover, under these conditions market participants are particularly exposed to trading strategies employed by many market participants simultaneously and on a large scale, such as crowded trades. The Company’s risk management and monitoring processes seek to quantify and mitigate risk to more extreme market moves. Severe market events have historically been difficult to predict, however, and the Company could realize significant losses if unprecedented extreme market events were to occur, such as the recent conditions in the global financial markets and global economy.

 

Concern of the Company’s customers over deposit insurance may cause a decrease in deposits.

 

With recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured. On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program (the “TLGP”) where all noninterest-bearing transaction deposit accounts, including all personal and business checking deposit accounts, and NOW accounts, which are capped at a rate no higher than 0.50%, are fully guaranteed, through June 30, 2010, regardless of dollar amount. The Company has elected to participate in the program. If this program is not extended beyond June 30, 2010, the Company may experience a decrease in deposits. Decreases in deposits may adversely affect the Company’s funding costs, net income, and liquidity.

 

The Bank’s deposit insurance premium could be substantially higher in the future, which could have a material adverse effect on the Company’s future earnings.

 

The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges the insured financial institutions premiums to maintain the Deposit Insurance Fund at a certain level. Current economic conditions have increased bank failures and expectations for further failures, in which case the FDIC ensures payments of deposits up to insured limits from the Deposit Insurance Fund.

 

On October 7, 2008, the FDIC released a five-year recapitalization plan and a proposal to raise premiums to recapitalize the fund. In order to implement the restoration plan, the FDIC proposed to change both its risk-based assessment system and its base assessment rates. In December 2008, the FDIC adopted its rule, uniformly increasing the risk-based assessment rates by seven basis points, annually, resulting in a range of risk-based assessment of 12 basis points to 50 basis points. Changes to the risk-based assessment system would include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities, and lowering premiums for smaller institutions with very high capital levels.

 

On May 22, 2009, the FDIC board agreed to impose an emergency special assessment of five basis points on all banks to restore the Deposit Insurance Fund to an acceptable level. The assessment, which was payable on September 30, 2009, is in addition to a planned increase in premiums and a change in the way regular premiums are assessed, which the FDIC board previously approved. The cost of this emergency special assessment to the Company was approximately $1.7 million. On November 12, 2009, the FDIC issued new assessment regulations that require FDIC-insured institutions to prepay on December 30, 2009 their estimated quarterly risk-based assessments for the fourth quarter 2009 and for all of 2010, 2011 and 2012; however certain financial institutions, including the Bank, were exempted from the new prepayment regulations and will continue to pay their risk-based assessments on a quarterly basis.

 

The recent assessment increases and special assessments discussed above, along with any future further assessment increases and special assessments applicable to the Bank, have increased and may continue to increase Banks expenses and adversely impact the Company’s earnings. Future assessments are also expected to increase as a result of the Bank being undercapitalized as of December 31, 2009.

 

FDIC insurance expense has increased substantially, from $2.6 million in 2008 to $9.3 million in 2009, which includes a special assessment. The Company expects to pay significantly higher FDIC premiums in the future, especially until its regulatory capital and risk profile improve. Bank failures have significantly depleted the FDIC’s DIF and reduced its ratio of reserves to insured deposits. The FDIC has adopted a revised risk-based deposit insurance assessment schedule which raised deposit insurance premiums, and the FDIC has also implemented a special assessment on all depository institutions. Additional special assessments may be imposed by the FDIC for

future periods. The Bank participates in the TLGP’s noninterest-bearing transaction account guarantee and pays the FDIC a fee for such guarantee. These actions significantly increased the Company’s noninterest expense in 2009 and are expected to increase its costs for the foreseeable future. The Bank’s insurance premiums will also increase as a result of becoming less than “well capitalized.” TLGP’s noninterest-bearing transaction account guarantee program has been extended to June 30, 2010. Institutions, such as the Bank, that participate in the extended program are required to pay 15 to 25 basis points annualized fee in accordance with its risk category rating assigned by the FDIC.

 

Defaults by another financial institution could adversely affect financial markets generally.

 

Since mid-2007, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence.

 

The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing, or other relationships between the institutions. As a result, concerns about, or a default or threatened default by, one institution could lead to significant market-wide liquidity and credit problems, losses, or defaults by other institutions. This is sometimes referred to as “systemic risk” and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which the Company interacts on a daily basis, and therefore could adversely affect the Company.

 

The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of the Company’s counterparty or client. In addition, the Company’s credit risk may be exacerbated when its collateral held cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due the Company. There is no assurance that any such losses would not materially and adversely affect the Company’s business, financial condition or results of operations.

 

The widespread effect of falling housing prices on financial markets has adversely affected and could continue to adversely affect the Company’s profitability, liquidity, and financial condition.

 

Turmoil in the financial markets, precipitated by falling housing prices and rising delinquencies and foreclosures, has negatively impacted the valuation of securities supported by real estate collateral, including certain securities owned by the Company. In 2008, the Company has experienced losses of $82.1 million on investments in government sponsored enterprises, such as Fannie Mae and Freddie Mac, which has materially adversely impacted its capital base. The Company relies on its investment securities portfolio as a source of net interest income and as a means to manage its funding and liquidity needs. If defaults in the underlying collateral are such that the security can no longer meet its debt service requirements, the Company’s net interest income, cash flows, and capital will be reduced.

 

The value of securities in the Company’s investment securities portfolio may be negatively affected by continued disruptions in securities markets.

 

The market for some of the investment securities held in the Company’s portfolio has become extremely volatile over the past twelve months. Generally, assets required to be carried at fair value are valued based on quoted market prices or on valuation models that use market data inputs. Because the Company’s carries these assets on its books at their fair values, the Company may incur losses even if the assets in question present minimal credit risk. Volatile market conditions may detrimentally affect the value of these securities, such as through reduced valuations due to the perception of heightened credit and liquidity risks. There can be no assurance that the declines in market value associated with these disruptions will not result in other than temporary impairments of these assets, which

would lead to accounting charges that could have a material adverse effect on the Company’s net income and capital levels.

 

If the Company is required to write down goodwill or other intangible assets or if it is required to mark-to-market certain of its assets or further reduce its deferred tax assets by a valuation allowance, its financial condition and results of operations would be negatively affected.

 

When the Company acquires a business, a portion of the purchase price of the acquisition may be allocated to goodwill and identifiable intangible assets. The amount of the purchase price which is allocated to goodwill is determined by the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. At December 31, 2009, the Company’s goodwill and identifiable intangible assets were approximately $77.3 million. Under generally accepted accounting principles, if the Company determines that the carrying value of its goodwill or identifiable intangible assets is impaired, the Company is required to write down the value of these assets. The Company conducts an annual review to determine whether goodwill and identifiable intangible assets are impaired and updates this analysis on an interim basis, under certain circumstances.

 

Under the authoritative guidance for intangibles — goodwill and other (ASC 350), goodwill must be tested for impairment annually and, under certain circumstances, at intervening interim dates. A goodwill impairment test also could be triggered between annual testing dates if an event occurs or circumstances change that would more likely than not reduce the fair value below the carrying amount. Examples of those events or circumstances would include the following:

 

 

The Company’s goodwill and intangible assets are reviewed annually for impairment as of September 30th of each year. This review in 2009 was conducted with the assistance of a third party valuation specialist. Based upon that review, the Company determined that the $78.9 million of goodwill recorded on the September 30, 2009 balance sheet was not impaired. The Company determined that activities in the fourth quarter of 2009, including the Written Agreement with the regulators, the decline in the Bank’s regulatory capital position to undercapitalized, and the significant deterioration in the market price of the Company’s common stock, constituted triggering events requiring an interim goodwill impairment test. As a result of that test, the Company recorded a $14.0 million goodwill impairment as of December 31, 2009. The Company cannot assure that it will not be required to take goodwill impairment charges in the future. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation — Financial Condition — Goodwill” for a discussion of the methodologies employed and assumptions used in conducting the Company’s annual impairment test.

 

The Company will continue to assess the shortfall in the Company’s equity fair value relative to its total book value and tangible book value, which management currently attributes to both industry-wide and Company-specific factors, and to evaluate whether any additional adjustments are required in the carrying value of goodwill. The Company may be required in a future period to recognize an impairment of all, or some portion, of its remaining goodwill.

 

Any impairment charge would have a negative effect on its stockholders’ equity and financial results. If an impairment charge is significant enough to result in or significantly contribute to negative net income for the period, it could affect the ability of the Bank to upstream dividends to the Company, which could have a material adverse effect on the Company’s liquidity.

If the Company decides to sell a loan or a portfolio of loans it is required to classify those loans as held for sale, which requires it to carry such loans at the lower of cost or market. If it decides to sell loans at a time when the fair market value of those loans is less than their carrying value, the adjustment will result in a loss. The Company may from time to time decide to sell particular loans or groups of loans, for example to resolve classified loans, and the required adjustment could negatively affect its financial condition or results of operations.

 

The Company also is required, under generally accepted accounting principles, to assess the need for a valuation allowance on its deferred tax assets. If, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized, the Company would be required to reduce its deferred tax assets by a valuation allowance and increase income tax expense. The Company recently established a valuation allowance of $60.0 million related to its deferred tax assets, which contributed significantly to the net loss for the quarter ended June 30, 2009. At December 31, 2009, the valuation allowance increased to $117.1 million and the net deferred tax asset was $4.3 million. The Company may be required to reduce this remaining amount in the future, which would adversely affect the Company’s earnings or exacerbate any net loss.

 

Companies are subject to a change of ownership test under Section 382 of the Internal Revenue Code of 1986, as amended, that, if met, would limit the annual utilization of the pre-change of ownership carryforward as well as the ability to use certain unrealized built-in losses. Under the Company’s planned capital restructuring, it is likely that a change of ownership under Section 302 will occur. Generally, under Section 382, the yearly limitation on the Company’s ability to utilize such deductions will be equal to the product of the applicable long-term tax exempt rate and the sum of the values of the Company’s common stock and Series G preferred stock immediately before the ownership change. The Company’s ability to utilize deductions related to credit losses during the twelve-month period following such an ownership change would also be limited under Section 382, together with net operating loss carryforwards, to the extent that such deductions reflect a net loss that was “built-in” to the Company’s assets immediately prior to the ownership change.

 

If the Company’s investment in the common stock of the Federal Home Loan Bank of Chicago is other than temporarily impaired, its financial condition and results of operations could be materially impaired.

 

The Bank owns common stock of the Federal Home Loan Bank of Chicago (“FHLBC”). The common stock is held to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the FHLBC’s advance program. The aggregate cost and fair value of the Company’s FHLBC common stock as of December 31, 2009 was $17.0 million based on its par value. There is no market for the FHLBC common stock.

 

On October 10, 2007, the FHLBC entered into a consensual cease and desist order with the Federal Housing Finance Board, now known as the Federal Housing Finance Agency (“FHFA”). Under the terms of the order, capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other termination, are prohibited unless the FHLBC receives the prior approval of the Director of the Office of Supervision of the FHFA (the “Director”). The order also provides that dividend declarations are subject to the prior written approval of the Director and required the FHLBC to submit a capital structure plan to the FHFA. The FHLBC has not declared any dividends since the order was issued and it has not received approval of a capital structure plan. In July of 2008, the FHFA amended the order to permit the FHLBC to repurchase or redeem newly-issued capital stock to support new advances, subject to certain conditions set forth in the order. The Company’s FHLBC common stock is not newly-issued and is not affected by this amendment.

 

Recent published reports indicate that certain member banks of the Federal Home Loan Bank System could have materially lower regulatory capital levels due to the application of certain accounting rules and asset quality issues. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLBC, could be substantially diminished or reduced to zero. The Company’s FHLBC common stock is accounted for in accordance with the authoritative guidance for financial services — depository and lending (ASC 942-325-35). This guidance provides that, for impairment testing purposes, the value of long term investments such as FHLBC common stock is based on the “ultimate recoverability” of the par value of the security without regard to temporary declines in value. Consequently, if events occur that give rise to substantial doubt about the ultimate recoverability of the par value of the Company’s FHLBC common stock, this investment could be deemed to be

other-than-temporarily impaired, and the impairment loss that would be required to be recorded would cause the Company’s earnings to decrease by the after-tax amount of the impairment loss.

 

As a bank holding company that conducts substantially all of the Company’s operations through its subsidiaries, its ability to pay dividends, repurchase its shares, or to repay its indebtedness depends upon liquid assets held by the bank holding company, as well as the results of operations of the Company’s subsidiaries. The Company and its subsidiaries are subject to other restrictions.

 

The Company is a separate and distinct legal entity from its subsidiaries and it receives substantially all of its revenue from dividends from its subsidiaries. The Company’s net income depends primarily upon its net interest income. Net interest income is income that remains after deducting from total income generated by earning assets the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors, including the volume of earning assets, the general level of interest rates, the dynamics of changes in interest rates and the levels of nonperforming loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of noninterest-bearing demand deposits and equity capital.

 

Most of the Company’s ability to pay dividends and make payments on its debt securities comes from amounts paid to it by the Bank. Under applicable banking law, the total dividends declared in any calendar year by the Bank may not, without the approval of the Federal Reserve, exceed the aggregate of the Bank’s net profits and retained net profits for the preceding two years. The Bank is also subject to limits on dividends under the Illinois Banking Act. Because of its lack of earnings, the PCA and the Written Agreement, the Bank is prohibited from paying any dividends or making any loans to the Company.

 

If, in the opinion of the federal bank regulatory agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution, could include the payment of dividends), the agency may require that the bank cease and desist from the practice. The Federal Reserve has similar authority with respect to bank holding companies. In addition, the federal bank regulatory agencies have issued policy statements which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Finally, these regulatory authorities have established guidelines with respect to the maintenance of appropriate levels of capital by a bank, bank holding company or savings association under their jurisdiction. Compliance with the standards set forth in these guidelines has restricted and will continue to restrict the amount of dividends, if any, that the Company and its affiliates can pay in the future.

 

The Company’s ability to declare and pay dividends or to repurchase its shares is also subject to:

 

 

The Company must seek additional capital in the future, but capital may not be available when it is needed.

 

The Company is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. A number of financial institutions have recently raised considerable amounts of capital as a result of deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors, which may diminish the Company’s ability to raise additional capital. As discussed under “Business — Recent Developments —

Outlook for 2010” and “— Capital Plan,” the Company also is seeking to raise capital in an effort to improve the Company’s capital position and comply with the PCA.

 

The Company’s ability to raise additional capital will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside its control, and on its current and anticipated financial performance. Accordingly, the Company cannot be assured of its ability to raise, sufficient amount of additional capital, as part of its Capital Plan or otherwise, or on terms acceptable to it. If the Company cannot raise, sufficient amount of additional capital it may have a material adverse effect on its financial condition, results of operations and prospects, as further described under “Risk Factors-If the Company fails to raise additional capital in a timely manner, the Company may be forced to seek bankruptcy and/or the Bank could be placed under FDIC receivership.

 

The Company’s effective tax rates may be adversely affected by changes in federal and state tax laws.

 

The Company’s effective tax rates may be adversely affected by changes in federal or state tax laws, regulations and agency interpretations. In this regard, recent changes in Illinois laws may adversely affect the Company’s results of operations. Under prior tax law, the Company enjoyed favorable tax treatment with respect to the dividends it received from Midwest Funding, L.L.C., a captive real estate investment trust, or a REIT. A change in Illinois tax law relating to the deductibility of captive REIT dividends eliminated this tax benefit beginning January 1, 2009, and increased the Company’s effective tax rate beginning in that year.

 

In addition, in connection with the determination of the Company’s provision for income and other taxes and during the preparation of its tax returns, management makes certain judgments based upon reasonable interpretations of tax laws, regulations and agency interpretations which are inherently complex. Management’s interpretations are subject to challenge upon audit by the tax authorities, which have become increasingly aggressive in challenging tax positions taken by financial institutions, including certain positions that the Company has taken. If the Company is not successful in defending the tax positions that it has taken, the Company’s financial condition and results of operations may be adversely affected.

 

An interruption in or breach in security of the Company’s information systems may result in a loss of customer business.

 

The Company relies heavily on communications and information systems to conduct its business. Any failure or interruptions or breach in security of these systems could result in failures or disruptions in its customer relationship management, general ledger, deposits, servicing, or loan origination systems. The occurrence of any failures or interruptions or breach in security could result in a loss of customer business, costly remedial actions, or legal liabilities and have a material adverse effect on the Company’s results of operations and financial condition.

 

Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations, cash flows and financial condition.

 

The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of the Company’s information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. Additionally, the Company outsources a portion of its data processing to a third party. If the Company’s third party provider encounters difficulties or if the Company has difficulty in communicating with such third party, it will significantly affect the Company’s ability to adequately process and account for customer transactions, which would significantly affect the Company’s business operations. Furthermore, breaches of such third party’s technology may also cause reimbursable loss to the Company’s consumer and business customers, through no fault of its own. The occurrence of any failures,

interruptions or security breaches of information systems used to process customer transactions could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

 

The Company continually encounters technological change.

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company’s operations. Many competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, its financial condition, results of operations and cash flows.

 

The Company is subject to various reporting requirements that increase compliance costs, and failure to comply timely could adversely affect its reputation and the value of its securities.

 

The Company is required to comply with various corporate governance and financial reporting requirements under the Sarbanes-Oxley Act of 2002, as well as rules and regulations adopted by the Securities and Exchange Commission, the Public Company Accounting Oversight Board and Nasdaq. In particular, the Company is required to include management and independent auditor reports on internal controls as part of its Annual Report on Form 10-K pursuant to Section 404 of the Sarbanes-Oxley Act. The Company expects to continue to spend significant amounts of time and money on compliance with these rules. In addition, pursuant to the Written Agreement, the Company is required to prepare and submit various reports to its regulators and may face further reporting obligations in the future due to its financial condition. Compliance with various regulatory reporting requires significant commitments of time from management and its directors, which reduces the time available for the performance of their other responsibilities. The Company’s failure to track and comply with the various rules may materially adversely affect its reputation, ability to obtain the necessary certifications to financial statements, lead to additional regulatory enforcement actions, and could adversely affect the value of its securities.

 

The Company’s ability to attract and retain management and key personnel may affect future growth and earnings and may be adversely affected by compensation and employment restrictions to which it may be subject.

 

The Company’s success is largely dependent on the personal contacts of its officers and employees in its market areas. If the Company loses key employees, temporarily or permanently, its business could be hurt. The Company could be particularly hurt if its key employees leave to work for the Company’s competitors. The Company’s future success depends on the continued contributions of its existing senior management personnel.

 

Both the Company and the Bank are currently required to obtain regulatory approval to add new executive officers or directors or to enter into any agreement to provide indemnification or severance payments. The personal and financial disclosures required by the regulators of prospective executives and directors are detailed and invasive. For this reason, the Company may not be able to attract qualified candidates who are willing to provide the necessary disclosures.

 

The Federal Reserve and the FDIC have indicated they are considering policies to change financial institutions compensation to avoid promoting undue risk taking. The terms of these policies are unknown, and the timing and effects of any such policies on the Company are also unknown.

The Company’s business may be adversely affected by the highly regulated environment in which it operates.

 

The Company is subject to extensive federal and state legislation, regulation and supervision. The burden of regulatory compliance has increased under current legislation and banking regulations and is likely to continue to have a significant impact on the financial services industry. Recent legislative and regulatory changes, as well as changes in regulatory enforcement policies and capital adequacy guidelines, are increasing the Company’s costs of doing business and, as a result, may create an advantage for its competitors who may not be subject to similar legislative and regulatory requirements. In addition, future regulatory changes, including changes to regulatory capital requirements, could have an adverse impact on the Company’s future results. In addition, the federal and state bank regulatory authorities who supervise the Company have broad discretionary powers to take enforcement actions against banks for failure to comply with applicable regulations and laws. If the Company fails to comply with applicable laws or regulations, it could become subject to enforcement actions that have a material adverse effect on its future results.

 

There can be no assurance that the recently enacted Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009 and other recently enacted government programs will help stabilize the U.S. financial system.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008, EESA, was enacted. The U.S. Treasury and banking regulators have implemented and may continue to implement a number of programs under this legislation and otherwise to address capital and liquidity issues in the banking system, including the TARP Capital Purchase Program. In addition, other regulators have taken steps to attempt to stabilize and add liquidity to the financial markets, such as the FDIC Temporary Liquidity Guarantee Program, TLG Program, which the Company did not “opt-out” of. However, there can be no assurance that the Company will issue any guaranteed debt under the TLG Program, or that the Company will participate in any other stabilization programs in the future.

 

The EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the SEC and others to address recent liquidity and credit instability crises. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.

 

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, ARRA, more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The new limits remain in place until the participant has redeemed the preferred stock sold to U.S. Treasury, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.

 

There can also be no assurance as to the ultimate impact that the EESA, the ARRA, the programs promulgated under these acts and other programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the EESA, the ARRA and other programs to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect the Company’s business, financial condition, results of operations, access to credit or the trading price of the Company’s common stock.

 

The EESA, the ARRA and the programs enacted under these acts are relatively new legislation and regulations and, as such, are subject to change and evolving interpretation. There can be no assurances as to the effects that such changes will have on the effectiveness of the EESA, the ARRA or on the Company’s business, financial condition or results of operations.

The purpose of these legislative and regulatory actions is to stabilize the U.S. banking system. The EESA, the ARRA and the other regulatory initiatives described above and which may be proposed in the future may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, the Company’s business, financial condition, results of operations and cash flows could be materially and adversely affected.

 

The limitations on incentive compensation contained in the ARRA may adversely affect the Company’s ability to retain its highest performing employees.

 

The ARRA imposes new executive compensation limits on participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The ARRA and regulations promulgated under the ARRA contain numerous limitations on the amount and form of compensation that may be paid to the highest paid employees, including restrictions on bonus and other incentive compensation payable to the five executives named in a company’s proxy statement, restrictions on severance payments to the ten highest paid employees, and requirements for the repayment of bonuses in certain circumstances by the 25 highest paid employees. It is possible that the Company may be unable to create a compensation structure that permits it to retain its highest performing employees. If this were to occur, the Company’s business and results of operations could be adversely affected, perhaps materially.

 

The Company is subject to claims and litigation pertaining to fiduciary responsibility.

 

From time to time, customers make claims and take legal action pertaining to the Company’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services as well as impact customer demand for the Company’s products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

 

Future sales of the Company’s common stock or other securities will dilute the ownership interests of its existing stockholders and could depress the market price of the Company’s common stock.

 

The Company will need to issue additional shares of common stock in the near future to meet its capital needs and regulatory requirements. The Company can issue common stock without stockholder approval, up to the number of authorized shares set forth in its amended and restated certificate of incorporation, as amended (the “Certificate of Incorporation”). The Company’s Board of Directors may determine from time to time a need to obtain additional capital through the issuance of additional shares of common stock or other securities including securities convertible into or exchangeable for shares of the Company’s common stock, subject to limitations imposed by Nasdaq and the Federal Reserve. There can be no assurance that such shares can be issued at prices or on terms better than or equal to the terms obtained by the Company’s current stockholders. The issuance of any additional shares of common stock or convertible or exchangeable securities by the Company in the future may result in a reduction of the book value or market price, if any, of the then-outstanding common stock. Issuance of additional shares of common stock or convertible or exchangeable securities will reduce the proportionate ownership and voting power of the Company’s existing stockholders.

 

In addition, sales of a substantial number of shares of the Company’s common stock or convertible or exchangeable securities in the public market by its stockholders, or the perception that such sales are likely to occur, could cause the market price of the Company’s common stock to decline. The Company cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of its common stock. Therefore, the Company can give no assurance sales of substantial amounts of its common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of its common stock to decline or impair the Company’s ability to raise capital through sales of its common stock.

The Company cannot guarantee whether such financing will be available to it on acceptable terms or at all. If the Company is unable to obtain future financing, it may not have the capital and financial resources it requires for its business or that are necessary to meet regulatory requirements.

 

Shares of the Company’s preferred stock may be issued in the future which could materially adversely affect the rights of the holders of the Company’s common stock.

 

The Company has the authority under its Certificate of Incorporation to issue additional series of preferred stock and to determine the designations, preferences, rights and qualifications or restrictions of those shares without any further vote or action of its stockholders. The rights of the holders of the Company’s common stock will be subject to, and may be materially adversely affected by, the rights of the holders of any preferred stock that may be issued by the Company in the future.

 

Offerings of debt, which could be senior to the Company’s common stock upon liquidation, or preferred equity securities, which may be senior to its common stock for purposes of dividend distributions or upon liquidation, may adversely affect the market price of the Company’s common stock.

 

The Company may attempt to increase its capital resources or, it could be forced to raise additional capital through other securities offerings, including trust preferred securities, senior or subordinated notes and preferred stock. Holders of the Company’s debt securities and other lenders, as well as holders of the Company’s preferred securities generally will be entitled to receive distributions of its available assets prior to distributions to the holders of its common stock upon the Company’s bankruptcy, dissolution or liquidation. Additional equity offerings may dilute the holdings of the Company’s existing stockholders or reduce the market price of the Company’s common stock, or both. Holders of the Company’s common stock are not entitled to preemptive rights or other protections against dilution.

 

The outstanding shares of the Company’s Series G preferred stock may be converted by the U.S. Treasury at any time or will be converted if certain conditions are met, which will dilute the Company’s existing stockholders in the case of conversion. In addition, the Company’s ability to pay dividends on those shares is restricted.

 

On March 8, 2010, the U.S. Treasury exchanged the 84,784 shares of Series T preferred stock, having an aggregate approximate liquidation preference of $84.8 million, plus approximately $4.6 million in cumulative dividends not declared or paid on such preferred stock, for a new series of fixed rate cumulative mandatorily convertible preferred stock, Series G, with the same liquidation preference. The warrant dated December 5, 2008 to purchase 4,282,020 shares of common stock was also amended to re-set the strike price of the warrant to be consistent with the conversion price of the Series G preferred stock. The U.S. Treasury has the authority to convert the new preferred stock into the Company’s common stock at any time. In addition, the Company can compel a conversion of the new preferred stock into common stock, subject to the following conditions: (i) the Company receives appropriate approvals from the Federal Reserve; (ii) approximately $78.6 million principal amount of the Company’s revolving, senior, and subordinated debt shall have previously been converted into common stock on terms acceptable to the U.S. Treasury in its sole discretion; (iii) the Company shall have completed a new cash equity raise of not less than $125 million on terms acceptable to the U.S. Treasury in its sole discretion; and (iv) the Company has made the anti-dilution adjustments to the new preferred stock, if any, as required by the terms thereof. Unless earlier converted, the new preferred stock converts automatically into shares of the Company’s common stock on March 8, 2017. If the outstanding shares of the Company’s Series G preferred stock are converted by the U.S. Treasury, it will dilute the Company’s existing stockholders. In addition, the Company’s ability to pay dividends on those shares is restricted.

 

The Company is exposed to risk of environmental liabilities with respect to properties to which it takes title.

 

In the course of the Company’s business, the Company may own or foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. The Company may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs

incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, the Company may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If the Company ever becomes subject to significant environmental liabilities, the Company’s business, financial condition, cash flows, liquidity and results of operations could be materially and adversely affected.

 

Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact the Company’s business.

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of the Company’s deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Although management has established disaster recovery policies and procedures and is insured for these situations, the occurrence of any such event could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

 

Non-Compliance with USA PATRIOT Act, Bank Secrecy Act, or Other Laws and Regulations Could Result in Fines or Sanctions, and Curtail Expansion Opportunities

 

Financial institutions are required under the USA PATRIOT and Bank Secrecy Acts to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. Financial institutions are also obligated to file suspicious activity reports with the U.S. Treasury’s office of Financial Crimes Enforcement Network if such activities are detected. These rules also require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure or the inability to comply with these regulations could result in fines or penalties, curtailment of expansion opportunities, intervention or sanctions by regulators and costly litigation or expensive additional controls and systems. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. The Company has developed policies and continue to augment procedures and systems designed to assist in compliance with these laws and regulations.

 

Provisions in the Company’s amended and restated certificate of incorporation and its amended and restated bylaws may delay or prevent an acquisition of the Company by a third party.

 

The Company’s amended and restated certificate of incorporation and its amended and restated bylaws contain provisions that may make it more difficult for a third party to gain control or acquire the Company without the consent of its board of directors. These provisions also could discourage proxy contests and may make it more difficult for dissident stockholders to elect representatives as directors and take other corporate actions.

 

These provisions of the Company’s governing documents may have the effect of delaying, deferring or preventing a transaction or a change in control that some or many of its stockholders might believe to be in their best interest.

 

 

None.

 

The following table sets forth certain information regarding the Company’s principal office and bank branches.

 

 

 

 

Management believes that the facilities are of sound construction, in good operating condition, appropriately insured, and adequately equipped for carrying on the business of the Company.

 

 

The Company and its subsidiaries are from time to time parties to various legal actions arising in the normal course of business. Management believes that there is no proceeding pending against the Company or any of its subsidiaries which, if determined adversely, would have a material adverse effect on the financial condition or results of operations of the Company.

 

 

 

The Company’s common stock is traded and quoted on the Nasdaq Capital Market under the symbol “MBHI.” On March 16, 2010, the Company transferred the listing of its common stock from the Nasdaq Global Market to the Nasdaq Capital Market in light of the Company’s failure to meet the Nasdaq Global Market’s minimum closing bid price requirement of $1.00 per share. If the Company is not able to satisfy the minimum closing bid price requirement by September 13, 2010, the Company’s common stock may be delisted. See “Risk Factors.” As of March 26, 2010, the Company had approximately 913 stockholders of record, based upon securities position listings furnished by the Company’s transfer agent. The Company believes the number of beneficial owners is greater than the number of record holders because a large portion of the Company’s common stock is held through brokerage firms in “street name.” The table below sets forth the high and low sale prices of the common stock and the cash dividends declared during the periods indicated.

 

 

Issuer Purchases of Equity Securities

 

In 2006, the Company announced a 5.0% stock repurchase program. No shares were repurchased during 2009 nor 2008 under this program. As of December 31, 2009, there were 374,111 shares remaining for repurchase under this program, should the Company decide to do so with the approval of the U.S. Treasury and, as a result of the Written Agreement, the Federal Reserve.

 

Information regarding the equity compensation plan is included in Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters and the information included therein is incorporated herein by reference.

Holders of common stock are entitled to receive such dividends that may be declared by the Board of Directors from time to time and paid out of funds legally available therefore. Because the Company’s consolidated net income consists largely of net income of the Bank, the Company’s ability to pay dividends depends upon its receipt of dividends from the Bank. The Bank’s ability to pay dividends is regulated by banking statutes. The Bank will not be able to pay dividends to the Company in 2010 without prior approval of the Federal Reserve. See “Supervision and Regulation, Financial Institution Regulation — Dividend Limitations.” The Company will only be able to pay dividends with the approval of the U.S. Treasury and, as a result of the Written Agreement, the Federal Reserve must approve any dividend payments by the Company. The declaration of dividends by the Company is discretionary and depends on the Company’s earnings and financial condition, regulatory limitations, tax considerations and other factors including limitations imposed by the terms of the Company’s outstanding junior subordinated debentures owed to its unconsolidated trusts. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity.”

Performance Graph

 

The following graph shows a comparison of the cumulative returns for the Company, the S&P 500 Index, and the NASDAQ Market Bank Stocks Index for the period beginning December 31, 2004 and ending December 31, 2009. The information assumes that $100 was invested at the closing price on December 31, 2004 in the common stock of the Company and each index and that all dividends were reinvested.

 

 

The following table sets forth certain selected consolidated financial data at or for the periods indicated. In accordance with the authoritative guidance for the disposal of long-lived assets (ASC 360-10-05), the results of operations and gain on sale of Midwest Bank of Western Illinois are shown in the Company’s statement of income for 2005 as “discontinued operations.” This information should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto included herein. See “Item 8, Consolidated Financial Statements and Supplementary Data.”

 

 

 

 

N/M Not meaningful

 

 

 

 

 

 

 

 

 

Overview

 

The Company’s principal business is conducted by the Bank which provides a full range of community-based financial services, including commercial and retail banking. The profitability of the Company’s operations depends primarily on its net interest income, provision for credit losses, noninterest income, noninterest expenses, and income taxes. Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings. The provision for credit losses reflects the cost of credit risk related to the Company’s loan relationships. Noninterest income consists of service charges on deposit accounts, securities gains or losses or impairments, gains or losses on sales of loans, insurance and brokerage commissions, trust income, increase in cash surrender value of life insurance, gains on sale of property and extinguishment of debt, and other noninterest income. Noninterest expenses include salaries and employee benefits, occupancy and equipment expenses, professional services, goodwill impairment, loss on extinguishment of debt, marketing expenses, foreclosed property expenses, amortization of intangible assets, merger-related expenses, FDIC premiums, and other noninterest expenses. The Company is subject to state and federal income taxes.

 

Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market interest rates and is also dependent on the Company’s asset/liability management processes to react appropriately to such changes. The provision for credit losses is based upon management’s assessment of the collectibility of the loan portfolio and related commitments under current economic conditions. Noninterest expenses are influenced by the growth of operations. Growth in the number of account relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses. The provision for income taxes is affected by tax law and regulation, accounting principles and policies, and income tax strategies.

 

The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Selected Consolidated Financial Data presented herein. In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Company’s financial position or results of operations. Actual results could differ from those estimates. Discussed below are those critical accounting policies that are of particular significance to the Company.

 

Allowance for Loan Losses:  The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows and collateral values on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.

 

The Company’s methodology for determining the allowance for loan losses represents an estimation pursuant to the authoritative guidance for contingencies (ASC 450) and loan impairments (ASC 310-10-35). The allowance

reflects estimated incurred losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for other loans grouped within the Company’s internal credit rating framework. The specific credit allocations are based on regular analyses of all loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume and other qualitative factors. The results of examination from regulatory agencies are also considered.

 

There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance, which management believes adequately considers all of the potential factors which result in credit losses, includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses could be required that could adversely affect the Company’s earnings or financial position in future periods.

 

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all principal and interest under the original loan terms. Impairment is evaluated in total for smaller-balance impaired loans of similar nature such as residential mortgage and consumer loans below a specific internal credit rating and on an individual basis for other loans that exceed the set threshold of $300,000. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.

 

Income Taxes:  The Company recognizes expense for federal and state income taxes currently payable, as well as for deferred federal and state taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the consolidated balance sheets, as well as loss carryforwards and tax credit carryforwards. Realization of deferred tax assets is dependent upon generating sufficient taxable income in either the carryforward or carryback periods to cover net operating losses generated by the reversal of temporary differences. A valuation allowance is provided by way of a charge to income tax expense if it is determined that it is not more likely than not that some or all of the deferred tax asset will be realized. If different assumptions and conditions were to prevail, the valuation allowance may not be adequate to absorb unrealized deferred taxes and the amount of income taxes payable may need to be adjusted by way of a charge or credit to expense. Furthermore, income tax returns are subject to audit by the IRS and state taxing authorities. Income tax expense for current and prior periods is subject to adjustment based upon the outcome of such audits. The Company believes it has adequately accrued for all probable income taxes payable. Accrual of income taxes payable and valuation allowances against deferred tax assets are estimates subject to change based upon the outcome of future events.

 

The Company has entered into tax allocation agreements with its subsidiary entities included in the consolidated US federal and unitary and combined state income tax returns. These agreements govern the timing and amount of income tax payments required by the various entities.

 

The Company accounts for uncertainties in the application of income tax laws and income tax positions taken or expected to be taken in income tax returns under the authoritative guidance for income taxes (ASC 740).

 

Evaluation of Securities for Impairment:  Securities are classified as held-to-maturity when the Company has the ability and intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on the disposition of securities available-for-sale are based on the net proceeds and the adjusted cost of the securities sold, using the specific identification method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are recognized in earnings as realized losses, if the amounts are related to credit loss, or

recognized in other comprehensive income, if the amounts are related to other factors. In determining other-than-temporary losses for debt securities, management considers whether the Company (i) intends to sell the security, (ii) more likely than not will be required to sell the security before recovering its cost, or (iii) does not expect to recover the security’s entire amortized cost. Other-than-temporary losses are separated between the amount related to credit loss (which is recognized in current earnings) and the amount related to all other factors (which is recognized in other comprehensive income). In estimating other-than-temporary losses for equity securities, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

 

Evaluation of Goodwill Impairment:  When the Company acquires a business, a portion of the purchase price of the acquisition may be allocated to goodwill and identifiable intangible assets. The amount of the purchase price which is allocated to goodwill is determined by the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. At December 31, 2009, the Company’s goodwill and identifiable intangible assets were $77.3 million. Under generally accepted accounting principles, if the Company determines that the carrying value of its goodwill or identifiable intangible assets is impaired, the Company is required to write down the value of these assets. The Company conducts an annual review to determine whether goodwill and identifiable intangible assets are impaired and updates this analysis on an interim basis, under certain circumstances.

 

Goodwill impairment charges are non-cash, non tax deductible, do not impact tangible equity, and do not adversely affect the Company’s overall liquidity position. Goodwill impairments are classified in the income statement as noninterest expense.

 

Under the authoritative guidance for intangibles — goodwill and other (ASC 350), goodwill must be tested for impairment annually and, under certain circumstances, at intervening interim dates. A goodwill impairment test also could be triggered between annual testing dates if an event occurs or circumstances change that would more likely than not reduce the fair value below the carrying amount. Examples of those events or circumstances would include the following: a) significant adverse change in business climate, b) significant unanticipated loss of clients/assets under management, c) unanticipated loss of key personnel, d) sustained periods of poor investment performance, e) significant loss of deposits or loans, f) significant reductions in profitability, or g) significant changes in loan credit quality. Representative indicators of fair value considered by management during interim reporting periods include, but are not limited to: a) stock price, b) estimated control premiums for the Company and peer banking organizations, c) future available cash flows generated by earnings, d) market multiples of other community banking firms in our market area, e) institutional investors’ and correspondent lender’s understanding and acceptance of business strategy, f) credit quality metrics, g) loan growth and the ability to generate lending activity, h) core deposit levels and activity, and i) regulatory capital levels.

 

The Company’s goodwill and intangible assets are reviewed annually for impairment as of September 30th of each year. This review is conducted with the assistance of a third party valuation specialist. In conducting the review, the market value of the Company’s common stock and preferred stocks, estimated control premiums, projected cash flow and various pricing analyses are all taken into consideration to determine if the fair value of the assets and liabilities in its business exceed their carrying amounts. On September 30, 2008 and December 31, 2009, the Company recorded goodwill impairment charges of $80.0 million and $14.0 million, respectively. The Company also completed its annual goodwill impairment study for 2009 as of September 30, 2009 and determined that goodwill was not impaired at that time. The Company will continue to assess any shortfall in its equity fair value relative to its total book value and tangible book value, including what might be attributed to either industry-wide or Company-specific factors, and to evaluate whether any additional adjustments are required in the carrying value of goodwill. If the Company’s common stock continues to trade at a price below book value, the Company may be required in a future period to recognize an impairment of all, or some portion, of its remaining goodwill. The Company cannot assure that it will not be required to take additional goodwill impairment charges in the future. Any impairment charge would have a negative effect on its stockholders’ equity and financial results. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Goodwill.”

Accounting Pronouncements

 

The Financial Accounting Standards Board (“FASB”) has established the FASB Accounting Standards Codification^tm (“Codification” or “ASC”) as the single source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities (ASC 105). Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The Codification supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification has become non-authoritative. The Board will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates (“ASU”), which will serve to update the Codification, provide background information about the guidance and provide the basis for conclusions on the changes to the Codification. GAAP is not intended to be changed as a result of the Codification, but it has changed the way the guidance is organized and presented.

 

In December 2007, FASB revised the authoritative guidance for business combinations (ASC 805), which modifies the accounting for business combinations and requires, with limited exceptions, the acquirer in a business combination to recognize all of the assets acquired, liabilities assumed, and any noncontrolling interests in the acquiree at the acquisition-date, at fair value. This guidance also requires certain contingent assets and liabilities acquired as well as contingent consideration to be recognized at fair value. In addition, the statement requires payments to third parties for consulting, legal, audit, and similar services associated with an acquisition to be recognized as expenses when incurred rather than capitalized as part of the cost of the acquisition. The adoption of this guidance on January 1, 2009 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

The Company adopted the authoritative guidance for fair value measurements (ASC 820) on January 1, 2008, which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This guidance applies to other ASC topics that require or permit fair value measurements. Accordingly, this guidance did not require any new financial assets or liabilities to be measured at fair value. In February 2008, FASB delayed the effective dates of this guidance for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. In October 2008, the FASB amended this guidance, which clarifies the application of fair value measurements in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is to be determined when the market for that financial asset is not active. This amendment became effective for the Company’s interim financial statements as of September 30, 2008 and did not significantly impact the methods by which the Company determines the fair values of its financial assets. On April 9, 2009, the FASB amended the authoritative guidance for fair value measurements and disclosures (ASC 820), which amendment requires increased analysis and management judgment to estimate fair value if an entity determines that either the volume and/or level of activity for an asset or liability has significantly decreased or price quotations or observable inputs are not associated with orderly transactions. Valuation techniques such as an income approach might be appropriate to supplement or replace a market approach in those circumstances. This guidance requires entities to disclose in interim and annual periods the inputs and valuation techniques used to measure fair value along with any changes in valuation techniques and related inputs during the period. This guidance is effective for interim and annual periods ending after June 15, 2009. Accordingly, the Company included these new disclosures beginning April 1, 2009. See Note 20 — Fair Value of the notes to the consolidated financial statements for more details.

 

In June 2008, the FASB provided guidance for determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock (ASC 815-40-15). This guidance applies to any freestanding financial instrument or embedded feature that has all of the characteristics of a derivative or freestanding instrument that is potentially settled in an entity’s own stock (with the exception of share-based payment awards within the scope of the authoritative guidance for stock compensation (ASC 718)). To meet the definition of “indexed to own stock,” an instrument’s contingent exercise provisions must not be based on (a) an observable market, other than the market for the issuer’s stock (if applicable), or (b) an observable index, other than an index calculated or measured solely by reference to the issuer’s own operations, and the variables that could affect the settlement amount must be inputs to the fair value of a “fixed-for-fixed” forward or option on equity shares. The adoption of this guidance on

January 1, 2009 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

In June 2008, the FASB issued authoritative guidance for determining whether instruments granted in share-based payment transactions are participating securities (ASC 260). This guidance addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method. The Company adopted the provisions of this guidance effective January 1, 2009 and computed earnings per share using the two-class method for all periods presented. Upon adoption, the Company was required to retrospectively adjust earnings per share data to conform to the provisions in this guidance.

 

In April 2009, the FASB amended the authoritative guidance for interim disclosures about fair value of financial instruments (ASC 825), which relates to fair value disclosures in public entity financial statements for financial instruments. This guidance increases the frequency of fair value disclosures from annual only to quarterly. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have a material effect on the Company’s consolidated results of operations or consolidated financial position, but enhanced required disclosures. Accordingly, the Company included these new disclosures beginning April 1, 2009. See Note 20 — Fair Value of the notes to the consolidated financial statements for more details. In January 2010, the FASB issued authoritative guidance on improving disclosures about fair value measurements (ASU 2010-6). This guidance requires new disclosures for transfers in and out of Levels 1 and 2 and the reasons for the transfers as well as additional breakout of asset and liability categories. This guidance is effective for interim and annual reporting periods beginning after December 15, 2009. This guidance also requires purchases, sales, issuances and settlements to be reported separately in the summary of changes in Level 3 fair value measurements. This additional guidance will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company does not anticipate a material effect on the its consolidated results of operations or consolidated financial position from adopting this guidance.

 

In April 2009, FASB issued new authoritative guidance that revises the recognition and reporting requirements for other-than-temporary impairments of debt securities (ASC 320). This new guidance revises the recognition and reporting requirements for other-than-temporary impairments of debt securities. This guidance eliminates the “ability and intent to hold” provision for debt securities and impairment is considered to be other than temporary if a company (i) intends to sell the security, (ii) more likely than not will be required to sell the security before recovering its cost, or (iii) does not expect to recover the security’s entire amortized cost. This guidance also eliminates the “probability” standard relating to the collectibility of cash flows and impairment is considered to be other than temporary if the present value of cash flows expected to be collected is less than the amortized cost (credit loss). Other-than-temporary losses also need to be separated between the amount related to credit loss (which is recognized in current earnings) and the amount related to all other factors (which is recognized in other comprehensive income). This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance on April 1, 2009 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

In May 2009, the FASB issued authoritative guidance establishing principles and requirements for subsequent events (ASC 855). This guidance establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance is based on the same principles as those that currently exist in the auditing standards. This guidance also requires disclosure of subsequent events that keep the financial statements from being misleading. The adoption of this guidance on June 30, 2009 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position. In February 2010, the FASB issued ASU 2010-09, Subsequent Events (“ASU 2010-09”), effective immediately, which amends ASC 855 to clarify that an SEC filer is not required to disclose the date through which subsequent events have been evaluated in the financial statements. The adoption of ASU 2010-09 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position. See Note 30 — Subsequent Events of the notes to the consolidated financial statements for more details.

 

In June 2009, the FASB issued authoritative guidance establishing accounting and reporting standards for transfers and servicing of financial assets and also establishing the accounting for transfers of servicing rights (ASC

860). This guidance eliminates the concept of a qualifying special-purpose entity and introduces the concept of a “participating interest,” which will limit the circumstances where the transfer of a portion of a financial asset will qualify as a sale, assuming all other derecognition criteria are met. This guidance also clarifies and amends the derecognition criteria for determining whether a transfer qualifies for sale accounting as well as requires additional disclosures. These additional disclosures are intended to provide greater transparency about a transferor’s continuing involvement with transferred assets. The adoption of ASC 860 on January 1, 2010 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

In June 2009, the FASB issued authoritative guidance which eliminates the quantitative approach previously required for determining the primary beneficiary of a variable interest entity (ASC 810). If an enterprise is required to consolidate an entity as a result of the initial application of this standard, it should describe the transition method(s) applied and shall disclose the amount and classification in its statement of financial position of the consolidated assets or liabilities by the transition method(s) applied. If an enterprise is required to deconsolidate an entity as a result of the initial application of this standard, it should disclose the amount of any cumulative effect adjustment related to deconsolidation separately from any cumulative effect adjustment related to consolidation of entities. The adoption of ASC 810 on January 1, 2010 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

Consolidated Results of Operations

 

The Company incurred net losses for the years ended December 31, 2009 and 2008. Due to the resulting deterioration in capital levels of the Bank and the Company, combined with the current uncertainty as to the Company’s ability to raise sufficient amounts of new equity capital, recent regulatory actions with respect to the Company and the Bank, and the current inability of the Company to repay amounts owed under its Loan Agreements with its primary lender if, upon or subsequent to the expiration of the Forbearance Agreement on March 31, 2010, its primary lender were to declare the amounts outstanding thereunder immediately due and payable, there is substantial doubt about the Company’s ability to continue as a going concern. See “Recent Developments — Outlook for 2010.”

 

2009 Compared to 2008

 

Results of operations for 2009 reflect aggressive actions taken to preserve capital and liquidity in order to better withstand the losses in the Company’s loan portfolio stemming from the worst economy in 75 years. While the Company provides a full line of financial services to corporate and individual customers located in the greater Chicago metropolitan area, it is primarily a lender to many middle market and small businesses within the community banking segment. The length and breadth of the economic downturn, including record high unemployment and vacancy rates, is continuing to put pressure on the Bank’s borrowers, reducing both their ability to support their borrowings from a cash flow perspective and the value of property pledged as collateral for those borrowings in the case of default. With a large concentration of the loan portfolio in commercial real estate, the Company experienced accelerated deterioration in its portfolio during 2009 as both delinquencies on commercial real estate loans increased and declines in related collateral values continued. Unfortunately, losses taken in 2008, mainly attributed to the recognition of impairment charges and realized losses on the preferred stock of FNMA and FHLMC, as well as the impairment charge on goodwill of $82.1 million and $80.0 million, respectively, and a $72.6 million provision for credit losses, eroded a large part of the Company’s capital base.

 

In response, in 2009, the Company initiated changes to optimize its balance sheet, preserve regulatory capital, enhance liquidity, reduce costs aggressively, tighten loan underwriting standards, and build a strong loan workout area in anticipation of growth in problem loans, and announced a capital restructuring plan. The Company’s actions to strengthen its balance sheet and capital position to enable it to withstand a challenging economic cycle as well as the credit quality deterioration have resulted in steep declines in results of operations for 2009. The Company had a net loss of $242.7 million for the year ended December 31, 2009 compared to net loss of $158.3 million for the prior year. Basic and diluted loss per share for the year ended December 31, 2009 were both $8.89 compared to $5.82 for 2008. The return on average assets was (6.69)% for 2009 compared to a (4.32)% for 2008. The return on average equity was (100.76)% in 2009 compared to (46.65)% in 2008.

This loss was mainly attributed to the $170.2 million provision for credit losses as the Company continued to address credit issues, tax charges including $116.3 million related to a valuation allowance on deferred tax assets and $8.1 million related to the liquidation of bank-owned life insurance, and a goodwill impairment charge of $14.0 million. The net interest margin was also negatively impacted by repositioning of the securities portfolio, which achieved a $107.2 million reduction in risk-weighted assets, along with several other liquidity preservation steps but at a cost of reduced earning asset yields for 2009. Noninterest expense was also negatively affected by higher FDIC insurance costs and professional fees incurred to perform independent cumulative loan loss studies under various methodologies and assumptions, including highly stressed scenarios, in order to determine the Company’s capital needs, as well as execute the Capital Plan. Operating expenses increased further to manage impaired loans within the special assets group, and carrying costs of foreclosed properties. The increases were offset substantially by the impact of staff reductions, suspension of the 401(k) match and other expense control initiatives estimated at $15.9 million on an annual basis.

 

Set forth below are additional highlights of 2009 results compared to 2008.

 

Net Interest Income.  Net interest income on a fully taxable-equivalent basis decreased $16.7 million, or 18.7%, to $72.9 million in 2009 from $89.6 million in 2008. This decrease was primarily due to the decrease in the overall market rates impacting variable-rate loans, interest foregone on nonaccrual loans, and the decline in interest income on securities due to the securities portfolio repositioning into shorter-term and lower risk-weighted securities featuring lower yields. As a result, the net interest margin, on a tax equivalent basis, decreased to 2.16% for the year ended December 31, 2009 from 2.75% for the prior year. Due to the Company’s current tax position, the net interest margin for 2009 does not reflect a fully taxable-equivalent adjustment.

 

Trends in Fully Taxable-Equivalent Interest Income and Average Interest-Earning Assets.  Interest income decreased $39.8 million to $150.5 million in 2009 compared to $190.3 million in 2008. Average earning assets increased by $113.5 million but average yields decreased by 138 basis points. Interest income on loans decreased $18.2 million to $133.2 million in 2009 from $151.4 million in 2008 due to a 79 basis point drop in yields and a decline in average loans. This decline in yields was primarily due to the re-pricing of the variable-rate loans resulting from decreases in the prime rate, which was partially mitigated by interest rate floors and the loss of interest income related to the increase in nonaccrual loans.

 

Interest income on securities decreased $21.7 million to $16.2 million in 2009 from $37.8 million in 2008 as a result of a decrease in yields from 5.20% in 2008 to 2.49% while average securities decreased by $78.0 million. The decline in securities yield was primarily due to the repositioning of the securities portfolio into shorter-term and lower risk-weighted securities featuring lower yields. During the second quarter of 2009, the Company repositioned its securities portfolio to (i) lower capital requirements associated with higher risk-weighted assets, (ii) restructure expected cash flows, and (iii) reduce credit risk.

 

Trends in Interest Expense and Average Interest-Bearing Liabilities.  Interest expense decreased $23.1 million to $77.6 million in 2009 from $100.7 million in 2008. Average balances of interest-bearing liabilities increased by $51.1 million in 2009 to $3.0 billion compared to the prior year while rates paid decreased 82 basis points to 2.58% during 2009 compared to 3.40% in 2008 due to the lower costs of interest-bearing deposits.

 

Interest expense on interest-bearing deposits decreased by $18.8 million to $47.2 million in 2009 from $66.0 million in 2008. Average interest-bearing deposits increased $120.1 million to $2.2 billion in 2009 compared to $2.1 billion in the prior year mainly as a result of successful certificates of deposit promotions and new channels of distribution. Average rates paid on interest-bearing deposits decreased by 102 basis points to 2.13% in 2009 compared to 3.15% in the prior year. Average interest-bearing demand deposit, money market, and savings accounts decreased $59.2 million in 2009 compared to 2008 while average rates paid decreased 48 basis points. Average certificates of deposit less than $100,000 increased by $178.4 million, due to successful deposit promotions and new distribution channels, while average rates paid decreased by 128 basis points. Average certificates of deposit greater than $100,000 remained flat in 2009 while average rates paid decreased 142 basis points. Most of the decrease in average rates was in certificates of deposit that matured and re-priced at lower rates. Average brokered deposits increased by $16.5 million in 2009 compared to the prior year, but average rates paid decreased by 218 basis points.

Interest expense on borrowings decreased to $30.4 million in 2009 from $34.7 million in 2008, largely due to decreases in short-term LIBOR rates and a decrease in borrowings. Average borrowings decreased by $68.9 million to $797.8 million in 2009 compared to $866.7 million in the prior year. Less reliance on borrowings was largely due to increased funds from deposits.

 

Interest expense on Federal funds purchased and securities sold under agreements to repurchase decreased by $2.3 million in 2009 while average balances decreased $78.3 million. Interest expense on FHLB advances slightly increased by $371,000 in 2009 compared to the prior year while average balances increased by $11.3 million during the same period. Interest expense on junior subordinated debentures decreased by $1.4 million in 2009 compared to the prior year and rates paid decreased by 231 basis points. During the second quarter of 2009, the Company begun to defer interest on its junior subordinated debentures. The accrued interest deferred on junior subordinated debentures was $1.5 million through December 31, 2009. Interest expense on the revolving and term notes, increased in the second half of 2009 due to the increase to the default rates beginning in the third quarter of 2009. The interest amount due relating to the credit agreements (as discussed in Note 17 — Credit Agreements of the notes to the consolidated financial statements) was $700,000 at December 31, 2009.

 

Provision for Credit Losses.  The provision for credit losses increased by $97.6 million to $170.2 million in 2009 from $72.6 million in 2008; the large increase reflected the continued deterioration in credit quality of the portfolio as a result of current economic conditions. Nonaccrual loans increased $212.7 million to $273.8 million at December 31, 2009 compared to the prior year, and net charged off loans increased $29.3 million to $83.3 million. See Financial Condition — Analysis of Allowance for Loan Losses.

 

Noninterest Income.  The Company’s total noninterest income was $17.1 million in 2009 compared to $(50.6) million in 2008. In 2008, the Company recognized an impairment charge on securities of $65.4 million, net losses of $16.6 million on securities transactions, and a gain on the sale of property of $15.2 million.

 

Service charges on deposits were flat at $7.7 million in 2009 compared to the prior year. The cash surrender value of life insurance decreased $2.2 million, or 62.0%, reflecting the liquidation of the bank owned life insurance in the second quarter of 2009. Trust income decreased $402,000, or 24.8%, to $1.2 million in 2009 compared to 2008, partially due to a decrease in accounts. Trust income is largely based on a percentage of assets under management, which were $154.8 million and $154.5 million at December 31, 2009 and 2008, respectively. Insurance and brokerage commissions decreased by $878,000, or 43.4%, to $1.1 million in 2009 compared to the prior year, mostly due to the difficult economy causing a lower volume of transactions and the departure of brokers.

 

Noninterest Expense.  The Company’s total noninterest expense decreased by $70.2 million, to $106.9 million in 2009, from $177.1 million in 2008. Noninterest expense for 2008 included an $80.0 million non-cash goodwill impairment charge and a $7.1 million loss on the early extinguishment of debt. Noninterest expense for 2009 included a $14.0 million non-cash goodwill impairment charge. Noninterest expense as a percentage of average assets was 2.95% for 2009 compared to 4.84% for 2008.

 

Salaries and employee benefits decreased $9.9 million, or 19.6%, which was due in large part to decreases of $4.6 million in incentive expense and $1.8 million in stock-based compensation expense. The decrease was also due to the reduction in force of 120 full-time equivalents employees from December 31, 2008, salary reductions for remaining employees, and the suspension of the Company’s 401(k) contribution. Occupancy and equipment increased $337,000 to $13.1 million in 2009 compared to the prior year. Professional services increased $920,000 to $9.5 million in 2009 due to higher legal, including legal expenses related to problem loan workouts, and consulting expenses related to Capital Plan activities, the goodwill impairment studies, and loan portfolio credit-loss studies. Marketing expenses decreased by $1.4 million, or 50.5%, in 2009 compared to the prior year, as certain programs were scaled back or put on hold in an effort to control costs.

 

Foreclosed properties expense increased by $7.0 million to $7.3 million in 2009 compared to the prior year, due to the increase in foreclosed properties and the write-down of certain properties to updated fair values less costs to sell. Foreclosed properties were $26.9 million at December 31, 2009 compared to $12.0 million at year end 2008. FDIC insurance expense increased $6.7 million to $9.3 million in the 2009 compared to the same period in 2008 due to the special assessment of $1.7 million and increased regular quarterly FDIC premiums. FDIC insurance expense is expected to increase in 2010 as a result of the Bank being undercapitalized as of December 31, 2009.

The efficiency ratio was 113.23% for the year ended December 31, 2009 compared to 144.15% in 2008.

 

Federal and State Income Tax.  The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax expense of $55.6 million in 2009 compared to a benefit of $55.1 million in 2008. The change in the effective tax rate reflects $116.3 million related to the recognition of a valuation allowance on deferred tax assets and the $8.1 million tax charge related to the liquidation of bank owned life insurance in the second quarter of 2009. The Company’s marginal tax rate is approximately 40%. Under current conditions, the Company would expect to offset any tax benefits earned with similar increases in tax expense as a result of an increase in the valuation allowance.

 

Set forth below is a reconciliation of the effective tax rate for the years ended December 31, 2009 and 2008 to statutory rates.

 

 

2008 Compared to 2007

 

The Company had a net loss of $158.3 million for the year ended December 31, 2008. This loss was mainly attributed to the impairment charges and realized losses on the preferred stock of FNMA and FHLMC as well as the impairment charge on goodwill of $82.1 million and $80.0 million, respectively, and a $72.6 million provision for credit losses. Set forth below are some highlights of 2008 results compared to 2007.

 

Net loss was $158.3 million for the year ended December 31, 2008 compared to net income of $18.6 million for the prior year. Basic and diluted (loss) earnings per share for the year ended December 31, 2008 were both $(5.82) compared to $0.72 for 2007. The return on average assets was (4.32)% for 2008 compared to a 0.58% for 2007. The return on average equity was (46.65)% in 2008 compared to a 6.13% in 2007. Top line revenue (net interest income plus noninterest income) decreased by $61.7 million, or 62.9%, to $36.4 million for 2008 compared to $98.1 million in the prior year. Excluding the gains, losses and impairment charges on securities and the gain on sale of property incurred in 2008, top line revenue increased 5.2%, or $5.1 million.

 

Net Interest Income.  Net interest income on a fully taxable-equivalent basis increased $3.3 million, or 3.9%, to $89.6 million in 2008 from $86.2 million in 2007. This increase was due to interest expense declining to a greater extent than interest income due to the drops in the federal funds and prime rates. The Federal Open Market Committee cut the federal funds rate target by 225 basis points during 2008. As a result, the Company aggressively re-priced its deposits downward and benefited from the decreases in the federal funds rate. The Northwest Suburban acquisition completed on October 1, 2007 also contributed to this increase. The Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) decreased to 2.75% for 2008 compared to 3.02% for 2007. The increase in nonaccrual loans and decrease in dividends on FNMA and FHLMC preferred stock contributed to the decline in the net interest margin. Impairment charges on FNMA and FHLMC preferred stock and net charge-offs partially offset the overall increase in earning assets.

Trends in Fully Taxable-Equivalent Interest Income and Average Interest-Earning Assets.  Interest income decreased $7.2 million to $190.3 million in 2008 compared to $197.5 million in 2007. Average earning assets increased by $398.4 million ($498.3 million of earning assets were acquired through the Northwest Suburban acquisition on October 1, 2007) but average yields decreased by 107 basis points. Interest income on loans decreased $4.0 million to $151.4 million in 2008 from $155.3 million in 2007 due to a 134 basis point drop in yield despite an increase of $394.4 million in average loans; $439.2 million in loans were acquired in the Northwest Suburban acquisition on October 1, 2007. The decline in loan yield was primarily due to the re-pricing of variable-rate loans resulting from decreases in the prime rate as well as the increase in nonaccrual loans. Most new and renewing loans beginning in the fourth quarter of 2008 have floors in place which will help mitigate future margin contraction.

 

Interest income on securities decreased $2.6 million to $37.8 million in 2008 from $40.4 million in 2007 as a result of a decrease in yields from 5.55% in 2007 to 5.20% while average securities increased slightly. The decline in securities yield was primarily due to the termination of dividends on FNMA and FHLMC preferred stock in the second half of the year and on the FHLBC stock in 2007. Dividend income on FNMA and FHLMC preferred stock decreased $2.2 million in 2008 compared to the prior year. Dividend income on FHLBC stock was $333,000 in 2007 compared to none in 2008.

 

Trends in Interest Expense and Average Interest-Bearing Liabilities.  Interest expense decreased $10.5 million to $100.7 million in 2008 from $111.2 million in 2007. Average balances of interest-bearing liabilities increased by $398.1 million in 2008 to $3.0 billion compared to $2.6 billion in the prior year while rates paid decreased 94 basis points to 3.40% during 2008 compared to 4.34% in 2007.

 

Interest expense on deposits decreased by $10.7 million to $66.0 million in 2008 from $76.7 million in 2007. Average interest-bearing deposits increased $240.2 million to $2.1 billion in 2008 compared to $1.9 billion in the prior year; $405.4 million in interest-bearing deposits were acquired in the Northwest Suburban acquisition on October 1, 2007. Average rates paid on interest-bearing deposits decreased by 98 basis points to 3.15% in 2008 compared to 4.13% in the prior year. Average interest-bearing core deposits (interest-bearing demand deposit, money market, and savings accounts) increased $16.4 million in 2008 compared to 2007 and average rates paid decreased 115 basis points. Average certificates of deposit less than $100,000 increased by $21.8 million and average rates paid decreased by 90 basis points. Average certificates of deposit greater than $100,000 increased $202.0 million in 2008 and average rates paid decreased 109 basis points. Average brokered deposits increased by $144.8 million in 2008 compared to the prior year.

 

Interest expense on borrowings increased slightly to $34.7 million in 2008 from $34.5 million in 2007 even though average borrowings were up. Average borrowings increased by $157.9 million to $866.7 million in 2008 compared to $708.8 million in the prior year, primarily as a result of the Company’s asset growth exceeding deposit growth and the $81.2 million cash used for the Northwest Suburban acquisition in October 2007.

 

Interest expense on Federal funds purchased and securities sold under agreements to repurchase increased by $2.2 million in 2008 as a result of the increases in average balances of $86.1 million, even as the average rates decreased 39 basis points. Interest expense on FHLB advances decreased by $2.9 million in 2008 compared to the prior year while average balances increased by $17.8 million during the same period. Average rates paid on FHLB advances dropped by 113 basis points in 2008 to 3.53% compared to 4.66% in 2007. In March 2008, the Company prepaid $130.0 million of FHLB advances at a weighted average rate of 4.94% and recognized a loss on the early extinguishment of debt of $7.1 million. The Company replaced these borrowings at a weighted average rate of 2.57% in the second quarter of 2008.

 

Average junior subordinated debentures decreased by $5.4 million in 2008 compared to the prior year while rates paid decreased by 190 basis points. The Company acquired $10.3 million in junior subordinated debentures at LIBOR plus 2.70% through the Northwest Suburban acquisition on October 1, 2007, but redeemed $15.5 million at LIBOR plus 3.45% in November 2007. Average notes payable, including revolving, term and subordinated notes, increased by $59.3 million in 2008 compared to the prior year. The Company used the proceeds from a $75.0 million term note it has with a correspondent bank to pay the cash portion of the Northwest Suburban acquisition. Short-term LIBOR rates, to which many of the Company’s borrowings are indexed, did not decline as quickly as prime and other short-term rates which dropped quickly in late 2008 as the economy faltered.

Provision for Credit Losses.  The provision for credit losses increased by $67.8 million to $72.6 million in 2008 from $4.9 million in 2007; the large increase reflected the deterioration in credit quality of the portfolio as economic conditions reduced: (i) the borrowers ability to make debt service payments; and (ii) the value of the underlying collateral for many loans.

 

Noninterest Income.  The Company’s total noninterest income was $(50.6) million in 2008 compared to $15.5 million in 2007. In 2008 losses on securities of $82.0 million were mostly related to sales and impairments recorded on FHLMC and FNMA preferred stock holdings. The Company also recorded a gain on the sale of a branch property of $15.2 million in the first quarter of 2008.

 

Service charges on deposits increased $1.0 million as a result of the increased deposit base from the Northwest Suburban acquisition. The cash surrender value of life insurance increased $446,000, reflecting the addition of $12.9 million of such insurance acquired with Northwest Suburban. Trust income decreased $234,000 due mostly to the drop in trust asset values from the difficult economy and the departure of trust customers. Insurance and brokerage commissions decreased by $263,000 mostly due to the difficult economy and the departure of employees. Gains on sale of loans decreased by $518,000, a result of outsourcing the residential mortgage origination operations in mid-2007.

 

Noninterest Expense.  The Company’s total noninterest expense increased by $106.6 million, to $178.0 million in 2008, from $71.4 million in 2007. Noninterest expense for 2008 included an $80.0 million non-cash goodwill impairment charge and a $7.1 million loss on the early extinguishment of debt. Noninterest expense as a percentage of average assets was 4.84% for 2008 compared to 2.24% for 2007.

 

Salaries and employee benefits increased $8.2 million, or 19.4%, reflecting the additions to management and employees from the Northwest Suburban acquisition, key additions to the management team, and separation benefits of $1.2 million. Occupancy and equipment increased $3.2 million in 2008 compared to the prior year reflecting the five additional branches acquired in the Northwest Suburban acquisition. Professional services increased $3.1 million in 2008 due to an increase in loan workout legal fees and consulting expense. Marketing expenses increased by $397,000, or 17.2%, in 2008 compared to the prior year as deposit retention efforts and Company image campaigns were increased.

 

Foreclosed properties expense increased by $298,000 in 2008 compared to the prior year as a result of the increase in properties. Amortization of intangible assets increased by $659,000 as a direct result of the increase in intangible assets from the Northwest Suburban acquisition in October 2007. Non-capitalized merger related expense was $271,000 in 2008 compared to $1.3 million in 2007.

 

The Company was granted a one-time credit to offset FDIC premiums as a result of the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”). This one-time credit artificially reduced the Company’s 2007 FDIC insurance expense, but the credit was fully utilized by the end of 2007, and as a result of the expiration of that credit and the addition of the Northwest Suburban deposits in late 2007, the Company incurred an FDIC insurance expense increase of $2.4 million in 2008.

 

The efficiency ratio was 144.15% for the year ended December 31, 2008 compared to 68.29% in 2007.

Federal and State Income Tax.  The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax benefit of $55.1 million in 2008 compared to expense of $3.2 million in 2007. Set forth below is a reconciliation of the effective tax rate for the years ended December 31, 2008 and 2007 to statutory rates.

 

Interest-Earning Assets and Interest-Bearing Liabilities

 

The following table sets forth the average balances, net interest income and expense and average yields and rates for the Company’s interest-earning assets and interest-bearing liabilities for the indicated periods on a taxable-equivalent basis assuming a 35.0% tax rate.