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Table of Contents

 

 

United States Securities and Exchange Commission

Washington, D.C. 20549

Form 10-K

Annual Report under Section 13 or 15 (d)

of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2011

Commission file number 1-13805

Harris Preferred Capital Corporation

(Exact name of registrant as specified in its charter)

 

Maryland   # 36-4183096
(State or other jurisdiction   (I.R.S. Employer
of incorporation or organization)   Identification No.)
111 West Monroe Street, Chicago, Illinois   60603
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code:

(312) 461-2121

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

 

Title of each class

 

Name of each exchange on which registered

7 3/8% Noncumulative Exchangeable

Preferred Stock, Series A, par value

$1.00 per share

  New York Stock Exchange

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

None

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

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

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   ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     þ

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

 

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

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

The number of shares of Common Stock, $1.00 par value, outstanding on March 23, 2012 was 1,180. No common equity is held by nonaffiliates.

 

 

 


Table of Contents

Harris Preferred Capital Corporation

TABLE OF CONTENTS

 

Part I   
Item 1.   

Business

     2   
Item 1A.   

Risk Factors

     7   
Item 1B.   

Unresolved Staff Comments

     13   
Item 2.   

Properties

     13   
Item 3.   

Legal Proceedings

     13   
Item 4.   

Reserved

     13   
Part II   
Item 5.    Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      14   
Item 6.   

Selected Financial Data

     15   
Item 7.   

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

     16   
Item 7A.   

Quantitative and Qualitative Disclosures About Market Risk

     20   
Item 8.   

Financial Statements and Supplementary Data

     20   
Item 9.   

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     20   
Item 9A.   

Controls and Procedures

     20   
Item 9B.   

Other Information

     21   
Part III   
Item 10.   

Directors, Executive Officers and Corporate Governance

     21   
Item 11.   

Executive Compensation

     24   
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      24   
Item 13.   

Certain Relationships and Related Transactions, and Director Independence

     25   
Item 14.   

Principal Accounting Fees and Services

     26   
Part IV   
Item 15   

Exhibits, Financial Statement Schedules

     26   
  

(a) Exhibits

  
  

(b) Reports on Form 8-K

  
  

None

  
Signatures      29   


Table of Contents

PART I

Forward-Looking Information

This Annual Report on Form 10-K (“Report”) of Harris Preferred Capital Corporation (the “Company”) includes 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, including (without limitation) statements with respect to the Company’s expectations, intentions, beliefs or strategies regarding the future. Forward-looking statements include the Company’s statements regarding tax treatment as a real estate investment trust, the regulatory environment in which the Company operates and future regulatory requirements, liquidity, provision for loan losses, capital resources and investment activities. In addition, in those and other portions of this document, the words “anticipate,” “believe,” “estimate,” “expect,” “intend” and other similar expressions, as they relate to the Company or the Company’s management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. It is important to note that the Company’s actual results could differ materially from those described herein as anticipated, believed, estimated or expected. Among the factors that could cause the results to differ materially are the risks discussed in “Risk Factors” below (Item 1A of this Report). The Company assumes no obligation to update any such forward-looking statements.

 

ITEM 1. BUSINESS

General

Harris Preferred Capital Corporation is a Maryland corporation incorporated on September 24, 1997 pursuant to the Maryland General Corporation Law. The Company’s principal business objective is to acquire, hold, finance and manage qualifying real estate investment trust (“REIT”) assets (the “Mortgage Assets”), consisting of mortgage-backed securities, notes issued by BMO Harris Bank N.A. formerly, Harris N.A. (the “Bank”) secured by Securing Mortgage Loans (defined below) and other obligations secured by real property, as well as certain other qualifying REIT assets. The Company’s assets are held in a Maryland real estate investment trust subsidiary, Harris Preferred Capital Trust. The Company has elected to be treated as a REIT under the Internal Revenue Code of 1986 (the “Code”), and will generally not be subject to federal income tax if it distributes 90% of its adjusted REIT ordinary taxable income and meets all of the qualifications necessary to be a REIT. All of the shares of the Company’s common stock, par value $1.00 per share (the “Common Stock”), are owned by Harris Capital Holdings, Inc. (“HCH”), a wholly owned subsidiary of the Bank. The Company was formed by the Bank to provide investors with the opportunity to invest in residential mortgages and other real estate assets and to provide the Bank with a cost-effective means of raising capital for federal regulatory purposes. Beginning January 1, 2009, Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single owner. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the Common Stock is held by HCH, a wholly owned subsidiary of the Bank, (2) the Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. The 2010 Illinois statutory tax rate was 7.3% and the 2011 tax rate is 9.5% and the tax rate for 2012 is expected to be 9.5%. Management believes that the state tax expense to be incurred by the Company has not had, and in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the Preferred Shares (as defined below). This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock.

On February 11, 1998, the Company, through a public offering (the “Offering”), issued 10,000,000 shares of its 73/8% Noncumulative Exchangeable Preferred Stock, Series A (the “Preferred Shares”), $1.00 par value. The Offering raised $250 million less $7.9 million of underwriting fees. The Preferred Shares are traded on the New York Stock Exchange under the symbol “HBC Pr A”. Holders of Preferred Shares are entitled to receive, if declared by the Company’s Board of Directors, noncumulative dividends at a rate of 73/8% per annum of the $25 per share liquidation preference (an amount equivalent to $1.8438 per share per annum). Dividends on the Preferred Shares, if authorized and declared, are payable quarterly in arrears on March 30, June 30, September 30 and December 30 of each year, provided that, if any interest payment date on the Preferred Shares (“Interest

 

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Payment Date”) would otherwise fall on a day that is not a Business Day, the Interest Payment Date will be on the following Business Day. The Preferred Shares may be redeemed for cash at the option of the Company, in whole or in part, at any time and from time to time, at the liquidation preference thereof, plus the quarterly accrued and unpaid dividends, if any, thereon. The Company may not redeem the Preferred Shares without prior approval from the Office of the Comptroller of the Currency (the “OCC”) or the appropriate successor or other federal regulatory agency.

Each Preferred Share will be automatically exchanged (the “Automatic Exchange”) for one newly issued preferred share of the Bank (“Bank Preferred Share”) in the event (i) the Bank becomes less than “adequately capitalized” under regulations established pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, as amended, (ii) the Bank is placed into conservatorship or receivership, (iii) the OCC directs such exchange in writing because, in its sole discretion and even if the Bank is not less than “adequately capitalized,” the OCC anticipates that the Bank may become less than adequately capitalized in the near term, or (iv) the OCC in its sole discretion directs in writing an exchange in the event that the Bank has a Tier 1 risk-based capital ratio of less than 5% (each an “Exchange Event”). As a result of an Exchange Event, the Bank Preferred Shares would constitute a new series of preferred shares of the Bank, would have the same dividend rights, liquidation preference, redemption options and other attributes as the Preferred Shares, except that the Bank Preferred Shares would not be listed on the New York Stock Exchange and would rank pari passu in terms of cash dividend payments and liquidation preference with any outstanding shares of preferred stock of the Bank.

Concurrent with the issuance of the Preferred Shares, the Bank contributed additional capital of $241 million, net of acquisition costs, to the Company. The Company and the Bank undertook the Offering for two principal reasons: (i) the qualification of the Preferred Shares as Tier 1 capital of the Bank for U.S. banking regulatory purposes under relevant regulatory capital guidelines, as a result of the treatment of the Preferred Shares as a minority interest in a consolidated subsidiary of the Bank, and (ii) lack of federal income tax on the Company’s earnings used to pay the dividends on the Preferred Shares, as a result of the Company’s qualification as a REIT. On December 30, 1998, the Bank contributed the Common Stock of the Company to HCH, a newly-formed and wholly-owned subsidiary of the Bank. The Bank is an indirect wholly-owned U.S. subsidiary of Bank of Montreal (“BMO”). The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any Preferred Shares are outstanding.

The Company used the Offering proceeds and the additional capital contributed by the Bank to purchase $356 million of notes (the “Notes”) from the Bank and $135 million of mortgage-backed securities at their estimated fair value. The Notes are obligations issued by the Bank that are recourse only to the underlying mortgage loans (the “Securing Mortgage Loans”) and were acquired pursuant to the terms of a loan agreement with the Bank. The principal amount of the Notes equals approximately 80% of the principal amounts of the Securing Mortgage Loans.

On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company entered into a contribution agreement with HCH pursuant to which the Company agreed to issue and sell 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash. HCH acquired the shares on March 5, 2009 and continues to own 100% of the shares of the Common Stock. The Company utilized proceeds from the Common Stock issuance to acquire assets in a manner consistent with Company investment guidelines.

Business

The Company was formed for the purpose of raising capital for the Bank. One of the Company’s principal business objectives is to acquire, hold, finance and manage Mortgage Assets. These Mortgage Assets generate interest income for distribution to stockholders. A portion of the Mortgage Assets of the Company consists of Notes issued by the Bank that are recourse only to Securing Mortgage Loans that are secured by real property. The Notes mature on October 1, 2027 and pay interest at 6.4% per annum. Payments of interest are made to the Company from payments made on the Securing Mortgage Loans. Pursuant to an agreement between the Company and the Bank, the Company, through the Bank as agent, receives all scheduled payments made on the Securing Mortgage Loans, retains a portion of any such payments equal to the amount due on the Notes and remits the balance, if any, to the Bank. The Company also retains approximately 80% of any prepayments of principal in respect of the Securing Mortgage Loans and applies such amounts as a prepayment on the Notes. The

 

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Company has a security interest in the real property securing the Securing Mortgage Loans and will be entitled to enforce payment on the loans in its own name if a mortgagor should default. In the event of such default, the Company would have the same rights as the original mortgagee to foreclose the mortgaged property and satisfy the obligations of the Bank out of the proceeds.

The Company may from time to time acquire fixed-rate or variable-rate mortgage-backed securities representing interests in pools of mortgage loans. The Bank may have originated a portion of any such mortgage-backed securities by exchanging pools of mortgage loans for the mortgage-backed securities. The mortgage loans underlying the mortgage-backed securities will be secured by single-family residential properties located throughout the United States. The Company intends to acquire only investment grade mortgage-backed securities issued by agencies of the federal government or government sponsored agencies, such as the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“Fannie Mae”) and the Government National Mortgage Association (“GNMA”). The Company does not intend to acquire any interest-only, principal-only or similar speculative mortgage-backed securities. All mortgage backed securities at December 31, 2011 and 2010 were government secured securities.

The Bank may from time to time acquire or originate both conforming and nonconforming residential mortgage loans. Conventional conforming residential mortgage loans comply with the requirements for inclusion in a loan guarantee program sponsored by either FHLMC or Fannie Mae. Nonconforming residential mortgage loans are residential mortgage loans that do not qualify in one or more respects for purchase by Fannie Mae or FHLMC under their standard programs. The nonconforming residential mortgage loans that the Company purchases will be nonconforming because they have original principal balances which exceed the limits for FHLMC or Fannie Mae under their standard programs. The Company believes that all residential mortgage loans will meet the requirements for sale to national private mortgage conduit programs or other investors in the secondary mortgage market. As of December 31, 2011 and 2010 and for each of the years then ended, the Company did not directly hold any residential mortgage loans.

The Company may from time to time acquire commercial mortgage loans secured by industrial and warehouse properties, recreational facilities, office buildings, retail space and shopping malls, hotels and motels, hospitals, nursing homes or senior living centers. The Company’s current policy is not to acquire any interest in a commercial mortgage loan if commercial mortgage loans would constitute more than 5% of the Company’s Mortgage Assets at the time of its acquisition. Unlike residential mortgage loans, commercial mortgage loans generally lack standardized terms. Commercial real estate properties themselves tend to be unique and are more difficult to value than residential real estate properties. Commercial mortgage loans may also not be fully amortizing, meaning that they may have a significant principal balance or “balloon” payment due on maturity. Moreover, commercial properties, particularly industrial and warehouse properties, are generally subject to relatively greater environmental risks than non-commercial properties, generally giving rise to increased costs of compliance with environmental laws and regulations. There is no requirement regarding the percentage of any commercial real estate property that must be leased at the time the Bank acquires a commercial mortgage loan secured by such commercial real estate property, and there is no requirement that commercial mortgage loans have third party guarantees. The credit quality of a commercial mortgage loan may depend on, among other factors, the existence and structure of underlying leases, the physical condition of the property (including whether any maintenance has been deferred), the creditworthiness of tenants, the historical and anticipated level of vacancies and rents on the property and on other comparable properties located in the same region, potential or existing environmental risks, the availability of credit to refinance the commercial mortgage loan at or prior to maturity and the local and regional economic climate in general. Foreclosures of defaulted commercial mortgage loans are generally subject to a number of complicated factors, including environmental considerations, which are generally not present in foreclosures of residential mortgage loans. As of December 31, 2011 and 2010 and for each of the years then ended, the Company did not hold any commercial mortgage loans.

The Company may invest in assets eligible to be held by REITs other than those described above. In addition to commercial mortgage loans and mortgage loans secured by multi-family properties, such assets could include cash, cash equivalents and securities, including shares or interests in other REITs and partnership interests. At December 31, 2011, the Company held $22 million of short-term money market assets and $100 million of U.S. Treasury securities. At December 31, 2010, the Company held $24 million of short-term money market assets and $40 million of U.S. Treasury Securities.

 

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The Company intends to continue to acquire Mortgage Assets from the Bank and/or affiliates of the Bank on terms that are comparable to those that could be obtained by the Company if such Mortgage Assets were purchased from unrelated third parties. The Company may also from time to time acquire Mortgage Assets from unrelated third parties.

The Company intends to maintain a substantial portion of its portfolio in Bank-secured obligations and mortgage-backed securities. The Company may, however, invest in other assets eligible to be held by a REIT. The Company’s current policy and the Servicing Agreement (defined below) prohibit the acquisition of any Mortgage Asset constituting an interest in a mortgage loan (other than an interest resulting from the acquisition of mortgage-backed securities), which mortgage loan (i) is delinquent (more than 30 days past due) in the payment of principal or interest at the time of proposed acquisition; (ii) is or was at any time during the preceding 12 months (a) on nonaccrual status or (b) renegotiated due to financial deterioration of the borrower; or (iii) has been, more than once during the preceding 12 months, more than 30 days past due in payment of principal or interest. Loans that are on “nonaccrual status” are generally loans that are past due 90 days or more in principal or interest. The Company maintains a policy of disposing of any mortgage loan which (i) falls into nonaccrual status, (ii) has to be renegotiated due to the financial deterioration of the borrower, or (iii) is more than 30 days past due in the payment of principal or interest more than once in any 12 month period. The Company may choose, at any time subsequent to its acquisition of any Mortgage Assets, to require the Bank (as part of the Servicing Agreement) to dispose of the mortgage loans for any of these reasons or for any other reason.

The Bank services the Securing Mortgage Loans and the other mortgage loans purchased by the Company on behalf of, and as agent for, the Company and is entitled to receive fees in connection with the servicing thereof pursuant to a servicing agreement (the “Servicing Agreement”). The Bank receives a fee equal to 0.25% per annum on the principal balances of the loans serviced. Payment of such fees is subordinate to payments of dividends on the Preferred Shares. The Servicing Agreement requires the Bank to service the loans in a manner generally consistent with accepted secondary market practices, with any servicing guidelines promulgated by the Company and, in the case of residential mortgage loans, with Fannie Mae and FHLMC guidelines and procedures. The Servicing Agreement requires the Bank to service the loans solely with a view toward the interest of the Company and without regard to the interest of the Bank or any of its affiliates. The Bank will collect and remit principal and interest payments, administer mortgage escrow accounts, submit and pursue insurance claims and initiate and supervise foreclosure proceedings on the loans it services. The Bank may, with the approval of a majority of the Company’s Board of Directors, as well as a majority of the Company’s Independent Directors (as defined in Item 13 (c) below), subcontract all or a portion of its obligations under the Servicing Agreement to unrelated third parties. The Bank will not, in connection with the subcontracting of any of its obligations under the Servicing Agreement, be discharged or relieved in any respect from its obligations under the Servicing Agreement. The Company may terminate the Servicing Agreement upon the occurrence of such events as they relate to the Bank’s proper and timely performance of its duties and obligations under the Servicing Agreement. As long as any Preferred Shares remain outstanding, the Company may not terminate, or elect to renew, the Servicing Agreement without the approval of a majority of the Company’s Independent Directors (as defined in Item 13 (c) below).

The Bank administers the day-to-day operations of the Company, pursuant to an advisory agreement (the “Advisory Agreement”). The Bank is responsible for (i) monitoring the credit quality of Mortgage Assets held by the Company, (ii) advising the Company with respect to the reinvestment of income from and payments on, and with respect to the acquisition, management, financing and disposition of the Mortgage Assets held by the Company, and (iii) monitoring the Company’s compliance with the requirements necessary to qualify as a REIT, and other financial and tax-related matters. The Bank may from time to time subcontract all or a portion of its obligations under the Advisory Agreement to one or more of its affiliates. The Bank may, with the approval of a majority of the Company’s Board of Directors, as well as a majority of the Company’s Independent Directors, subcontract all or a portion of its obligations under the Advisory Agreement to unrelated third parties. The Bank will not, in connection with the subcontracting of any of its obligations under the Advisory Agreement, be discharged or relieved in any respect from its obligations under the Advisory Agreement. The Advisory Agreement is renewed annually. The Company may terminate the Advisory Agreement at any time upon 60 days’ prior written notice. As long as any Preferred Shares remain outstanding, any decision by the Company either to renew the Advisory Agreement or to terminate the Advisory Agreement must be approved by a majority of the Board of Directors, as well as by a majority of the Company’s Independent Directors (as defined in Item 13 (c) below).

 

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The Advisory Agreements in effect in 2011 and 2010 entitled the Bank to receive advisory fees of $144 thousand and $167 thousand, respectively. It is expected that 2012 advisory fees will be approximately $151 thousand.

The Company may from time to time purchase additional Mortgage Assets out of proceeds received in connection with the repayment or disposition of Mortgage Assets, the issuance of additional shares of preferred stock or additional capital contributions with respect to the Common Stock. The Company may also issue additional series of preferred stock. However, pursuant to the Company’s Articles of Incorporation, as amended (the “Charter”), the Company may not issue additional shares of preferred stock senior to the Series A preferred shares either in the payment of dividends or in the distribution of assets on liquidation without the consent of holders of at least 67% of the outstanding shares of preferred stock at that time or without approval of a majority of the Company’s Independent Directors. The Company does not currently intend to issue any additional shares of preferred stock unless it simultaneously receives additional capital contributions from HCH or other affiliates sufficient to support the issuance of such additional shares of preferred stock.

Employees

As of December 31, 2011, the Company had no paid employees. All officers of the Company were employed by the Bank.

Environmental Matters

In the event that the Company is forced to foreclose on a defaulted Securing Mortgage Loan to recover its investment in such loan, the Company may be subject to environmental liabilities in connection with the underlying real property, which could exceed the value of the real property. Although the Company intends to exercise due diligence to discover potential environmental liabilities prior to the acquisition of any property through foreclosure, hazardous substances or wastes, contaminants, pollutants or sources thereof (as defined by state and federal laws and regulations) may be discovered on properties during the Company’s ownership or after a sale thereof to a third party. If such hazardous substances are discovered on a property which the Company has acquired through foreclosure or otherwise, the Company may be required to remove those substances and clean up the property. There can be no assurance that in such a case the Company would not incur full recourse liability for the entire costs of any removal and clean-up, that the cost of such removal and clean-up would not exceed the value of the property or that the Company could recoup any of such costs from any third party. The Company may also be liable to tenants and other users of neighboring properties. In addition, the Company may find it difficult or impossible to sell the property prior to or following any such clean-up. The Company has not foreclosed on any Securing Mortgage Loans during 2011 and 2010.

Qualification as a REIT

The Company elected to be taxed as a REIT commencing with its taxable year ended December 31, 1998 and intends to comply with the provisions of the Code with respect thereto. The Company will not be subject to Federal income tax to the extent it distributes 90% of its adjusted REIT ordinary taxable income to stockholders and as long as certain assets, income and stock ownership tests are met. For 2011 as well as 2010, the Company met all Code requirements for a REIT, including the asset, income, stock ownership and distribution tests. Beginning January 1, 2009, the state of Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single owner. Management believes that the Company would be classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock is held by HCH, a wholly owned subsidiary of the Bank, (2) the Company’s Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. Management believes that the state tax expense incurred by the Company has not had, and in future years should not have, a material adverse effect upon the Company’s ability to declare and pay future dividends on the preferred shares. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock. The Illinois statutory tax rate for 2011 was 9.5%, 7.3% for 2010 and it is expected to be 9.5% for 2012.

 

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The following tables sets forth selected dividend information:

 

     Year Ended December 31, 2011  
     Dividends
per share
     # of Shares      Declared Date      Record Date      Paid Date      Amount in
Thousands
 

Preferred Dividends

   $ .46094         10,000,000         03/02/2011         03/15/2011         03/30/2011       $ 4,609   
     .46094         10,000,000         05/25/2011         06/15/2011         06/30/2011         4,609   
     .46094         10,000,000         08/31/2011         09/15/2011         09/30/2011         4,610   
     .46094         10,000,000         11/30/2011         12/15/2011         12/30/2011         4,610   
                 

 

 

 
                  $ 18,438   
                 

 

 

 

Common Stock Dividends

   $ 294         1,180         05/25/2011         06/01/2011         08/31/2011       $ 347   
     424         1,180         11/30/2011         12/15/2011         12/16/2011         500   
                 

 

 

 
                  $ 847   
                 

 

 

 

 

     Year Ended December 31, 2010  
     Dividends
per share
     # of Shares      Declared Date      Record Date      Paid Date      Amount in
Thousands
 

Preferred Dividends

   $ .46094         10,000,000         03/05/2010         03/15/2010         03/30/2010       $ 4,609   
     .46094         10,000,000         06/11/2010         06/15/2010         06/30/2010         4,609   
     .46094         10,000,000         09/02/2010         09/15/2010         09/30/2010         4,610   
     .46094         10,000,000         12/02/2010         12/15/2010         12/30/2010         4,610   
                 

 

 

 
                  $ 18,438   
                 

 

 

 

No common stock dividends were paid in the fiscal year ended December 31, 2010

 

ITEM 1A. RISK FACTORS

Set forth below and elsewhere in this Report and in other documents filed with the SEC (including the February 5, 1998 Prospectus (the “1998 Prospectus”) for the Offering (SEC File No. 333-40257)), are risks and uncertainties with respect to the Company, the Preferred Shares and the Bank. This Report contains forward-looking statements that involve risks and uncertainties. The Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include those discussed below.

Declining interest rates will reduce earnings of the Company

The Company’s income will consist primarily of interest payments on the earning assets held by it. If there is a decline in interest rates during a period of time when the Company must reinvest payments of interest and principal in respect of its earning assets, the Company may find it difficult to purchase additional earning assets that generate sufficient income to support payment of dividends on the Preferred Shares.

Because the rate at which dividends, if, when and as authorized and declared, are payable on the Preferred Shares is fixed, there can be no assurance that an interest rate environment in which there is a decline in interest rates would not adversely affect the Company’s ability to pay dividends on the Preferred Shares.

Dividends may not be authorized quarterly by our Board of Directors and dividends not authorized will not be paid

Dividends on the Preferred Shares are not cumulative. Consequently, if the Board of Directors does not authorize a dividend on the Preferred Shares for any quarterly period, the holders of the Preferred Shares would

 

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not be entitled to recover such dividend whether or not funds are or subsequently become available. Quarterly dividends may not always be paid on the Preferred Shares. The Board of Directors may determine, in its business judgment, that it would be in the best interests of the Company to pay less than the full amount of the stated dividend on the Preferred Shares or no dividend for any quarter, notwithstanding that funds are available. Factors that may be considered by the Board of Directors in making this determination are the Company’s financial condition and capital needs, the impact of legislation and regulations as then in effect or as may be proposed, economic conditions, and such other factors as the Board of Directors may deem relevant. To remain qualified as a REIT, the Company must distribute annually at least 90% of its “REIT taxable income” (not including capital gains) to stockholders. See “Tax Risks.”

Dividends and operations of the Company restricted by regulation

Because the Company is a subsidiary of the Bank, bank regulatory authorities have the right to examine the Company and its activities. Under certain circumstances, including any determination that the Bank’s relationship to the Company results in an unsafe and unsound banking practice, such regulatory authorities will have the authority to restrict the ability of the Company to transfer assets, to make distributions to its stockholders (including dividends to the holders of Preferred Shares, as described below), or to redeem Preferred Shares, or even to require the Bank to sever its relationship with, or divest its ownership of, the Company. Such actions could potentially result in the Company’s failure to qualify as a REIT.

Payment of dividends on the Preferred Shares could also be subject to regulatory limitations if the Bank became less than “adequately capitalized” for purposes of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). Less than “adequately capitalized” is currently defined as having (i) a total risk-based capital ratio of less than 8.0%, (ii) a Tier 1 risk-based capital ratio of less than 4.0%, or (iii) a Tier 1 leverage ratio of less than 4.0% (or 3.0% under certain circumstances not currently applicable to the Bank). At December 31, 2011, the Bank’s Total risk-based capital ratio was 16.72%, Tier 1 risk-based capital ratio was 14.34% and the Tier 1 leverage ratio was 9.91%. Consequently, the Bank was categorized as “well-capitalized” by its regulator at December 31, 2011.

In addition, the National Bank Act requires all national banks, including the Bank, to obtain prior approval from the OCC if dividends declared by the national bank (including subsidiaries of the national bank (except for dividends paid by such subsidiary to the national bank)) in any calendar year, will exceed its net income for that year, combined with its retained income (as defined in the applicable regulations) for the preceding two years. These provisions apply to a national bank and its subsidiaries on a consolidated basis, notwithstanding the earnings of any subsidiary on a stand-alone basis. Beginning in 2009, the Bank no longer had sufficient capacity to declare and pay dividends without prior regulatory approval of the OCC. As a result, the Company, as an indirect subsidiary of the Bank, became subject to the provisions relating to dividend approval, and the Bank had to receive prior approval from the OCC before the Company declared dividends on the Preferred Shares. Prior approval from the OCC was received for dividend declarations in March 2011, May 2011 and August 2011. Because the Bank’s third quarter 2011 earnings were sufficient to eliminate the need for OCC approval of dividends on the Preferred Shares that were declared by the Company’s Board of Directors in the fourth quarter ending December 31, 2011, the Company was not required to obtain approval from the OCC for such a declaration. Further, the Company was not required to obtain approval from the OCC for dividends on the Preferred Shares declared by the Company’s Board of Directors in March 2012. The need to request similar approvals from the OCC for subsequent quarters will be determined by the Bank’s earnings for those future periods. There is no assurance that the Bank and the Company will not be subject to the requirement to receive prior regulatory approvals for Preferred Shares dividend payments in the future or that, if required, such approvals will be obtained. At this time the Company has no reason to expect that such approvals, if required, will not be received.

On July 5, 2011 Bank of Montreal (“BMO”) completed the acquisition of Milwaukee based Marshall & Ilsley Corporation (“M&I”). M&I merged with and into BMO Financial Corporation (“BFC”) and M&I Marshall and Ilsley Bank and M&I Bank N.A. merged with and into the Bank. The acquisition was subject to an OCC Commitment Letter requiring the Bank to develop and submit a comprehensive capital plan for 2012 to the OCC. The required annual capital plan includes a schedule of capital actions, including external dividend payments by subsidiaries, which must be approved by the Federal Reserve and the OCC. On March 13, 2012 the Federal Reserve informed the Bank that it completed its 2012 Capital Plan Review, and it did not object to the proposed capital distributions through March 31, 2013 submitted to the Federal Reserve pursuant to the 2012 Capital Plan Review.

 

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Automatic exchange for Bank Preferred Shares could occur when value of Bank Preferred Shares is impaired

An investment in the Preferred Shares involves risk with respect to the performance and capital levels of the Bank. A decline in the performance and capital levels of the Bank or the placement of the Bank into conservatorship or receivership could result in the automatic exchange of the Preferred Shares for Bank Preferred Shares, which would be an investment in the Bank and not in the Company. As a result, holders of Preferred Shares would become preferred stockholders of the Bank at a time when the Bank’s financial condition was deteriorating or when the Bank had been placed into conservatorship or receivership. If an Exchange Event occurs, the Bank would likely be unable to pay dividends on the Bank Preferred Shares.

An investment in the Bank is also subject to certain risks that are distinct from the risks associated with an investment in the Company. For example, an investment in the Bank would involve risks relating to the capital levels of, and other federal regulatory requirements applicable to, the Bank, and the performance of the Bank’s loan portfolio. An investment in the Bank is also subject to the general risks inherent in equity investments in depository institutions. In the event of a liquidation of the Bank, the claims of depositors and secured, senior, general and subordinated creditors of the Bank would be entitled to a priority of payment over the claims of holders of equity interests such as the Bank Preferred Shares. As a result, if the Bank were to be placed into receivership, the holders of the Bank Preferred Shares likely would receive, if anything, substantially less than they would have received had the Preferred Shares not been exchanged for Bank Preferred Shares.

Bank Preferred Shares will not be listed on any exchange and markets may not be liquid

Although the Preferred Shares are listed on the New York Stock Exchange, the Bank does not intend to apply for listing of the Bank Preferred Shares on any national securities exchange. Consequently, there can be no assurance as to the liquidity of the trading markets for the Bank Preferred Shares, if issued, or that an active public market for the Bank Preferred Shares would develop or be maintained.

Adverse consequences of failure to qualify as a REIT

The Company intends to operate so as to qualify as a REIT under the Code. No assurance can be given that the Company will be able to continue to operate in a manner so as to qualify as a REIT. Qualification as a REIT involves the application of highly technical and complex Code provisions for which there are only limited judicial or administrative interpretations. The determination of various factual matters and circumstances, not entirely within the Company’s control, may affect the Company’s ability to continue to qualify as a REIT. Although the Company is not aware of any proposal in Congress to amend the tax laws in a manner that would materially and adversely affect the Company’s ability to operate as a REIT, no assurance can be given that new legislation or new regulations, administrative interpretations or court decisions will not significantly change the tax laws in the future with respect to qualification as a REIT or the federal income tax consequences of such qualification.

If, in any taxable year the Company fails to qualify as a REIT, the Company would not be allowed a deduction for distributions to stockholders in computing its taxable income and would be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. As a result, the amount available for distribution to the Company’s stockholders including the holders of the Preferred Shares, would be reduced for the year or years involved. In addition, unless entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost. A failure of the Company to qualify as a REIT would not necessarily give the Company the right to redeem the Preferred Shares, nor would it give the holders of the Preferred Shares the right to have their shares redeemed. Notwithstanding that the Company currently intends to operate in a manner designed to enable it to qualify as a REIT, future economic, market, legal, tax or other considerations may cause the Company to determine that it is in the best interest of the Company and the holders of its Common Stock and Preferred Shares to revoke the REIT election. As long as any Preferred Shares are outstanding, any such determination by the Company may not be made without the approval of a majority of the Independent Directors. The tax law prohibits the Company from electing treatment as a REIT for the four taxable years following the year of such revocation.

 

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REIT requirements with respect to stockholder distributions

To qualify as a REIT under the Code, the Company generally will be required each year to distribute as dividends to its stockholders at least 90% of its “REIT taxable income” (excluding capital gains). Failure to comply with this requirement would result in the Company’s income being subject to tax at regular corporate rates. In addition, the Company will be subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions considered as paid by it with respect to any calendar year are less than the sum of 85% of its ordinary income for the calendar year, 95% of its capital gains net income for the calendar year and any undistributed taxable income from prior periods. Under certain circumstances, banking regulatory authorities may restrict the ability of the Company, as a subsidiary of the Bank, to make distributions to its stockholders. Such a restriction could subject the Company to federal income and excise tax and result in the Company’s failure to meet REIT requirements with respect to stockholder distributions.

Redemption upon occurrence of a Tax Event

At any time following the occurrence of a Tax Event (as defined under “Description of Series A Preferred Shares — Redemption” in the 1998 Prospectus), the Company will have the right to redeem the Preferred Shares in whole but not in part. The occurrence of a Tax Event will not, however, give the holders of the Preferred Shares any right to have such shares redeemed.

Illinois Tax Law Change

Beginning January 1, 2009, Illinois required a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single owner. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock are held by HCH, a wholly owned subsidiary of the Bank, (2) the Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. The 2010 Illinois statutory tax rate was 7.3%, for 2011 it is 9.5% and for 2012 it is anticipated to be 9.5%. Management believes that the Illinois state tax expense to be incurred by the Company has not and in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the Preferred Shares. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock.

Automatic exchange upon occurrence of the Exchange Event

Upon the occurrence of the Exchange Event, the outstanding Preferred Shares will be automatically exchanged on a one-for-one basis into Bank Preferred Shares. Assuming, as is anticipated to be the case, that the Bank Preferred Shares are nonvoting, the Automatic Exchange will be taxable, and each holder of Preferred Shares will have a gain or loss, as the case may be, measured by the difference between the basis of such holder in the Preferred Shares and the fair market value of the Bank Preferred Shares received in the Automatic Exchange. Assuming that such holder’s Preferred Shares were held as capital assets prior to the Automatic Exchange, any gain or loss will be capital gain or loss.

Relationship with the Bank and its affiliates; conflicts of interest

The Bank and its affiliates are involved in virtually every aspect of the Company’s existence. The Bank is the sole holder of the Common Stock of the Company and will administer the day-to-day activities of the Company in its role as Advisor under the Advisory Agreement. The Bank will also act as servicer of the Mortgage Loans on behalf of the Company under the Servicing Agreement. In addition, other than the Independent Directors and Non Bank Directors (as defined in Item 10), all of the officers and directors of the Company are also officers and/or directors of the Bank and/or affiliates of the Bank. Their compensation is paid by the Bank, and they have substantial responsibilities in connection with their work as officers of the Bank. As the holder of all of the outstanding voting stock of the Company, the Bank will have the right to elect all directors of the Company, including the Independent Directors.

 

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The Bank and its affiliates may have interests which are not identical to those of the Company. Consequently, conflicts of interest may arise with respect to transactions, including without limitation, future acquisitions of Mortgage Assets from the Bank and/or affiliates of the Bank; servicing of Mortgage Loans; future dispositions of Mortgage Assets to the Bank; and the renewal, termination or modification of the Advisory Agreement or the Servicing Agreement. It is the intention of the Company and the Bank that any agreements and transactions between the Company, on the one hand, and the Bank and/or its affiliates, on the other hand, are fair to all parties and consistent with market terms, including prices paid and received for the Initial Mortgage Assets, on the acquisition or disposition of Mortgage Assets by the Company or in connection with the servicing of Mortgage Loans. The requirement in the terms of the Preferred Shares that certain actions of the Company be approved by a majority of the Independent Directors is also intended to ensure fair dealings between the Company and the Bank and its affiliates. However, there can be no assurance that such agreements or transactions will be on terms as favorable to the Company as those that could have been obtained from unaffiliated third parties.

Risk of future revisions in policies and strategies by Board of Directors

The Board of Directors has established the investment policies and operating policies and strategies of the Company, all material aspects of which are described in this report. These policies may be amended or revised from time to time at the discretion of the Board of Directors (in certain circumstances subject to the approval of a majority of the Independent Directors) without a vote of the Company’s stockholders, including holders of the Preferred Shares. The ultimate effect of any change in the policies and strategies of the Company on a holder of Preferred Shares may be positive or negative.

Possible leverage

Although the Company does not currently intend to incur any indebtedness in connection with the acquisition and holding of Mortgage Assets, the Company may do so at any time (although indebtedness in excess of 25% of the Company’s total stockholders’ equity may not be incurred without the approval of a majority of the Independent Directors of the Company). To the extent the Company were to change its policy with respect to the incurrence of indebtedness, the Company would be subject to risks associated with leverage, including, without limitation, changes in interest rates and prepayment risk.

Additional issuances of preferred stock could have dilutive effect

The Charter of the Company authorizes 20,000,000 shares of preferred stock, 10,000,000 shares of which have been issued. The Company could issue additional preferred shares that rank equal to the Preferred Shares in the payment of dividends or in the distribution of assets on liquidation without the approval of the holders of the Preferred Shares. Such future issuances could have the effect of diluting the holders of the Preferred Shares.

RISK FACTORS RELATING TO THE BANK

Because of the possibility of the Automatic Exchange, an investment in Preferred Shares involves a high degree of risk with respect to the performance and capital levels of the Bank. Investors in the Preferred Shares should carefully consider the following risk factors and other considerations relating to the Bank before deciding whether to invest in such shares.

Possible adverse effects of economic conditions

Economic conditions beyond the Bank’s control may have a significant impact on the Bank’s operations, including changes in net interest income. Examples of such conditions include: (i) the strength of credit demand by customers; (ii) the introduction and growth of new investment instruments and transaction accounts by nonbank financial competitors; (iii) changes in the general level of interest rates, including changes resulting from the monetary activities of the Board of Governors of the Federal Reserve System; (iv) adverse changes in the economic net worth of loan customers; (v) decline in the general level of employment; and (vi) increased levels of Federal government support and equity infusions intended for banks and other commercial enterprises. Economic growth in the Bank’s market areas is dependent upon the local economy. Continued adverse changes in the economy of the Chicago metropolitan area and other market areas would likely reduce the Bank’s growth

 

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rate and could otherwise have a negative effect on its business, including the demand for new loans, the ability of customers to repay loans and the value of the collateral pledged as security. Additionally, current conditions in credit and funding markets serving both corporate and consumer segments have remained weak, thereby causing a material contraction in the availability of credit as a result of more stringent underwriting standards. The Bank’s housing sector loan portfolio and related losses have primarily been concentrated in its commercial residential developer portfolio, in higher loan-to-value and broker sourced home equity loans as well as in its residential mortgage loan portfolio. The Bank has no significant exposures to sub-prime or ALT-A mortgages. The reduction in credit availability has contributed to reduced demand for new and existing homes, exacerbating an environment characterized by declining home prices and rising rates of foreclosure. A similar credit dynamic has adversely impacted the cost and availability of credit to corporate borrowers, notably in the highly leveraged lower rated credits. The ultimate severity and duration of these developments remain subject to considerable uncertainty and the attendant adverse feedback effects could deepen and exacerbate exposures to the general economic risk factors to which the Bank is exposed.

Acquisition of Marshall and lIsley Corporation

On July 5, 2011, BMO completed the acquisition of Milwaukee-based Marshall & Ilsley Corporation (“M&I”). Immediately upon acquisition, M&I merged with and into BMO Financial Corporation (“BFC”). The results of operations for M&I have been included in BFC’s consolidated financial statements since July 5, 2011. Similarly the primary banking subsidiaries of BFC and M&I were combined on that date under the Bank. This acquisition substantially increased the Bank’s assets, geographic presence, scope of operations and customer base. The Bank continues to incur substantial integration costs in order to fully consolidate M&I legacy operations, activities, personnel, etc. There can be no assurance that the Bank will be profitable or that returns on equity and assets will be maintained at a level comparable to what the resulting Bank would otherwise earn excluding M&I operations.

Increase in interest rates may adversely affect operating results

The Bank’s operating results depend to a large extent on its net interest income, which is the difference between the interest the Bank receives from its loans, securities and other assets and the interest the Bank pays on its deposits and other liabilities. Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Conditions such as inflation, recession, unemployment, money supply, international disorders and other factors beyond the control of the Bank may affect interest rates. If generally prevailing interest rates increase, the “net interest spread” of the Bank, which is the difference between the rates of interest earned and the rates of interest paid by the Bank, is likely to contract, resulting in less net interest income. The Bank’s liabilities generally have shorter terms and are more interest-sensitive than its assets. There can be no assurance that the Bank will be able to adjust its asset and liability positions sufficiently to offset any negative effect of changing market interest rates.

Competition

The Bank faces strong direct competition for deposits, loans and other financial services from other commercial banks, thrifts, credit unions, stockbrokers and finance divisions of auto and farm equipment companies. Some of the competitors are local, while others are statewide or nationwide. Several major multibank holding companies currently operate in the Chicago metropolitan area. Some of these financial institutions are larger than the Bank and have greater access to capital and other resources. Some of the financial institutions and financial services organizations with which the Bank competes are not subject to the same degree of regulation as that imposed on bank holding companies, and federally insured, state-chartered banks and national banks. As a result, such nonbank competitors have advantages over the Bank in providing certain services. The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Bank’s future success will depend in part on its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in the Bank’s operations. Some of the Bank’s competitors have greater resources to invest in technological improvements. There can be no assurance that the Bank will be able to effectively implement such products and services or be successful in marketing such products and services to its customers.

 

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Government regulation

The Bank is subject to extensive federal and state legislation, regulation and supervision. Recently enacted, proposed and future legislation and regulations have had, will continue to have or may have significant impact on the financial services industry. Some of the legislative and regulatory changes may benefit the Bank; others, however, may increase its costs of doing business and assist competitors of the Bank. In recent years, global regulators have proposed reforms that are intended to strengthen the banking sector regulatory capital and liquidity frameworks and strengthen the resilience of individual banking institutions in periods of stress, which are collectively referred to as Basel III. Based on regulatory guidance provided to date, the key building blocks of Basel III from a regulatory capital perspective include:

 

  Ÿ  

raising the quality of capital that banks are required to hold to ensure banks are better able to absorb losses on both a going-concern and liquidation basis;

 

  Ÿ  

increasing risk capital requirements, particularly for market risk, securitizations and counterparty credit risk;

 

  Ÿ  

introducing new regulatory capital ratios—primarily the Common Equity Ratio —to complement the existing Tier 1 Capital Ratio and Total Capital Ratio along with the Leverage Ratio; and

 

  Ÿ  

increasing minimum capital requirements.

The Basel III capital rules are expected to be implemented in a phased approach. The Final requirements and transition period applicable to BFC and the Bank have not yet been established by US Regulators. The final requirements may increase the amount of capital that BFC and the Bank are required to hold, and may have a negative impact on their results of operations.

On July 21, 2010, U.S. President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is referred to as Dodd-Frank. Dodd-Frank is broad in scope and the Bank is currently assessing the impact of the legislation. The reforms include heightened consumer protection, regulation of the over-the-counter derivatives markets, restrictions on proprietary trading by banks, which is referred to as the Volcker Rule, imposition of heightened prudential standards and broader application of leverage and risk-based capital requirements, greater supervision of systemically significant payment, clearing or settlement systems, restrictions on interchange fees, and the creation of a new financial stability oversight council of regulators with the objective of increasing stability by monitoring systemic risks posed by financial services companies and their activities. Many aspects of Dodd-Frank are subject to rulemaking and will take effect over several years, making it difficult to anticipate at this time the overall impact on the Bank or the financial services industry more generally. However, Dodd-Frank is likely to result in an increase in compliance costs and regulatory enforcement, particularly on the Bank’s U.S. business, and could have a negative impact on the Bank’s results of operations.

There can be no assurance that state or federal regulators will not, in the future, impose further restrictions or limits on the Bank’s activities.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

None as of December 31, 2011.

 

ITEM 3. LEGAL PROCEEDINGS

The Company is not currently involved in any material litigation nor, to the Company’s knowledge is any material litigation currently threatened against the Company or the Bank other than routine litigation arising in the ordinary course of business. See Note 10 to Consolidated Financial Statements.

 

ITEM 4. RESERVED

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

HCH presently owns all 1,180 shares of the Common Stock of the Company, which are not listed or traded on any securities exchange. On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company sold 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash, the proceeds of which was used to purchase Mortgage Assets. HCH continues to own 100% of the shares of the Common Stock. On August 31, 2011, the Company paid a cash dividend of $347 thousand (declared on May 25, 2011), on the outstanding common shares to HCH, as the stockholder of record, on June 1, 2011. On December 16, 2011, the Company paid a cash dividend of $500 thousand (declared on November 30, 2011), on the outstanding common shares to HCH, the stockholder of record, on December 15, 2011. No cash dividends were paid on the outstanding common shares during 2010.

The Preferred Shares are traded on the New York Stock Exchange under the symbol “HBC Pr A”. During each calendar year 2011 and 2010, the Company declared and paid $18.4 million in preferred dividends to preferred stockholders. Although the Company declared cash dividends on the Preferred Shares for 2011 and 2010, no assurances can be made as to the declaration of, or if declared, the amount of, future distributions since such distributions are subject to the Company’s financial condition and capital needs; the impact of legislation and regulations as then in effect or as may be proposed; economic conditions; and such other factors as the Board of Directors may deem relevant. Notwithstanding the foregoing, to remain qualified as a REIT, the Company must distribute annually at least 90% of its ordinary taxable income to preferred and /or common stockholders.

The Bank prepares notices relating to the Company’s dividend declaration on the Preferred Shares on the Bank’s website (www.harrisbank.com) under “Corporate Information/News Releases”. The information on the Bank’s website does not constitute a part of this Report.

The Company did not repurchase or redeem any Common Stock or Preferred Shares during 2011 or 2010. The Company did not authorize for issuance any securities of the Company under any equity compensation plans.

 

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ITEM 6. SELECTED FINANCIAL DATA

The following table sets forth selected financial data for the Company and should be read in conjunction with the Consolidated Financial Statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Report.

 

     For the Years Ended December 31  
     2011     2010     2009     2008     2007  
     (in thousands, except per share data)  

Statement of Income Data:

          

Interest income

   $ 17,323      $ 20,466      $ 22,635      $ 21,296      $ 22,524   

Non-interest income

     4,328        326                        
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total income

   $ 21,651      $ 20,792      $ 22,635      $ 21,296      $ 22,524   

Operating expenses:

          

Loan servicing fees paid to BMO Harris Bank N.A.

     9        11        12        15        18   

Advisory fees paid to BMO Harris Bank N.A.

     144        167        196        208        119   

General and administrative

     377        351        399        374        300   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

   $ 530      $ 529      $ 607      $ 597      $ 437   

Applicable state income taxes

     2,006        1,479        1,608                 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 19,115      $ 18,784      $ 20,420      $ 20,699      $ 22,087   

Preferred stock dividends

     18,438        18,438        18,438        18,438        18,438   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income available to common stockholder

   $ 677      $ 346      $ 1,982      $ 2,261      $ 3,649   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Basic and diluted earnings per common share

   $ 574      $ 293      $ 1,680      $ 2,261      $ 3,649   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Distributions per preferred share

   $ 1.8438      $ 1.8438      $ 1.8438      $ 1.8438      $ 1.8438   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance Sheet Data:

          

Total assets

   $ 588,379      $ 586,086      $ 583,574      $ 501,130      $ 492,923   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

   $ 1,755      $ 1,258      $ 1,084      $ 886      $ 3,129   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total stockholders’ equity

   $ 586,624      $ 584,828      $ 582,490      $ 500,244      $ 489,794   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash Flows Data:

          

Net cash provided by operating activities

   $ 15,478      $ 18,736      $ 20,618      $ 20,326      $ 22,235   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) investing activities

   $ 2,730      $ 811      $ (63,682   $ (6,424   $ (3,603
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

   $ (19,285   $ (18,438   $ 59,301      $ (24,088   $ (23,560
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the Consolidated Financial Statements and notes thereto appearing later in this Report.

Summary

Year Ended December 31, 2011 Compared to December 31, 2010

The Company’s net income for 2011 was $19.1 million. This represented a 1.8% increase from 2010 net income of $18.8 million primarily due to gain on sale of securities sold.

Interest income on securities purchased under agreement to resell for the year ended December 31, 2011 was $44 thousand on an average balance of $74 million with an average yield of .06% compared to interest income of $85 thousand on an average balance of $64 million with an average yield of .13% for 2010. Interest income on the Notes for 2011 totaled $186 thousand and yielded 6.2% on $3.0 million of average principal outstanding compared to $222 thousand of interest income yielding 6.4% on $3.5 million of average principal outstanding for 2010. The decrease in interest income from the Notes was attributable to a reduction in the Notes balance because of customer payoffs in the Securing Mortgage Loans. The average outstanding balance of the Securing Mortgage Loans was $3 million for 2011 and $4 million for 2010. Interest income on securities available-for-sale for 2011 was $17.1 million, resulting in a yield of 3.51% on an average balance of $487 million compared to interest income of $20.2 million, with a yield of 4.0% on an average balance of $500 million for 2010.

Gains from investment securities sales were $4.3 million and $326 thousand in 2011 and 2010, respectively.

Operating expenses for the year ended December 31, 2011 totaled $530 thousand compared to $529 thousand in 2010. Loan servicing expenses for 2011 totaled $9 thousand, a decrease of $2 thousand from 2010. The decrease was attributable to the reduction on the principal balance of the Notes. Advisory fees for the year ended December 31, 2011 were $144 thousand compared to $167 thousand a 13.8% decrease from 2010, primarily due to certain charges being reduced due to a reduction in internal costs of the Bank related to expenses of administering the Company’s activities. General and administrative expenses totaled $377 thousand for 2011 and $351 thousand for 2010, a 7.4% increase from 2010 primarily due to an adjustment reducing insurance costs in 2010.

Year Ended December 31, 2010 Compared to December 31, 2009

The Company’s net income for 2010 was $18.8 million. This represented an 8% decrease from 2009 net income of $20.4 million. Earnings decreased primarily because of a reduction in interest income on portfolio securities as market yields have declined significantly.

Interest income on securities purchased under agreement to resell for the year ended December 31, 2010 was $85 thousand on an average balance of $64 million with an average yield of .13% compared to interest income of $31 thousand on an average balance of $33 million with an average yield of .09% for 2009. Interest income on the Notes for 2010 totaled $222 thousand and yielded 6.4% on $3.5 million of average principal outstanding compared to $246 thousand and a 6.4% yield on $3.9 million average principal outstanding for 2009. The decrease in interest income from the Notes was attributable to a reduction in the Notes balance because of customer payoffs in the Securing Mortgage Loans. The average outstanding balance of the Securing Mortgage Loans was $4 million for 2010 and $5 million for 2009. Interest income on securities available-for-sale for 2010 was $20.2 million, resulting in a yield of 4.0% on an average balance of $500 million compared to interest income of $22.4 million with a yield of 4.3% on an average balance of $518 million for 2009. There were no Company borrowings during either year.

Gains from investment securities sales were $326 thousand in 2010. There were no investment securities sales in 2009 or 2008.

 

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Operating expenses for the year ended December 31, 2010 totaled $529 thousand compared to $607 thousand in 2009. Loan servicing expenses for 2010 totaled $11 thousand, a decrease of $1 thousand from 2009. This decrease was attributable to the reduction in the principal balance of the Notes. Advisory fees for the year ended December 31, 2010 were $167 thousand compared to $196 thousand, a 14.8% decrease from 2009, primarily due to certain charges for treasury services being assessed directly rather than as part of advisory fees in the current year. General and administrative expenses totaled $351 thousand for 2010 and $399 thousand for 2009, a 12.0% decrease from 2009 primarily as a result of decreased costs for insurance and legal fees partially offset by higher treasury costs.

Quarter Ended December 31, 2011 Compared to Quarter Ended December 31, 2010

The Company’s net income for the fourth quarter of 2011 was $3.4 million and for the fourth quarter of 2010 was $4.6 million.

Interest income on securities available-for-sale for the current quarter was $3.9 million resulting in a yield of 3.2% on an average balance of $481 million, compared to interest income of $4.8 million with a yield of 3.8% on an average balance of $508 million for the same period a year ago. The decrease in these assets largely reflected the challenge of generating suitable returns on new investments because of lower market interest rates. Interest income on the Notes for the fourth quarter 2011 totaled $38 thousand and yielded 6.1% on $3.0 million of average principal outstanding compared to $54 thousand and yielded 6.4% on $3.4 million of average principal outstanding. The decrease in interest income from the Notes was attributable to a reduction in the Notes balance because of customer payoffs in the Securing Mortgage Loans. Interest income on securities purchased under agreement to resell for the current quarter was $7 thousand on an average balance of $80 million resulting in an average yield of 0.03% compared to interest income of $23 thousand on an average balance of $63 million with an average yield of 0.15% for the same period in the year-ago quarter.

There were no Company borrowings during the fourth quarter of 2011 or 2010.

Fourth quarter 2011 operating expenses totaled $162 thousand, an increase of $8 thousand from the fourth quarter of 2010. Advisory fees for the fourth quarter of 2011 were $38 thousand compared to $31 thousand in the prior year’s fourth quarter. Loan servicing fees for the fourth quarter of 2011 was $2 thousand and 2010 was $3 thousand. General and administrative expenses totaled $122 thousand both in the current quarter and for the same period in 2010.

Allowance for Loan Losses

The Company does not currently maintain an allowance for loan losses due to the over-collateralization of the Securing Mortgage Loans and the prior and expected credit performance of the collateral pool and because the Company can, under certain conditions, require the Bank to dispose of nonperforming Mortgage Loans.

Concentrations of Credit Risk

The MBS portfolio securities currently held by the Company are all various issues of federal agency guaranteed conventional pass-through securities. The credit guarantees extended by Fannie Mae and FHLMC are characterized as full modification guarantees whereby the timely payment of both interest and principal is assured by the respective sponsoring federal agency.

A majority of the collateral underlying the Securing Mortgage Loans is located in Illinois. The financial viability of customers in this state is, in part, dependent on the state’s economy. The collateral may be subject to a greater risk of default than other comparable loans in the event of adverse economic, political or business developments or natural hazards that may affect such region and the ability of property owners in such region to make payments of principal and interest on the underlying mortgages. The Company’s maximum risk of accounting loss, should all customers in Illinois fail to perform according to contract terms and all collateral prove to be worthless, was approximately $2.1 million at December 31, 2011 and $2.6 million at December 31, 2010.

 

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Interest Rate Risk

The Company’s income consists primarily of interest payments received on the Mortgage Assets and the securities it holds. If there is a decline in interest rates during a period of time when the Company must reinvest payments of interest and principal with respect to its Mortgage Assets and other interest earning assets, the Company may find it difficult to purchase additional earning assets that generate sufficient income to support payment of dividends on the Preferred Shares. Because the rate at which dividends, if, when and as authorized and declared, are payable on the Preferred Shares is fixed, there can be no assurance that an interest rate environment in which there is a decline in interest rates would not adversely affect the Company’s ability to pay dividends on the Preferred Shares.

Competition

The Company does not engage in the business of originating mortgage loans. While the Company may acquire additional Mortgage Assets, it anticipates that such assets will be acquired from the Bank, affiliates of the Bank or unaffiliated parties. Accordingly, the Company does not expect to compete with mortgage conduit programs, investment banking firms, savings and loan associations, banks, thrift and loan associations, finance companies, mortgage bankers or insurance companies in originating Mortgage Assets.

Liquidity Risk Management

The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company’s financial commitments. In managing liquidity, the Company takes into account various legal limitations placed on a REIT.

The Company’s principal liquidity needs are to maintain the current portfolio size through the acquisition of additional qualifying assets and to pay dividends to its stockholders after satisfying obligations to creditors. The acquisition of additional qualifying assets is funded with the proceeds obtained from repayment of principal balances by individual mortgages or maturities of securities held for sale on a reinvested basis. The payment of dividends on the Preferred Shares will be made from legally available funds, principally arising from operating activities of the Company. The Company’s cash flows from operating activities principally consist of the collection of interest on short term qualifying investments, the Notes and mortgage-backed securities. The Company does not have and does not anticipate having any material capital expenditures.

In order to remain qualified as a REIT, the Company must distribute annually at least 90% of its adjusted REIT ordinary taxable income, as provided for under the Code, to its common and preferred stockholders. The Company currently expects to distribute dividends annually equal to 90% or more of its adjusted REIT ordinary taxable income.

The Company anticipates that cash and cash equivalents on hand and the cash flow from the Notes, short-term investments and mortgage-backed securities will provide adequate liquidity for its operating, investing and financing needs including the capacity to continue preferred dividend payments on an uninterrupted basis.

As presented in the accompanying consolidated Statement of Cash Flows, the primary sources of funds in addition to the $15.5 million provided from operations during 2011 were $504.5 million from the maturities and sales of securities available-for-sale. In 2010, the primary sources of funds other than $18.7 million provided from operations were $395.3 million from the maturities and sales of securities available-for-sale. The primary uses of funds for 2011 were $502.6 million in purchases of securities available-for-sale and $18.4 million and $847 thousand in Preferred Share dividends and Common Stock dividends paid, respectively. In 2010, the primary uses of funds were $394.5 million in purchases of securities available-for-sale and $18.4 million in Preferred Share dividends

Accounting Pronouncements

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructung, in April 2011. The update clarifies the existing guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring is a troubled debt restructuring. The Company’s adoption of this standard during the third quarter 2011 had no impact on the Company’s financial position or results of operations.

 

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The FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreement in April 2011. The ASU removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and the collateral maintenance implementation guidance related to that criterion. The ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and is to be applied prospectively to new transactions or modifications of existing transactions that occur on or after the effective date. Repurchase transactions entered into by the Company are accounted for as secured borrowings; therefore, the adoption of this ASU, effective January 1, 2012 is not expected to have an impact on the Company’s consolidated financial position or results of operations.

The FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, in May 2011. The update provides guidance about how fair value should be applied where it is already required or permitted under U.S. GAAP and International Financial Reporting Standards (“IFRS”). The standard results in common requirements for fair value measurement and disclosure in U.S. GAAP and IFRS and does not extend the use of fair value. The amendment will be effective for the Company for the annual reporting period ending December 31, 2012. The Company is in process of assessing the impact of adopting this standard on its financial position and results of operations.

The FASB issued ASU 2011-05, Presentation of Comprehensive Income, in June 2011. The update eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. It requires companies to present reclassification adjustments from other comprehensive income to net income in the statements of net income and other comprehensive income. The amendment will be effective for the Company for the annual reporting period ending December 31, 2012. The Company is in the process of assessing the impact of adopting this standard on its financial position and results of operations.

Tax Matters

As of December 31, 2011, the Company believes that it is in full compliance with the REIT federal income tax rules, and expects to qualify as a REIT under the provisions of the Code. The Company expects to meet all REIT requirements regarding the ownership of its stock and anticipates meeting the annual distribution requirements. Beginning January 1, 2009, Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single owner. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock is held by HCH, a wholly-owned subsidiary of the Bank, (2) the Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. Management believes that the state tax expense incurred by the Company in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the preferred shares. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock. The Illinois statutory tax rate for 2011 is 9.5% and the tax rate for 2012 is expected to be 9.5%. For the fourth quarter and twelve months of 2011, $356 thousand and $2 million of Illinois income tax expense was recorded, respectively. For the fourth quarter and twelve months of 2010, $367 thousand and $1.5 million of Illinois income tax expense was recorded, respectively.

Ratings Adjustment

On January 22, 2010, Moody’s Investors Services, Inc. (“Moody’s”) downgraded its long-term ratings for Bank of Montreal (“BMO”) (the Company’s ultimate parent). BMO’s deposit rating dropped to Aa2 from Aa1 and its bank financial strength rating (BFSR) fell to B- from B. Further, Moody’s downgraded BMO’s preferred stock securities (which include non-cumulative preferred shares and other hybrid capital instruments) four notches to BaaI from Aa3. The first notch reflected the BFSR downgrade. The other three notches were a consequence of Moody’s implementing a revised methodology for rating bank hybrid securities. At that time, Moody’s downgraded the bank financial strength rating of the Bank to C+ from B-. In addition, Moody’s

 

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lowered its rating for the Company’s Preferred Stock from A2 to Baa1 and described this action as reflecting both the BFSR downgrade and Moody’s implementation of the aforementioned revised methodology.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As of December 31, 2011, the Company had $2.5 million invested in Notes, a decrease of $881 thousand from December 31, 2010. The decline was attributable to customer payoffs in the Securing Mortgage Loans. At December 31, 2011, the Company held $461 million in residential mortgage-backed securities compared to $517 million at December 31, 2010. At December 31, 2011 the Company has $100 million in U.S. Treasury Securities and at December 31, 2010, the Company had $40 million in U.S. Treasury Securities. At December 31, 2011, the Company held an investment of $22.0 million in securities purchased from the Bank under agreement to resell compared to $23.5 million at December 31, 2010. The Company is subject to exposure for fluctuations in interest rates. Adverse changes in interest rates could impact negatively the value of mortgage-backed securities, as well as the levels of interest income to be derived from these assets.

The following table stratifies the Company’s available-for-sale securities as of December 31, 2011 by maturity date (in thousands of dollars):

 

     Year Ending December 31                    Fair Value at  
     2012      2013      2014      2015      2016      Thereafter      Total      December 31, 2011  

Residential mortgage-backed

                       

Amortized cost

   $       $ 3,517       $       $       $       $ 439,816       $ 443,333       $ 461,356   

Average Yield

             4.00%                                 3.84%         3.84%      

US Treasuries

                       

Amortized cost

   $ 100,000                                               $ 100,000       $ 100,000   

Average Yield

     0.00%                                                 0.00%      

The Company’s investments held in residential mortgage-backed securities are secured by adjustable and fixed interest rate residential mortgage loans. The yield to maturity on each security depends on, among other things, the price at which each such security is purchased, the rate and timing of principal payments (including prepayments, repurchases, defaults and liquidations), the pass-through rate and interest rate fluctuations. Changes in interest rates could impact prepayment rates as well as default rates, which in turn would impact the value and yield to maturity of the Company’s residential mortgage-backed securities.

The Company currently has no outstanding borrowings.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Refer to the Index to Consolidated Financial Statements for the required information.

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There have been no disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure.

 

ITEM 9A. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As of December 31, 2011, Paul R. Skubic, the Chairman of the Board, Chief Executive Officer and President of the Company, and Pamela C. Piarowski, the Chief Financial Officer of the Company, evaluated the effectiveness of the disclosure controls and procedures of the Company (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) and concluded that these disclosure controls and procedures are effective to ensure that material information for the Company required to be included in this Report has been made known to them in a timely fashion.

 

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Management’s Report on Internal Control over Financial Reporting

The management of Harris Preferred Capital Corporation is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Harris Preferred Capital Corporation’s management, including the Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our internal control over financial reporting using the framework and criteria established in Internal Control–Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that internal control over financial reporting was effective as of December 31, 2011.

This report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to an exemption for non-accelerated filers under Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal controls over financial reporting identified in connection with such evaluations that occurred during the quarter ended December 31, 2011 that have materially affected or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

ITEM 9B. OTHER INFORMATION

Not applicable.

PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The Company’s Board of Directors consists of five members. The Company does not anticipate that it will require any employees because it has retained the Bank to perform certain functions pursuant to the Advisory Agreement described above. Each officer of the Company currently is also an officer of the Bank and/or affiliates of the Bank. The Company maintains corporate records and audited financial statements that are separate from those of the Bank or any of the Bank’s affiliates. None of the officers, directors or employees of the Company will have a direct or indirect pecuniary interest in any Mortgage Asset to be acquired or disposed of by the Company or in any transaction in which the Company has an interest or will engage in acquiring, holding and managing Mortgage Assets.

Pursuant to terms of the Preferred Shares, the Company’s Independent Directors (as defined in Item 13 (c) below) will consider the interests of the holders of both the Preferred Shares and the Common Stock in determining whether any proposed action requiring their approval is in the best interests of the Company.

 

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The persons who are directors and executive officers of the Company are as follows:

 

Name

   Age     

Position and Offices Held

Paul R. Skubic

     63       Chairman of the Board, President

Pamela C. Piarowski

     52       Chief Financial Officer, Treasurer

Margaret M. Sulkin

     53       Assistant Treasurer

Delbert J. Wacker

     80       Director

David J. Blockowicz

     69       Director

Forrest M. Schneider

     64       Director

Frank M. Novosel

     65       Director

The following is a summary of the business experience of the directors of the Company:

Mr. Skubic has been a director of the Company since inception, January 2, 1998. Mr. Skubic was Vice President and Controller of the Bank and Chief Accounting Officer for Harris Bankcorp, Inc. and the Bank since 1990 to 2011. In July, 2011, Mr. Skubic became Vice President Financial Strategy for the Bank. Prior to joining Harris Bankcorp, Inc., Mr. Skubic was employed by Arthur Andersen & Co. He is a Certified Public Accountant. Based primarily upon Mr. Skubic’s extensive 21 year management and leadership experience as the Vice President and Controller of a national banking association and as the Chief Accounting Officer for Harris Bankcorp, Inc.; strong strategic planning, accounting, financial, banking and risk analysis skills and experience; and tenure and contributions as a current officer, Board member and Board committee member, the Board and the Company’s common stockholder determined that Mr. Skubic should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.

Mr. Wacker has been a director of the Company since inception, January 2, 1998. Mr. Wacker is a retired partner from Arthur Andersen & Co. since 1987 after 34 years. From July 1988 to November 1990, he was Vice President -Treasurer, Parkside Medical Services, a subsidiary of Lutheran General Health System. From November 1990 to September 1993, he completed various financial consulting projects for Lutheran General. He is a Certified Public Accountant. Based primarily upon Mr. Wacker’s extensive 40-year management and leadership experience as a former partner of a national accounting firm and as former Vice President-Treasurer and financial consultant for a health care system; strong accounting, financial and risk analysis skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board and the Company’s common stockholder determined that Mr. Wacker should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.

Mr. Blockowicz has been a director of the Company since inception, January 2, 1998. Mr. Blockowicz is a Certified Public Accountant and is a partner with Blockowicz & Tognocchi LLC. Prior to forming his firm, Mr. Blockowicz was a partner with Arthur Andersen & Co. through 1990. Blockowicz & Tognocchi LLC is a professional tax consulting firm and is not a parent, subsidiary or other affiliate of the Company. Based primarily upon Mr. Blockowicz’s extensive 33-year management and leadership experience as a former partner of a national accounting firm and as a partner of a professional tax consulting firm; strong taxation, accounting and financial skills and experience; and tenure and contributions as a current Board member and Board committee chairperson, the Board and the Company’s common stockholder determined that Mr. Blockowicz should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.

Mr. Schneider has been a director of the Company since 2000. Mr. Schneider is a retired Vice President of Lane Industries, Inc (until September 30, 2010 Mr. Schneider served as President and Chief Executive Officer of Lane Industries). Mr. Schneider has been a director of Lane Industries, a diversified holding company from 2000 until September 30, 2010. He was originally employed by Lane Industries in 1976. Lane Industries is not a parent, subsidiary or other affiliate of the Company. He is a graduate of the University of Illinois at Chicago, where he received his B.S. in Finance. He also holds a M.S. in Finance from the University of Illinois at Urbana, Champaign. Mr. Schneider served as a director of General Binding Corporation (NASDAQ) from 2000 until 2005 and served on the governance and compensation committees. Mr. Schneider served as a director of ACCO Brands Corporation (NYSE) from 2005 until 2006. Based primarily upon Mr. Schneider’s extensive 10 year executive management and leadership experience as a President, Chief Executive Officer and director of a

 

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diversified holding company; strong strategic planning, financial, risk analysis and administrative skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board and the Company’s common stockholder determined that Mr. Schneider should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.

Mr. Novosel has been a director of the Company since inception, January 2, 1998. Mr. Novosel was a Vice President in the Treasury Group of the Bank from 1995 and served as Treasurer of the Company until his retirement from the Bank in November, 2008. Previously, he served as Treasurer of Harris Bankcorp, Inc. Mr. Novosel is a Chartered Financial Analyst and a member of the CFA Society of Chicago. Based primarily upon Mr. Novosel’s extensive 25-year management and leadership experience as a former Vice President of the Bank and former Treasurer of the Company; strong strategic planning, financial, banking and risk analysis skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board and the Company’s common stockholder determined that Mr. Novosel should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.

The following is a summary of the business experience of the executive officers who are not directors of the Company:

Ms. Piarowski has been Chief Financial Officer of the Company since May 31, 2006 and Treasurer since 2008, although she previously served as Chief Financial Officer of the Company from June 2001 through July 2003. In 2003, she was appointed Vice-President, Financial Performance Management, Bank of Montreal. In April, 2006 she was appointed Vice-President and Chief Financial Officer, BMO US. As of January 25, 2012 she was appointed Senior Vice-President Finance BMO Financial Corp. She is a certified public accountant.

Ms. Sulkin has been a Vice President in the Taxation Department of the Bank since 1992. Ms. Sulkin has been employed by the Bank since 1984. Prior to joining the Bank, she was employed by KPMG LLP. She is a certified public accountant.

Independent Directors

The terms of the Preferred Shares require that, as long as any Preferred Shares are outstanding, certain actions by the Company be approved by a majority of the Company’s Independent Directors (as defined in Item 13 (c) below). Delbert J. Wacker, David J. Blockowicz, Frank M. Novosel and Forrest M. Schneider are the Company’s Independent Directors.

If at any time the Company fails to declare and pay a quarterly dividend payment on the Preferred Shares, the number of directors then constituting the Board of Directors of the Company will be increased by two at the Company’s next annual meeting and the holders of Preferred Shares, voting together with the holders of any other outstanding series of preferred stock as a single class, will be entitled to elect two additional directors to serve on the Company’s Board of Directors. Any member of the Board of Directors elected by holders of the Company’s Preferred Shares will be deemed to be an Independent Director for purposes of the actions requiring the approval of a majority of the Independent Directors.

Audit Committee

The Board of Directors of the Company has established an Audit Committee, with an approved Audit Committee Charter, which will review the engagement of an independent registered public accounting firm and review their independence. The Audit Committee will also review the adequacy of the Company’s internal accounting controls. The Audit Committee is comprised of Delbert J. Wacker, David J. Blockowicz and Forrest M. Schneider. David J.Blockowicz is the chairperson of the Audit Committee. The Company’s Board of Directors has determined that each member of the Audit Committee is an Audit Committee financial expert as defined in rules of the Securities and Exchange Commission. Each Audit Committee member is an Independent Director (as defined in Item 13 (c) below).

Investment Committee

The Board of Directors of the Company has established an Investment Committee, with an approved Investment Committee Charter, which will assist the Board of Directors in discharging its oversight responsibilities in reviewing the Company’s investment policies, strategies, transactions and performance, and in

 

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overseeing the Company’s capital and financial resources. The Investment Committee is required to be composed of at least two members of the Board of Directors, with one appointed chairperson. The Investment Committee is comprised of the Committee chairperson, Frank M. Novosel and Paul R. Skubic.

Compensation of Directors

The Company pays directors who are not currently officers of the Bank or its affiliates (“Non Bank Director”) and Independent Directors (as defined in Item 13 (c) below) fees for their services as directors. For the Company’s 2011 fiscal year, Non Bank Directors and Independent Directors received a fee of $3,000 per quarter, and the members of the Investment Committee received $4,000 per quarter. Directors also received $1,000 for each meeting of the Board of Directors or Audit Committee that they attended as members. The following table shows the compensation received in 2011. The Company has not paid and does not currently intend to pay any compensation to directors who are not Independent Directors or to Non Bank Directors or who are active Bank officers.

For the Company’s 2012 fiscal year, Non Bank Directors and Independent Directors will receive a fee of $4,000 per quarter, and the members of the Investment Committee will receive $6,000 per quarter. Directors will also receive $1,200 for each meeting of the Board of Directors or Audit Committee that they attend as members.

 

Name

   Fees Earned
or Paid in
Cash
     Stock
Awards
($)
   Option
Awards
($)
   Non-Equity
Incentive Plan
Compensation
($)
   Non-Qualified
Deferred
Compensation
Earnings

($)
   All Other
Compensation
($)
  Total  

Delbert J. Wacker *

   $ 20,000                     $ 20,000   

David J. Blockowicz *

     20,000                       20,000   

Forrest M. Schneider *

     20,000                       20,000   

Frank M. Novosel **

     32,000                       32,000   
  

 

 

    

 

  

 

  

 

  

 

  

 

 

 

 

 
   $ 92,000                     $ 92,000   

 

  * Represents $16,000 in compensation received as Independent Director and $4,000 in compensation received as an Audit Committee Member.

 

** Represents $16,000 in compensation received as a Independent Director and $16,000 in compensation received as an Investment Committee Member.

The Company has adopted a code of ethics for its senior officers, including the executive officers, which is filed as an Exhibit hereto.

Section 16(a) Beneficial Ownership Reporting Compliance

Based on a review of reports filed with respect to the year ended December 31, 2011, the Company believes that all ownership reports were filed on a timely basis.

 

ITEM 11. EXECUTIVE COMPENSATION

The Company has not paid and does not currently intend to pay any compensation to its officers or employees or to directors who are not Independent Directors or Non Bank Directors or who are active Bank officers.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

(a)    Security ownership of certain beneficial owners

No person owns of record or is known by the Company to own beneficially more than 5% of the outstanding 7 3/8% Noncumulative Exchangeable Preferred Stock, Series A.

 

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(b)    Security Ownership of Management

The following table shows the ownership as of March 23, 2012 of 7 3/8% Noncumulative Exchangeable Preferred Stock, Series A, by the officers or directors who own any such shares.

 

Title of Class

 

Name of

Beneficial Owner

 

Amount of

Beneficial Ownership

 

Percent

of Class

Preferred Stock

  Paul R. Skubic   8,625 Shares   .032%

Preferred Stock

  Forrest Schneider   8,965 Shares   .033%

Preferred Stock

  David J. Blockowicz   3,300 Shares   .012%

Preferred Stock

  Frank M. Novosel   3,500 Shares   .013%

Preferred Stock

  Delbert Wacker   3,000 Shares   .011%

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

(a)    Transactions with Related Persons

The Bank, through its wholly-owned subsidiary, HCH, indirectly owns 100% of the Common Stock of the Company. Paul R. Skubic, Chairman of the Board of the Company, and its executive officers, Pamela C. Piarowski, and Margaret M. Sulkin, are also officers of the Bank.

A substantial portion of the assets of the Company initially consisted of Notes issued by the Bank. The Notes mature on October 1, 2027 and pay interest at 6.4% per annum. During 2011, 2010 and 2009 the Company received repayments on the Notes of $881 thousand, $215 thousand and $700 thousand, respectively. In years ended December 31, 2011, 2010 and 2009 the Bank paid interest on the Notes in the amount of $186 thousand, $222 thousand and $246 thousand, respectively, to the Company.

The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. At December 31, 2011, the Company held $22 million of such assets and earned $44 thousand of interest from the Bank during 2011. At December 31, 2010, the Company held $24 million of such assets and earned $85 thousand of interest for 2010. At December 31, 2009, the Company held $22 million of such assets and earned $31 thousand of interest for 2009. The Company receives rates on these assets comparable to the rates that the Bank offers to unrelated counterparties under similar circumstances.

The Bank and the Company have entered into a Servicing Agreement and an Advisory Agreement, the terms of which are described in further detail on page 5 of this report. In 2011, the Bank received payments of $9 thousand and $144 thousand, respectively, compared to $11 thousand and $167 thousand for 2010, under the terms of these agreements. In 2009, the Bank received payments of $12 thousand and $196 thousand for 2009, under the terms of these agreements.

(b)    Review, Approval or Ratification of Transactions with Related Persons

The terms of the Preferred Shares require that, as long as any Preferred Shares are outstanding, certain actions by the Company, including transactions with the Bank and other related persons, be approved by a majority of the Independent Directors (as defined in the following paragraph). Each of the transactions described in Item 13(a) above was approved by a majority of the Independent Directors.

(c)    Director Independence

The Articles of Incorporation (the “Charter”) of the Company defines an “Independent Director” as one who is not a current officer or employee of the Company or a current director, officer or employee of the Bank or of its affiliates. In addition, pursuant to the Charter, so long as the Preferred Shares are listed for trading on the New York Stock Exchange, a director shall not be deemed to be an “Independent Director” unless he or she meets the applicable requirements for independence as set forth under New York Stock Exchange rules and regulations.

 

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Table of Contents
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

Audit Fees

For the years ended December 31, 2011 and 2010, the Company’s principal accountant billed $66 thousand and $65 thousand, respectively, for the audit of the Company’s annual financial statements and review of financial statements included in Form 10-Q filings.

Audit-Related Fees

There were no fees billed for services reasonably related to the performance of the audit or review of the Company’s financial statements outside of those fees disclosed above under “Audit Fees” for the years ended December 31, 2011 and 2010.

Tax Fees

There were no fees billed for tax-related services for the years ended December 31, 2011 and 2010.

All Other Fees

There were no other fees billed to the Company by the Company’s principal accountants other than those disclosed above for the years ended December 31, 2011 and 2010.

Pre-Approval Policies and Procedures

Prior to engaging accountants to perform a particular service, the Board of Directors obtains an estimate for the service to be performed. All of the services described above were approved by the Audit Committee and Board of Directors in accordance with its procedures.

PART IV

 

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a) Documents filed with Report:

(1) Consolidated Financial Statements (See page 27 for a listing of all financial statements included in Item 8)

(2) Financial Statement Schedules

All schedules normally required by Form 10-K are omitted since they are either not applicable or because the required information is shown in the financial statements or notes thereto.

(3) Exhibits:

 

*3(a)(I)

   Articles of Incorporation of the Company, as amended

**3(b)

   Bylaws of the Company

***4

   Specimen of certificate representing Series A Preferred Shares

***10(a)

   Form of Servicing Agreement between the Company and the Bank

***10(b)

   Form of Advisory Agreement between the Company and the Bank

***10(c)

   Form of Bank Loan Agreement between the Company and the Bank

***10(d)

   Form of Mortgage Loan Assignment Agreement between the Company and the Bank

14

   Code of Ethics for Senior Officers (Incorporated by reference to Exhibit 14 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003)

24

   Power of attorney

31.1

   Certification of Pamela C. Piarowski pursuant to Rule 13a — 14(a)

 

26


Table of Contents

31.2

   Certification of Paul R. Skubic pursuant to Rule 13a — 14(a)

32.1

   Certification pursuant to 18 U.S.C. Section 1350

101.INS*****

   XBRL Instance Document

101.SCH*****

   XBRL Taxonomy Extension Schema Document

101.CAL*****

   XBRL Taxonomy Extension Calculation Linkbase Document

101.LAB*****

   XBRL Taxonomy Extension Label Linkbase Document

101.PRE*****

   XBRL Taxonomy Extension Presentation Linkbase Document

101.DEF*****

   XBRL Taxonomy Extension Definition Linkbase Document

 

        * Incorporated by reference to Exhibit 3.1 filed with the Company’s Form 8-K dated March 4, 2009.

 

      ** Incorporated by reference to Exhibit 3.1 filed with the Company’s Form 8-K dated August 31, 2007.

 

    *** Incorporated by reference to the exhibit of the same number filed with the Company’s Registration Statement on Form S-11 (Securities and Exchange Commission file number 333-40257)

 

***** XBRL information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934, and is not subject to liability under those sections, is not part of any registration statement or prospectus to which it relates and is not incorporated or deemed to be incorporated by reference into any registration statement, prospectus or other document

 

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Index to Consolidated Financial Statements

The following consolidated financial statements are included in Item 8 of this Annual Report on Form 10-K:

 

Harris Preferred Capital Corporation

  

Report of Independent Registered Public Accounting Firm

     30   

Consolidated Balance Sheets

     31   

Consolidated Statements of Income and Comprehensive Income

     32   

Consolidated Statements of Changes in Stockholders’ Equity

     33   

Consolidated Statements of Cash Flows

     34   

Notes to Consolidated Financial Statements

     35   

BMO Harris Bank N.A.

  

Financial Review

     45   

Independent Auditors’ Report

     48   

Consolidated Statements of Condition

     49   

Consolidated Statements of Operations

     50   

Consolidated Statements of Comprehensive Income (Loss)

     51   

Consolidated Statements of Changes in Stockholder’s Equity

     52   

Consolidated Statements of Cash Flows

     53   

Notes to Consolidated Financial Statements

     56   

All schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements and notes hereof.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Harris Preferred Capital Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 23rd day of March, 2012.

 

 

/s/ PAUL R. SKUBIC

 

Paul R. Skubic

 

Chairman of the Board and President and CEO

 

(Principal Executive Officer)

 

 

/s/ PAMELA C. PIAROWSKI

 

Pamela C. Piarowski

 

Chief Financial Officer and Chief Accounting Officer

 

(Principal Financial and Accounting Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by Paul R. Skubic, Chairman of the Board and President of the Company, as attorney-in-fact for the following Directors on behalf of Harris Preferred Capital Corporation of the 23rd day of March 2012.

 

David J. Blockowicz    Forrest M. Schneider
Frank M. Novosel    Delbert J. Wacker

Paul R. Skubic

Attorney-In-Fact

Supplemental Information

No proxy statement will be sent to security holders in 2012.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and Board of Directors of

Harris Preferred Capital Corporation:

We have audited the accompanying consolidated balance sheets of Harris Preferred Capital Corporation and subsidiary (the Company) as of December 31, 2011 and 2010, and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harris Preferred Capital Corporation and subsidiary as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.

/s/KPMG LLP

Chicago, Illinois

March 23, 2012

 

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Table of Contents

Harris Preferred Capital Corporation

Consolidated Balance Sheets

 

     December 31
2011
    December 31
2010
 
     (in thousands, except share
data)
 

Assets

  

Cash on deposit with BMO Harris Bank N.A.

   $ 948      $ 525   

Securities purchased from BMO Harris Bank N.A. under agreement to resell

     22,000        23,500   
  

 

 

   

 

 

 

Total cash and cash equivalents with BMO Harris Bank N.A.

   $ 22,948      $ 24,025   

Notes receivable from BMO Harris Bank N.A.

     2,488        3,369   

Securities available for sale, at fair value

    

Mortgage-backed

     461,356        516,911   

U.S. Treasury Bills

     100,000        40,000   

Other assets

     1,587        1,781   
  

 

 

   

 

 

 

Total assets

   $ 588,379      $ 586,086   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

  

Accrued expenses

   $ 111      $ 114   

Accrued taxes payable and deferred tax liabilities

     1,644        1,144   
  

 

 

   

 

 

 

Total liabilities

   $ 1,755      $ 1,258   
  

 

 

   

 

 

 

Stockholders’ Equity

    

7 3/8% Noncumulative Exchangeable Preferred Stock, Series A ($1 par value); liquidation value of $250,000; 20,000,000 shares authorized; 10,000,000 shares issued and outstanding

   $ 250,000      $ 250,000   

Common stock ($1 par value); 5,000 shares authorized; 1,180 issued and outstanding

     1        1   

Additional paid-in capital

     320,733        320,733   

Distributions in Excess of Earnings

     (425     (255

Accumulated other comprehensive income

     16,315        14,349   
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 586,624      $ 584,828   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 588,379      $ 586,086   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

Harris Preferred Capital Corporation

Consolidated Statements of Income

and Comprehensive Income

 

     For the Years Ended
December 31
 
      2011      2010      2009  
     (in thousands)  

Interest income:

        

Securities purchased from BMO Harris Bank N.A. under agreement to resell

   $ 44       $ 85       $ 31   

Notes receivable from BMO Harris Bank N.A.

     186         222         246   

Securities available for sale:

        

Mortgage-backed

     17,091         20,152         22,356   

U.S. Treasury Bills

     2         7         2   
  

 

 

    

 

 

    

 

 

 

Total interest income

   $ 17,323       $ 20,466       $ 22,635   
  

 

 

    

 

 

    

 

 

 

Noninterest income:

        

Gain on sale of securities

     4,328         326           
  

 

 

    

 

 

    

 

 

 

Total income

   $ 21,651       $ 20,792       $ 22,635   
  

 

 

    

 

 

    

 

 

 

Operating expenses:

        

Loan servicing fees paid to BMO Harris Bank N.A.

   $ 9       $ 11       $ 12   

Advisory fees paid to BMO Harris Bank N.A.

     144         167         196   

General and administrative

     377         351         399   
  

 

 

    

 

 

    

 

 

 

Total operating expenses

   $ 530       $ 529       $ 607   
  

 

 

    

 

 

    

 

 

 

Income before income taxes

   $ 21,121       $ 20,263       $ 22,028   

Applicable state income taxes

     2,006         1,479         1,608   
  

 

 

    

 

 

    

 

 

 

Net Income

   $ 19,115       $ 18,784       $ 20,420   

Preferred stock dividends

     18,438         18,438         18,438   
  

 

 

    

 

 

    

 

 

 

Net income available to common stockholder

   $ 677       $ 346       $ 1,982   
  

 

 

    

 

 

    

 

 

 

Basic and diluted earnings per common share

   $ 574       $ 293       $ 1,680   
  

 

 

    

 

 

    

 

 

 

Average number of common shares outstanding

     1,180         1,180         1,148   

Net income

   $ 19,115       $ 18,784       $ 20,420   

Other comprehensive income:

        

Available-for-sale securities:

        

Unrealized holding gains arising during the period, net of deferred state taxes

     5,883         2,294         2,525   

Less reclassification adjustment for realized gains included in net income, net of state tax effect

     3,917         302           
  

 

 

    

 

 

    

 

 

 

Comprehensive income

   $ 21,081       $ 20,776       $ 22,945   
  

 

 

    

 

 

    

 

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

Harris Preferred Capital Corporation

Consolidated Statements of Changes in Stockholders’ Equity

For the Years Ended December 31, 2011, 2010 and 2009

 

     Preferred
Stock
     Common
Stock
     Additional
Paid-in
Capital
     Distributions
in Excess of
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
     Total
Stockholders’
Equity
 
     (in thousands except per share data)  

Balance at December 31,
2008

   $ 250,000       $ 1       $ 240,733       $ (322   $ 9,832       $ 500,244   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Net income

   $       $       $       $ 20,420      $       $ 20,420   

Other comprehensive
income

                                    2,525         2,525   

Capital contribution and issuance of common stock

           80,000              80,000   

Dividends declared on common stock ($1,916 per share)

                             (2,261             (2,261

Dividends declared on preferred stock ($1.8438 per share)

                             (18,438        (18,438
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Balance at December 31,
2009

   $ 250,000       $ 1       $ 320,733       $ (601   $ 12,357       $ 582,490   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Net income

   $       $       $       $ 18,784      $       $ 18,784   

Other comprehensive
income

                                    1,992         1,992   

Dividends declared on preferred stock ($1.8438 per share)

                             (18,438             (18,438
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Balance at December 31,
2010

   $ 250,000       $ 1       $ 320,733       $ (255   $ 14,349       $ 584,828   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Net income

   $       $       $       $ 19,115      $       $ 19,115   

Other comprehensive
income

                                    1,966         1,966   

Dividends declared on common stock ($.7178 per share)

                        (847             (847

Dividends declared on preferred stock ($1.8438 per share)

                             (18,438        (18,438
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Balance at December 31,
2011

   $ 250,000       $ 1       $ 320,733       $ (425   $ 16,315       $ 586,624   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

Harris Preferred Capital Corporation

Consolidated Statements of Cash Flows

 

     For the Years Ended December 31  
     2011     2010     2009  
     (in thousands)  

Operating Activities:

      

Net income

   $ 19,115      $ 18,784      $ 20,420   

Adjustments to reconcile net income to net cash provided by operating activities:

      

Gain on sale of securities

     (4,328     (326       

Decrease in other assets

     194        104          

Increase (decrease) in accrued expenses

     (3     (2     4   

Increase in accrued taxes payable and deferred tax liabilities

     500        176        194   
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

   $ 15,478      $ 18,736      $ 20,618   
  

 

 

   

 

 

   

 

 

 

Investing Activities:

      

Repayments of notes receivable from BMO Harris Bank N.A.

   $ 881      $ 215      $ 700   

Purchases of securities available-for-sale

     (502,611     (394,504     (336,736

Proceeds from maturities/redemptions of securities available-for-sale

     446,714        389,407        272,354   

Proceeds from sales of securities available-for-sale

     57,746        5,693          
  

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) investing activities

   $ 2,730      $ 811      $ (63,682
  

 

 

   

 

 

   

 

 

 

Financing Activities:

      

Cash dividends paid on preferred stock

   $ (18,438   $ (18,438   $ (18,438

Cash dividends paid on common stock

     (847            (2,261

Capital contribution and issuance of common stock

                   80,000   
  

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

   $ (19,285   $ (18,438   $ 59,301   
  

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents with BMO Harris Bank N.A.

   $ (1,077   $ 1,109      $ 16,237   

Cash and cash equivalents with BMO Harris Bank N.A. at beginning of year

     24,025        22,916        6,679   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents with BMO Harris Bank N.A. at end of year

   $ 22,948      $ 24,025      $ 22,916   
  

 

 

   

 

 

   

 

 

 

Supplemental Disclosures of Cash Flow Information:

      

Cash paid during the year for:

      

State income taxes

   $ 2,089        16          

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

Harris Preferred Capital Corporation

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.     Organization and Basis of Presentation

Harris Preferred Capital Corporation (the “Company”) is a Maryland corporation whose principal business objective is to acquire, hold, finance and manage qualifying real estate investment trust (“REIT”) assets (the “Mortgage Assets”), consisting of a limited recourse note or notes (the “Notes”) issued by BMO Harris Bank N.A. (the “Bank”) secured by real estate mortgage assets (the “Securing Mortgage Loans”) and other obligations secured by real property, as well as certain other qualifying REIT assets. The Company holds its assets through a Maryland real estate investment trust subsidiary, Harris Preferred Capital Trust. The Company has elected to be a REIT under sections 856-860 of the Internal Revenue Code of 1986, as amended (the “Code”), and will generally not be subject to Federal income tax to the extent that it meets all of the REIT requirements in the Code Sections 856-860. All of the 1,180 shares of the Company’s common stock, par value $1.00 per share (the “Common Stock”), are owned by Harris Capital Holdings, Inc. (“HCH”), a wholly-owned subsidiary of the Bank. On December 30, 1998, the Bank transferred its ownership of the common stock of the Company to HCH. The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any 7 3/8% Noncumulative Exchangeable Preferred Stock, Series A (the “Preferred Shares”), $1.00 par value, is outstanding. The Company was formed to provide the opportunity to invest in residential mortgages and other real estate assets and to provide the Bank with a cost-effective means of raising capital for federal regulatory purposes.

On February 11, 1998, the Company completed an initial public offering (the “Offering”) of 10,000,000 shares of the Company’s Preferred Shares, receiving proceeds of $242,125,000, net of underwriting fees. The Preferred Shares are traded on the New York Stock Exchange. Concurrent with the issuance of the Preferred Shares, the Bank contributed additional capital of $250 million to the Company.

On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company entered into a contribution agreement with HCH pursuant to which the Company agreed to issue and sell 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash. HCH acquired the shares on March 5, 2009 and continues to own 100% of the shares of the Common Stock. The Company utilized proceeds from the Common Stock issuance to acquire assets in a manner consistent with Company investment guidelines.

Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements.

2.     Summary of Significant Accounting Policies

Cash and Cash Equivalents

Cash and cash equivalents include cash on deposit with the Bank and securities purchased from the Bank under agreement to resell.

Allowance for Loan Losses

The allowance for probable loan losses is maintained at a level considered adequate to provide for probable loan losses or losses on Notes Receivable collateralized by loans. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Known losses of principal on impaired loans are charged off. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio securing the Mortgage Assets under current economic conditions and management’s estimate of anticipated, but as yet not specifically identified, loan losses. Such estimates are reviewed periodically and adjustments, if necessary, are recorded during the periods in which they become known. At December 31, 2011 and 2010, no allowance for loan losses or provision for loan losses was recorded under this policy.

 

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Table of Contents

Income Taxes

The Company has elected to be taxed as a REIT commencing with its taxable year ended December 31, 1998 and intends to comply with the provisions of the Code with respect thereto. The Company does not expect to be subject to Federal income tax because assets, income distribution and stock ownership tests in Code Sections 856-860 are met. Accordingly, no provision for federal income taxes is included in the accompanying financial statements. Beginning January 1, 2009 the Company is classified as a “captive” REIT for Illinois tax purposes. As a captive REIT, the Company will not claim a deduction for dividends paid and will accrue Illinois income tax on Illinois taxable income.

The REIT Modernization Act, which took effect on January 1, 2001, modified certain provisions of the Code with respect to the taxation of REITs. A key provision of this tax law change reduced the required level of distributions by a REIT from 95% to 90% of ordinary taxable income.

At December 31, 2011 the Company has provided $1.6 million of deferred Illinois taxes on unrealized holdings gains recognized in comprehensive income. At December 31, 2010 the Company provided $1.1 million of deferred Illinois taxes on unrealized holdings gains recognized in comprehensive income.

At December 31, 2011 and 2010, the Company recorded deferred state income taxes related to unrealized holding gains in its investment portfolio. These taxes would be payable in future periods, assuming such gains were realized. During 2011, several securities were sold with a gain of $4.3 million and the related state tax payment was $411 thousand. During 2010, a security was sold with a gain of $326 thousand and the related state tax payment was $24 thousand.

Securities

The Company classifies all securities as available-for-sale, even if the Company has no current plans to divest. Available-for-sale securities are reported at fair value with unrealized gains and losses included as a separate component of stockholders’ equity net of related tax effects.

Interest income on securities, including amortization of discount or premium on an effective yield basis, is included in earnings. Realized gains and losses, as a result of securities sales, are included in gain or loss on sale of securities in the consolidated statements of income, with the cost of securities sold determined on the specific identification basis.

The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. The amounts advanced under these agreements represent short-term assets and are reflected as securities purchased under agreement to resell in the consolidated balance sheets. Securities purchased under agreement to resell for 2011 and 2010 totaled $22 million and $24 million, respectively. The securities underlying the agreements are book-entry securities. Securities are transferred by appropriate entry into the Company’s account with the Bank under a written custodial agreement with the Bank that explicitly recognizes the Company’s interest in these securities.

The Company’s investment securities are exposed to various risks such as interest rate, market and credit. Due to the level of risk associated with certain investment securities and the level of uncertainty related to changes in the value of investment securities, it is at least reasonably possible that changes in risks in the near term would materially affect the carrying value of investments in securities available-for-sale currently reported in the consolidated balance sheet.

Available-for-sale securities and other investments are subject to ongoing other-than-temporary impairment reviews. In determining whether a loss is temporary, factors considered include the extent of the unrealized loss, the length of time that the security has been in an unrealized loss position, the financial condition and near-term prospects of the issuer, and whether the Company has the intent to sell the security or it is more likely than not that the Company will be required to sell the investment before the recovery of the investment’s amortized cost basis. If a decline is considered to be other-than-temporary, a write-down is recorded in the Consolidated Statements of Income and Comprehensive Income as other-than-temporary impairment on securities, and a new cost basis is established. In the event an available-for-sale debt security is considered to be other-than-temporarily impaired and the Company does not intend to sell the security, then the amount of the impairment charge equal to the credit loss is recorded in earnings and the remaining non credit-related impairment charge is recorded in other comprehensive income.

 

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New Accounting Pronouncements

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, in April 2011. The standard clarifies the existing guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring is a troubled debt restructuring. The Company’s adoption of this standard during the third quarter 2011, had no impact on the Company’s financial position or results of operations.

The FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements in April 2011. The ASU removes from the assessment of effective control the criterion requiring a transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and the collateral maintenance implementation guidance related to that criterion. The ASU is effective for the first interim or annual period beginning on or after December 15, 2011 and is to be applied prospectively to new transactions or modifications of existing transactions that occur on or after the effective date. Repurchase transactions entered into by the Company are accounted for as secured borrowings; therefore, the adoption of this ASU, effective January 1, 2012, is not expected to have an impact on the Company’s consolidated financial position or results of operations.

The FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, in May 2011. The standard provides guidance about how fair value should be applied where it is already required or permitted under U.S. GAAP and International Financial Reporting Standards (“IFRS”). The standard results in common requirements for fair value measurement and disclosure in U.S. GAAP and IFRS and does not extend the use of fair value. The amendment will be effective for the Company for the annual reporting period ending December 31, 2012. The Company is in process of assessing the impact of adopting this standard on its financial position and results of operations.

The FASB issued ASU 2011-05, Presentation of Comprehensive Income, in June 2011. The standard eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. It requires companies to present reclassification adjustments from other comprehensive income to net income in the statements of net income and other comprehensive income. The amendment will be effective for the Company for the annual reporting period ending December 31, 2012. The Company is in the process of assessing the impact of adopting this standard on its financial position and results of operations.

Management’s Estimates

The preparation of consolidated 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 disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

3.     Notes Receivable from the Bank

On February 11, 1998, proceeds received from the Offering were used in part to purchase $356 million of Notes at a fixed rate of 6.4%. The Notes are secured by mortgage loans originated by the Bank. The principal amount of the Notes equals approximately 80% of the aggregate outstanding principal amount of the Securing Mortgage Loans. During 2011, 2010 and 2009 the Company received principal repayments on the Notes of $881 thousand, $215 thousand and $700 thousand, respectively. For years ended December 31, 2011, 2010 and 2009, the Bank paid interest on the Notes in the amount of $186 thousand, $222 thousand and $246 thousand, respectively, to the Company.

The Notes are recourse only to the Securing Mortgage Loans that are secured by real property. The Notes mature on October 1, 2027. Payments of principal and interest on the Notes are recorded monthly from payments received on the Securing Mortgage Loans. The Company has a security interest in the real property securing the underlying mortgage loans and is entitled to enforce payment on the Securing Mortgage Loans in its own name if

 

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a mortgagor should default. In the event of default, the Company has the same rights as the original mortgagee to foreclose the mortgaged property and satisfy the obligations of the Bank out of the proceeds. The Securing Mortgage Loans are serviced by the Bank, as agent of the Company.

The Company intends that each mortgage loan securing the Notes will represent a first lien position and will be originated in the ordinary course of the Bank’s real estate lending activities based on the underwriting standards generally applied (at the time of origination) for the Bank’s own account. The Company also intends that all Mortgage Assets held by the Company will meet market standards, and servicing guidelines promulgated by the Company, and Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“FHLMC”) guidelines and procedures.

The balance of Securing Mortgage Loans at December 31, 2011 and 2010 was $3 million and $4.2 million, respectively. The weighted average interest rate on those loans at December 31, 2011 and 2010 was 5.2% and 5.7%, respectively.

None of the Securing Mortgage Loans collateralizing the Notes were on nonaccrual status at December 31, 2011 or 2010.

A majority of the collateral securing the underlying mortgage loans is located in Illinois. The financial viability of customers in Illinois is, in part, dependent on that state’s economy. The Company’s maximum risk of accounting loss, should all customers in Illinois fail to perform according to contract terms and all collateral prove to be worthless, was approximately $2.1 million at December 31, 2011 and $2.6 million at December 31, 2010.

4.     Securities

The amortized cost and estimated fair value of securities available-for-sale were as follows:

 

     December 31, 2011  
     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  
     (in thousands)  

Available-for-Sale Securities

  

Residential mortgage-backed

   $ 443,333       $ 18,023       $       $ 461,356   

U.S. Treasury Bills

     100,000                         100,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Securities

   $ 543,333       $ 18,023       $       $ 561,356   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2010  
     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  
     (in thousands)  

Available-for-Sale Securities

           

Residential mortgage-backed

   $ 501,435       $ 17,439       $ 1,963       $ 516,911   

U.S. Treasury Bills

     40,000                       $ 40,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Securities

   $ 541,435       $ 17,439       $ 1,963       $ 556,911   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table summarizes residential mortgage-backed securities with unrealized losses as of December 31, 2011 and 2010, the amount of the unrealized loss and the related fair value of the securities with unrealized losses. The unrealized losses have been further segregated by residential mortgage-backed securities that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 or more months. There were no securities with unrealized losses as of December 31, 2011. Management believes that all of the unrealized losses are temporary, since the unrealized losses on investments in mortgage-backed securities and U.S. Treasuries reflect changes in interest rates rather than credit deterioration. The contractual cash flows of these securities are guaranteed by a U.S. government-

 

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sponsored enterprise. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired. There was a $3.9 million reclassification adjustment for realized securities gains to other comprehensive income during 2011. There was a $302 thousand reclassification adjustment for realized securities gains to other comprehensive income during 2010. There were no reclassification adjustments to other comprehensive income during 2009.

December 31, 2010

 

     Length of Continuous Unrealized Loss Position  
     Less than 12 months      12 months or longer      Total  
            Unrealized             Unrealized             Unrealized  
     Fair Value      Losses      Fair Value      Losses      Fair Value      Losses  
     (in thousands)  

Residential mortgage-backed

   $ 79,133       $ 1,963       $       $       $ 79,133       $ 1,963   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 79,133       $ 1,963       $       $       $ 79,133       $ 1,963   

The amortized cost and estimated fair value of total available-for-sale securities at December 31, 2011, by contractual maturity, are shown below. Expected maturities can differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     December 31, 2011  
     Amortized
Cost
     Fair
Value
 
     (in thousands)  

Maturities:

     

Within 1 year

   $ 100,000       $ 100,000   

1 to 5 years

     3,517         3,610   

5 to 10 years

     70,055         75,031   

Over 10 years

     369,761         382,715   
  

 

 

    

 

 

 

Total Securities

   $ 543,333       $ 561,356   
  

 

 

    

 

 

 

5.    Fair Value Measurements

The Company follows the guidance within FASB ASC 820, “Fair Value Measurements and Disclosures”, in determining the accounting for and disclosure of fair values of its assets and liabilities. The pronouncement provides methods for measuring fair value, establishes a fair value hierarchy and requires expanded disclosure. It applies when other standards require or permit assets or liabilities to be measured at fair value.

Fair value represents the estimate of the proceeds to be received, or paid in the case of a liability, in a current transaction between willing parties. ASC 820 establishes a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Inputs are either observable or unobservable in the marketplace. Observable inputs are based on market data from independent sources and unobservable inputs reflect the reporting entity’s assumptions about market participant assumptions used to value an asset or liability. Level 1 includes quoted prices in active markets for identical instruments. Level 2 includes quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in inactive markets; and model-derived valuations using observable market information for significant inputs. Level 3 includes valuation techniques where one or more significant inputs are unobservable. Financial instruments are classified according to the lowest level input that is significant to their valuation. A financial instrument that has a significant unobservable input along with significant observable inputs may still be classified Level 3.

 

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The Company uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Level 1 relies on the use of quoted market prices. Level 2 relies on internal models using observable market information as inputs and Level 3 relies on internal models without observable market information. The Company has investments in U.S. Treasury securities that are classified as Level 1, and has U.S. government sponsored residential mortgage-backed securities that are classified in Level 2 of the fair value hierarchy. External vendors typically use pricing models to determine fair values for the securities. Standard market inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets and additional market reference data.

The valuations of assets that are measured at fair value on a recurring basis at December 31, 2011 and 2010 are presented in the following table.

 

    

Fair Value

12/31/11

     Fair Value Measurements Using  
        Level 1      Level 2      Level 3  
            (in thousands)  

Available-for-sale securities:

           

Residential mortgage-backed

   $ 461,356       $       $ 461,356       $   

U.S. Treasury

     100,000         100,000                   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 561,356       $ 100,000       $ 461,356       $   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Fair  Value
12/31/10
     Fair Value Measurements Using  
        Level 1      Level 2      Level 3  
            (in thousands)  

Available-for-sale securities:

           

Residential mortgage-backed

   $ 516,911       $       $ 516,911       $   

U.S. Treasury

     40,000         40,000                   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 556,911       $ 40,000       $ 516,911       $   
  

 

 

    

 

 

    

 

 

    

 

 

 

6.    Fair Value of Financial Instruments

FASB ASC 825, “Financial Instruments”, requires the disclosure of estimated fair values for both on and off-balance-sheet financial instruments. The Company’s fair values are based on quoted market prices when available. For financial instruments not actively traded, such as certain loans, deposits, off-balance-sheet transactions and long-term borrowings, fair values have been estimated using various valuation methods and assumptions. The fair value estimates presented herein are not necessarily indicative of the amounts the Company could realize in an actual transaction. The fair value estimation methodologies employed by the Company were as follows:

Fair value was assumed to equal carrying value for cash on deposit with the Bank, securities purchased under agreement to resell and accrued interest receivable, due to their short term nature.

The fair value of notes receivable from the Bank was estimated using a discounted cash flow calculation utilizing current market rates offered by the Bank as the discount rates.

The fair value of securities available-for-sale and the methods used to determine fair value are provided in Notes 4 and 5.

 

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The estimated fair values of the Company’s financial instruments at December 31, 2011 and 2010 are presented in the following table:

 

     December 31, 2011      December 31, 2010  
     Carrying
Value
     Fair
Value
     Carrying
Value
     Fair
Value
 
     (in thousands)  

Assets

           

Cash on deposit with BMO Harris Bank N.A.

   $ 948       $ 948       $ 525       $ 525   

Securities purchased from BMO Harris Bank N.A. under agreement to resell

     22,000         22,000         23,500         23,500   

Notes receivable from BMO Harris Bank N.A.

     2,488         4,800         3,369         4,758   

Securities available-for-sale

     561,356         561,356         556,911         556,911   

Accrued interest receivable

     1,587         1,587         1,781         1,781   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total on-balance-sheet financial assets

   $ 588,379       $ 590,691       $ 586,086       $ 587,475   
  

 

 

    

 

 

    

 

 

    

 

 

 

7.    Common and Preferred Stock

On February 11, 1998, the Company issued 10,000,000 Preferred Shares, Series A, at a price of $25 per share pursuant to its Registration Statement on Form S-11. Proceeds from this issuance, net of underwriting fees, totaled $242,125,000. The liquidation value of each Preferred Share is $25 plus any authorized, declared and unpaid dividends. The Preferred Shares are redeemable at the option of the Company, in whole or in part, at the liquidation preference thereof, plus the quarterly accrued and unpaid dividends, if any, to the date of redemption. The Company may not redeem the Preferred Shares without prior approval from the Office of the Comptroller of the Currency or the appropriate successor or other federal regulatory agency. Except under certain limited circumstances, as defined, the holders of the Preferred Shares have no voting rights. The Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events.

Holders of Preferred Shares are entitled to receive, if declared by the Board of Directors of the Company, noncumulative dividends at a rate of 7 3/8% per annum of the $25 per share liquidation preference (an amount equivalent to $1.84375 per share per annum). Dividends on the Preferred Shares, if authorized and declared, are payable quarterly in arrears on March 30, June 30, September 30, and December 30 each year. Dividends declared to the holders of the Preferred Shares for the years ended December 31, 2011 and 2010 were $18,438,000 in both years. The allocations of the distributions declared and paid for income tax purposes for the year ended December 31, 2011 were 100% ordinary income for the dividends paid in Quarters 2 and 4 and 33.37% ordinary and 66.63% capital gain for the dividend paid in the 1st quarter and 72.72% ordinary and 27.28% capital gain for the dividend paid in the 3rd quarter of 2011. The allocations of the distributions declared and paid for income tax purposes for the year ended December 31, 2010 were 100% ordinary income for the dividends paid in Quarters 1, 2 and 3 and 92.99% ordinary and 7.01% capital gain for the dividend paid in the 4th quarter of 2010.

On December 30, 1998, the Bank contributed the Common Stock of the Company to HCH. The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any Preferred Shares are outstanding. Dividends on Common Stock are paid if and when authorized and declared by the Board of Directors out of funds legally available after all preferred dividends have been paid. On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company sold 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash to bring the number of shares outstanding to 1,180. On August 31, 2011 the Company paid a cash dividend of $347 thousand (declared on May 25, 2011) on the outstanding common shares to the stockholder of record on June 1, 2011. The Company made the election under Internal Revenue Code Section 858(a) to treat this dividend as having been paid in 2010. On December 16, 2011 the Company paid a cash dividend of $500 thousand (declared on November 30, 2011) on the outstanding common shares to the stockholder of record on December 15, 2011.

 

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8.    Transactions with Affiliates

The Company entered into an advisory agreement (the “Advisory Agreement”) with the Bank pursuant to which the Bank administers the day-to-day operations of the Company. The Bank is responsible for (i) monitoring the credit quality of Mortgage Assets held by the Company; (ii) advising the Company with respect to the reinvestment of income from and payments on, and with respect to, the acquisition, management, financing, and disposition of the Mortgage Assets held by the Company; and (iii) monitoring the Company’s compliance with the requirements necessary to qualify as a REIT.

The Advisory Agreement in effect for 2011, 2010 and 2009 entitled the Bank to receive advisory fees of $144 thousand, $167 thousand, and $196 thousand, respectively for processing, recordkeeping, legal, management and other services.

The Securing Mortgage Loans are serviced by the Bank pursuant to the terms of a servicing agreement (the “Servicing Agreement”). The Bank receives a fee equal to 0.25% per annum on the principal balances of the loans serviced. The Servicing Agreement requires the Bank to service the mortgage loans in a manner generally consistent with accepted secondary market practices, and servicing guidelines promulgated by the Company and with Fannie Mae and FHLMC guidelines and procedures. In 2011, 2010 and 2009 the Bank received payments of $9 thousand, $11 thousand and $12 thousand, respectively.

The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. At December 31, 2011, the Company held $22 million of such assets and had earned $44 thousand of interest from the Bank during 2011. At December 31, 2010, the Company held $24 million of such assets and earned $85 thousand of interest for 2010. At December 31, 2009, the Company held $22 million of such assets and earned $31 thousand of interest for 2009. The Company receives rates on these assets comparable to the rates that the Bank offers to unrelated counterparties under similar circumstances.

9.    Operating Segment

The Company’s operations consist of monitoring and evaluating the investments in mortgage assets. Accordingly, the Company operates in only one segment. The Company has no external customers and transacts most of its business with the Bank.

10.    Commitments and Contingencies

Legal proceedings in which the Company is a defendant may arise in the normal course of business. At December 31, 2011 and 2010, there was no pending litigation against the Company.

 

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11.    Quarterly Financial Information (unaudited)

The following table sets forth selected quarterly financial data for the Company:

 

     Year Ended December 31, 2011     Year Ended December 31, 2010  
     First
Quarter
     Second
Quarter
    Third
Quarter
     Fourth
Quarter
    First
Quarter
     Second
Quarter
     Third
Quarter
     Fourth
Quarter
 
     (in thousands except per share data)  

Total interest income

   $ 4,745       $ 4,593      $ 4,075       $ 3,910      $ 5,350       $ 5,211       $ 5,062       $ 4,843   

Total noninterest income

     3,115         (44     1,258                                        326   

Total operating expenses

     155         113        100         162        195         119         61         154   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Net income before income taxes

   $ 7,705       $ 4,436      $ 5,233       $ 3,748      $ 5,155       $ 5,092       $ 5,001       $ 5,015   

Applicable state income taxes

     732         421        498         356        376         371         365         367   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Net Income

   $ 6,973       $ 4,015      $ 4,735       $ 3,392      $ 4,779       $ 4,721       $ 4,636       $ 4,648   

Preferred dividends

     4,609         4,609        4,610         4,610        4,609         4,609         4,610         4,610   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Net income available (loss allocated)to common stockholder

   $ 2,364       $ (594   $ 125       $ (1,218   $ 170       $ 112       $ 26       $ 37   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Basic and diluted earnings(loss) per common share

   $ 2,004       $ (504   $ 107       $ (1,032   $ 144       $ 94       $ 23       $ 32   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Financial Statements of BMO Harris Bank N.A.

The following unaudited financial information and audited financial statements for the Bank are included because the Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events.

 

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BMO HARRIS BANK N.A.

(formerly Harris N.A.)

a wholly-owned subsidiary of BMO Financial Corp.

(formerly Harris Financial Corp.)

Consolidated Financial Statements

For the Years Ended December 31, 2011, 2010 and 2009


Table of Contents

BMO HARRIS BANK N.A. AND SUBSIDIARIES

FINANCIAL REVIEW

2011 Compared to 2010

Summary

For 2011, BMO Harris Bank N.A. and subsidiaries (the “Bank”) reported net income available for common stockholder of $337.4 million, an increase of $331.9 million from 2010 earnings of $5.5 million, mainly due to the significant increase in the size of the entity from the acquisition of M&I Marshall & Ilsley Bank and M&I Bank N.A. (collectively “M&I Bank”) (Note 2). Excluding the results of M&I as well as related costs for restructuring and integration with a net impact of $87.7 million, the Bank would have reported a net loss available for common stockholder of $35.6 million.

Net interest income was $1,971.6 million in 2011, up $1,078.0 million from a year ago, largely due to the additional net interest income associated with M&I. Excluding the impact of M&I, net interest income would have declined $54.5 million or 6.1 percent as lower interest income on loans and other earning assets were partially offset by a reduction in the cost of borrowings and deposits. Average earning assets increased to $64.4 billion in 2011 from $41.1 billion in 2010. This reflects the addition of $17.4 billion from M&I and an increase in lower-yielding interest bearing deposits placed at the Federal Reserve Bank (“FRB”) ($5.7 billion) partially offset by a decrease in the Bank’s legacy loan balances ($1.0 billion). Net interest margin for the year was 3.10 percent, an increase of 86 basis points from 2.24 percent in 2010. The higher margin reflects $487.3 million of interest income related to the purchased loan portfolio discount amortization and higher yield on the M&I portfolio partially offset by reduced yields on the legacy loan portfolio and securities available-for-sale as well as the increase in the level of low-yielding interest bearing deposits placed at the Federal Reserve Bank. The margin was also favorably affected by reduced interest cost on long-term notes payable.

Provision for loan losses for 2011 was $343.2 million, an increase of $24.6 million from 2010, mainly attributable to $102.9 million related to the M&I portfolio and $20.2 million of provision for loan losses related to loans associated with the acquisition of AMCORE Bank, N.A. (“AMCORE”) from the Federal Deposit Insurance Corporation (“FDIC”) on April 23, 2010 (Note 2), partially offset by the release of $73.0 million of general reserves of the legacy Bank portfolio. Net loan charge-offs for the year were $316.8 million compared to $303.4 million in 2010 mainly due to higher consumer and commercial charge-offs. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio.

Noninterest income for 2011 of $753.2 million reflects the addition of $196.6 million of fees and other income from M&I. Excluding this additional revenue, noninterest income decreased $40.7 million or 6.8 percent from a year ago driven by lower charge card income ($22.0 million), trading revenue ($16.6 million) and service charges and fees ($12.2 million) plus a reduction in the FDIC indemnification asset associated with the AMCORE acquisition ($38.8 million) partially offset by higher net securities gains, other than trading ($21.4 million), net equity securities gains ($8.9 million), dividends on FRB stock ($8.7 million), trust and investment management fees ($7.3 million) and a lower level of other-than-temporary impairment on securities ($4.2 million).

In 2011 noninterest expenses were $1,921.3 million, which reflects the addition of $486.4 million of operating expense, $109.9 million of integration costs, $47.6 million of intangible amortization, and $24.4 million of restructuring charges related to the M&I acquisition. Excluding these costs, expenses were up $57.0 million or 4.8 percent from 2010 driven by higher personnel expense ($34.3 million), other real estate expense ($21.5 million), outside information processing, database and network fees ($10.4 million), net charges for intercompany services ($7.4 million) and professional fees ($7.1 million) partially offset by lower marketing costs ($6.9 million), FDIC insurance ($5.7 million), charge card expense ($5.0 million) and equipment ($2.8 million) and an increase in the Visa indemnification reversal ($3.6 million). Income tax expense increased $150.9 million from a tax benefit in 2010 primarily due to the increase in pre-tax income between periods. The tax benefit recorded a year ago exceeded pre-tax earnings primarily due to the benefit of certain tax exempt loans and investments as well as bank owned life insurance.

 

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Nonperforming loans at December 31, 2011 totaled $1,202 million or 2.35 percent of total loans, up from $916 million or 4.00 percent of total loans at December 31, 2010, primarily attributable to the addition of M&I non-performing commercial loans. Total nonperforming loans at December 31, 2011 include $414 million of M&I impaired loans from new originations. The purchased impaired loans of M&I are excluded from nonperforming loan totals. Nonperforming loans as a percentage of total loans decreased from last year attributable to higher total loans as a result of the acquisition of M&I loan portfolio ($28.4 billion as of December 31, 2011). At December 31, 2011, the allowance for loan losses was $760.9 million, equal to 1.49 percent of loans outstanding compared to $721.9 million or 3.16 percent of loans outstanding at December 31, 2010. Coverage of nonperforming loans by the allowance for loan losses decreased from 79 percent at December 31, 2010 to 71 percent at December 31, 2011 primarily due to M&I non-performing loans. Ratios reflect the fair value adjustments recorded on the M&I loan portfolio at the time of acquisition and the merger of The Harris Bank N.A. into the Bank effective July 5th (Note 2).

At December 31, 2011, total stockholders’ equity amounted to $14.0 billion, up $8.6 billion from December 31, 2010, largely due to the M&I acquisition, effected through the issuance of stock and capital contribution from BMO. Return on equity was 3.68 percent for the year, compared to 0.12 percent last year. Return on assets was 0.47 percent compared to 0.01 percent a year ago. The Bank did not declare any dividends on common stock in either 2011 or 2010.

At December 31, 2011, Tier 1 capital of the Bank amounted to $8.8 billion, up $4.4 billion from a year ago, while risk-weighted assets increased by $33.9 billion to $61.5 billion. The Bank’s December 31, 2011 Tier 1 and total risk-based capital ratios were 14.34 percent and 16.72 percent compared to respective ratios of 15.98 percent and 17.87 percent at December 31, 2010. The regulatory Tier 1 leverage capital ratio was 9.91 percent for the year compared to 9.64 percent at year-end 2010. The Bank’s capital ratios significantly exceed the prescribed regulatory minimum for “well-capitalized” banks.

BMO Financial Corp. (“BFC”) was required to submit a capital plan to the Federal Reserve in January 2012, pursuant to its 2012 Capital Plan Review. On March 13, 2012, the Federal Reserve informed BFC that it had completed its 2012 Capital Plan Review and it did not object to the proposed capital distributions included in BFC’s capital plan through March 31, 2013. These distributions include potential dividends to be paid to preferred shareholders of Harris Preferred Capital Corporation.

2010 Compared to 2009

Summary

For 2010, BMO Harris Bank N.A. and subsidiaries (the “Bank”) reported net income available for common stockholder of $5.5 million, compared to a net loss of $121.3 million for 2009, reflecting a significant reduction in the provision for loan losses. Results for 2010 also include the impact associated with both the Diners Club North American (“Diners Club”) franchise purchased from an unrelated bank, which closed on December 31, 2009, and the acquisition of certain assets and liabilities of Rockford, IL based AMCORE Bank, N.A. (“AMCORE”) from the Federal Deposit Insurance Corporation (FDIC) on April 23, 2010.

Net interest income was $893.6 million, down $13.8 million or 1.5 percent from a year ago, as lower earnings on loans and securities available-for-sale were largely offset by a reduction in the cost of deposits and the additional net interest income associated with the acquisition of AMCORE and Diners Club. Average earning assets of $41.1 billion in 2010 were up slightly from 2009, as a $3.5 billion increase in interest bearing deposits placed at the Federal Reserve Bank was offset by a $1.5 billion decrease in loan balances and a $1.3 billion decline in other securities and money market assets. The impact on interest income from a $0.3 billion increase in earning assets was more than offset by a 5 basis point decline in the net interest margin to 2.24 percent from 2.29 percent for 2009. The lower margin reflects reduced yield on loans and a lower rate of return on securities available-for-sale as well as an increase in the level of low-yielding interest bearing deposits placed at the Federal Reserve Bank, partially offset by lower interest costs of deposits.

Provision for loan losses for 2010 was $318.6 million, a decrease of $248.1 million from 2009. The decline is attributed to decreases in both commercial and consumer net charge-offs as well as a reduction in the general

 

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provision for consumer loan losses, partially offset by provisions of $39.1 million for the Diners Club card portfolio and $22.0 million for mortgage loans. Net loan charge-offs for the year were $303.4 million compared to $446.4 million in 2009 primarily due to lower commercial charge-offs. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio.

Noninterest income for 2010 was $597.2 million, an increase of $87.9 million or 17.3 percent from 2009. The $113.0 million of additional charge card income associated with the Diners Club credit card portfolio and higher trust fees ($14.0 million) and trading income ($9.3 million) were partially offset by decreases in net gains on equity securities and securities other than trading ($29.2 million), service charges and fees ($9.0 million) and foreign exchange trading gains ($6.6 million).

Noninterest expenses were $1,195.4 million during 2010, an increase of $120.9 million or 11.3 percent from 2009. Higher costs associated with the Diners Club credit card portfolio ($45.0 million) and the acquisition of AMCORE ($82.8 million – of which $26.4 million is directly related to integration activities) drove the increase. Excluding these costs, noninterest expenses decreased $6.9 million or 0.6 percent as a reduction in FDIC insurance ($17.4 million), charges for intercompany services ($8.6 million) and net occupancy costs ($6.5 million) were largely offset by higher costs associated with recent marketing campaigns ($17.1 million) and credit reserves for off-balance sheet risks ($10.6 million). The income tax benefit decreased $74.6 million from 2009 primarily due to the decrease in pre-tax loss between periods. The tax benefit also includes the benefit of certain tax exempt loans and investments as well as bank owned life insurance.

Nonperforming loans at December 31, 2010 totaled $916 million or 4.00 percent of total loans, up from $498 million or 2.10 percent of total loans at December 31, 2009. The increase was mainly in commercial real estate loans partially offset by sales of nonperforming loans in 2009 and 2010 to psps Holdings, LLC (“psps”), a subsidiary of BMO Financial Corp., in the amount of $503 million and $272 million, respectively. At December 31, 2010, the allowance for loan losses was $721.9 million, equal to 3.16 percent of loans outstanding compared to $698.6 million or 2.95 percent of loans outstanding at December 31, 2009. Coverage of nonperforming loans by the allowance for loan losses decreased from 140 percent at December 31, 2009 to 79 percent at December 31, 2010.

At December 31, 2010 consolidated stockholder’s equity of the Bank amounted to $5.3 billion, up $965 million from December 31, 2009, mainly due to capital contributions from BMO Financial Corp. of approximately $1.0 billion during the year. Return (loss) on equity was 0.12 percent for the year compared to (3.11) percent last year. Return (loss) on assets was 0.01 percent compared to (0.27) percent a year ago. The Bank did not declare any dividends on common stock in either 2010 or 2009.

At December 31, 2010, Tier 1 capital of the Bank amounted to $4.4 billion, up $0.9 billion from a year ago, while risk-weighted assets declined by $3.0 billion to $27.7 billion. The Bank’s December 31, 2010 Tier 1 and total risk-based capital ratios were 15.98 percent and 17.87 percent compared to respective ratios of 11.46 percent and 13.55 percent at December 31, 2009. The regulatory leverage capital ratio was 9.64 percent as of December 31, 2010 and 8.82 percent at year-end 2009. The Bank’s capital ratios significantly exceed the prescribed regulatory minimum for “well-capitalized” banks.

 

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Independent Auditors’ Report

The Stockholder and Board of Directors

BMO Harris Bank N.A.:

We have audited the accompanying consolidated statements of condition of BMO Harris Bank N.A., and subsidiaries (the Bank), an indirect wholly-owned subsidiary of Bank of Montreal, as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholder’s equity, and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BMO Harris Bank N.A. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011 in conformity with U.S. generally accepted accounting principles.

We also have examined in accordance with attestation standards established by the American Institute of Certified Public Accountants, BMO Harris Bank N.A.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 23, 2012 expressed an unqualified opinion on the effectiveness of BMO Harris Bank N.A.’s internal control over financial reporting.

/s/ KPMG LLP

Chicago, Illinois

March 23, 2012

 

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BMO HARRIS BANK N.A. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CONDITION

 

     December 31  
     2011     2010  
     (In thousands except share data)  

Assets

  

Cash and demand balances due from banks

   $ 1,604,779      $ 737,227   

Money market assets:

    

Interest-bearing deposits at banks ($16.8 billion and $14.1 billion held at Federal Reserve Bank at December 31, 2011 and 2010, respectively)

     18,535,041        15,015,453   

Federal funds sold and securities purchased under agreement to resell

     1,687,258        1,255,313   
  

 

 

   

 

 

 

Total cash and cash equivalents

   $ 21,827,078      $ 17,007,993   

Securities available-for-sale, at fair value

     12,600,130        5,689,293   

Trading account assets and derivative instruments

     910,130        1,161,940   

Loans, net of unearned income

     51,060,062        22,880,126   

Allowance for loan losses

     (760,851     (721,888
  

 

 

   

 

 

 

Net loans

   $ 50,299,211      $ 22,158,238   

Loans held for sale

     98,888        29,915   

Premises and equipment, net

     966,914        550,750   

Bank-owned insurance

     2,633,123        1,373,099   

Goodwill and other intangible assets, net

     3,313,431        909,883   

Deferred tax asset, net

     2,370,890        333,354   

Other assets

     2,238,761        1,359,171   
  

 

 

   

 

 

 

Total assets

   $ 97,258,556      $ 50,573,636   
  

 

 

   

 

 

 

Liabilities

    

Deposits in domestic office — noninterest-bearing

   $ 24,932,593      $ 9,265,697   

— interest-bearing (includes $1.7 billion and $1.3 billion measured

    

at fair value at December 31, 2011 and 2010, respectively)

     47,392,753        23,443,770   

Deposits in foreign offices — noninterest-bearing

     2,628,071        2,718,059   

— interest-bearing

     671,226        1,518,884   
  

 

 

   

 

 

 

Total deposits

   $ 75,624,643      $ 36,946,410   

Federal funds purchased

     244,914        131,251   

Securities sold under agreement to repurchase

     469,443        864,918   

Trading account liabilities and derivative instruments

     527,804        364,241   

Short-term borrowings

     279,334        1,353,761   

Short-term senior notes

     80,956          

Accrued interest, taxes and other

     465,191        203,161   

Accrued pension and post-retirement

     46,926        27,172   

Other liabilities

     728,335        358,379   

Long-term notes — senior/unsecured

     1,100,000        2,446,500   

Long-term notes — senior/secured

     2,375,000        2,375,000   

Long-term notes — subordinated

     1,363,802        200,000   
  

 

 

   

 

 

 

Total liabilities

   $ 83,306,348      $ 45,270,793   
  

 

 

   

 

 

 

Stockholder’s Equity

    

Common stock ($10 par value); authorized 60,430,512 shares; issued and outstanding 50,430,512 at December 31, 2011 and 20,256,027 at December 31, 2010

   $ 504,305      $ 202,560   

Surplus

     11,326,166        3,364,727   

Retained earnings

     1,959,325        1,621,915   

Accumulated other comprehensive loss

     (98,308     (136,359
  

 

 

   

 

 

 

Stockholder’s equity before noncontrolling interest in subsidiaries

   $ 13,691,488      $ 5,052,843   

Noncontrolling interests in subsidiaries

     260,720        250,000   
  

 

 

   

 

 

 

Total stockholder’s equity

   $ 13,952,208      $ 5,302,843   
  

 

 

   

 

 

 

Total liabilities and stockholder’s equity

   $ 97,258,556      $ 50,573,636   
  

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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BMO Harris Bank N.A. and Subsidiaries

Consolidated Statements of Operations

 

     For the Years Ended December 31  
         2011             2010             2009      
     (In thousands)  

Interest Income

      

Loans

   $ 2,116,666      $ 1,061,025      $ 1,178,542   

Money market assets:

      

Deposits at banks

     45,317        29,054        19,420   

Federal funds sold and securities purchased under agreements to resell

     698        333        151   

Trading account assets

     6,999        10,267        9,009   

Securities available-for-sale:

      

U.S. Treasury and federal agency

     74,187        49,153        100,876   

State and municipal

     44,167        49,455        54,303   

Other

     13,466        8,658        10,831   
  

 

 

   

 

 

   

 

 

 

Total interest income

   $ 2,301,500      $ 1,207,945      $ 1,373,132   
  

 

 

   

 

 

   

 

 

 

Interest Expense

      

Deposits

   $ 219,359      $ 180,010      $ 313,465   

Short-term borrowings

     2,201        6,245        7,936   

Short-term senior notes

     449        4        1,726   

Long-term notes — senior/unsecured

     70,666        92,564        89,457   

Long-term notes — senior/secured

     25,206        33,927        49,183   

Long-term notes — subordinated

     12,043        1,587        4,005   
  

 

 

   

 

 

   

 

 

 

Total interest expense

   $ 329,924      $ 314,337      $ 465,772   
  

 

 

   

 

 

   

 

 

 

Net Interest Income

   $ 1,971,576      $ 893,608      $ 907,360   

Provision for loan losses

     343,213        318,622        566,696   
  

 

 

   

 

 

   

 

 

 

Net Interest Income after Provision for Loan Losses

   $ 1,628,363      $ 574,986      $ 340,664   
  

 

 

   

 

 

   

 

 

 

Noninterest Income

      

Trust and investment management fees

   $ 119,957      $ 112,568      $ 98,536   

Net money market and bond trading income, including derivative activity

     12,260        29,585        20,270   

Foreign exchange trading gains, net

     7,087        4,821        11,462   

Service charges and fees

     262,300        193,902        202,906   

Charge card income

     110,576        113,395        416   

Equity securities gains, net

     16,432        7,490        8,365   

Net securities gains, other than trading

     27,485        6,573        35,772   

Other-than-temporary impairment of securities

     (1,062     (5,217     (1,350

Bank-owned insurance

     67,320        46,160        45,047   

Letter of credit fees

     20,209        22,341        20,674   

Net gains on loans held for sale

     29,029        19,031        21,680   

Other

     81,578        46,572        45,537   
  

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 753,171      $ 597,221      $ 509,315   
  

 

 

   

 

 

   

 

 

 

Noninterest Expenses

      

Salaries and other compensation

   $ 663,731      $ 454,628      $ 422,967   

Pension and other employee benefits

     162,408        103,576        106,851   

Net occupancy

     143,166        104,336        104,036   

Equipment

     106,688        76,545        68,370   

Marketing

     88,381        60,943        42,215   

Communication and delivery

     51,742        33,963        30,109   

Professional fees

     164,894        107,153        90,979   

Information processing, database and network fees

     73,101        39,064        35,197   

FDIC insurance

     58,747        46,528        63,012   

Intercompany services, net

     64,500        (2,366     4,027   

Restructuring expense (reversal)

     24,441               (702

Visa indemnification reversal

     (11,122     (7,500     (3,000

Charge card

     21,664        26,637          

Provision (reversal) for off-balance sheet credit losses

     13,629        10,253        (314

Other real estate

     27,965        4,789        2,991   

Amortization of intangibles

     71,736        25,966        25,409   

Other

     195,588        110,934        82,404   
  

 

 

   

 

 

   

 

 

 

Total noninterest expenses

   $ 1,921,259      $ 1,195,449      $ 1,074,551   
  

 

 

   

 

 

   

 

 

 

Income (loss) before income tax expense (benefit)

   $ 460,275      $ (23,242   $ (224,572

Applicable income tax expense (benefit)

     103,793        (47,138     (121,760
  

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ 356,482      $ 23,896      $ (102,812

Less: noncontrolling interest in subsidiaries

     19,072        18,438        18,438   
  

 

 

   

 

 

   

 

 

 

Net Income (Loss) Available for Common Stockholder

   $ 337,410      $ 5,458      $ (121,250
  

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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BMO Harris Bank N.A. and Subsidiaries

Consolidated Statements of Comprehensive Income (Loss)

 

     For the Years Ended December 31  
     2011     2010     2009  
     (In thousands)  

Net income (loss)

   $ 356,482      $ 23,896      $ (102,812

Other comprehensive income (loss):

      

Cash flow hedges:

      

Net unrealized gain (loss) on derivative instruments, net of tax expense (benefit) of $14,246 in 2011, ($7,118) in 2010 and $31,935 in 2009

     26,456        (13,219     61,530   

Reclassification adjustment for realized loss included in net income (loss), net of tax benefit of $1,108 in 2011, $2,134 in 2010 and $3,447 in 2009

     2,058        3,962        6,402   

Pension and postretirement medical benefit plans:

      

Net (loss) gain and net prior service cost, net of tax (benefit) expense of ($33,550) in 2011, ($10,288) in 2010 and $19,414 in 2009

     (62,306     (15,537     33,830   

Amortization included in net periodic benefit cost, net of tax benefit of $5,389 in 2011, $2,736 in 2010 and $1,525 in 2009

     10,008        5,082        2,832   

Securities available-for-sale:

      

Unrealized holding gains (losses) arising during the period, net of tax expense (benefit) of $43,160 in 2011, ($10,936) in 2010 and $10,840 in 2009

     80,003        (18,558     30,682   

Reclassification adjustment for realized gains included in net income (loss), net of tax expense of $8,352 in 2011, $559 in 2010 and $12,520 in 2009

     (18,168     (1,037     (23,252
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

   $ 38,051      $ (39,307   $ 112,024   
  

 

 

   

 

 

   

 

 

 

Comprehensive income (loss)

   $ 394,533      $ (15,411   $ 9,212   

Comprehensive income related to noncontrolling interest in subsidiaries

     19,072        18,438        18,438   
  

 

 

   

 

 

   

 

 

 

Comprehensive income (loss) available for common stockholder

   $ 375,461      $ (33,849   $ (9,226
  

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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BMO Harris Bank N.A. and Subsidiaries

Consolidated Statements of Changes in Stockholder’s Equity

 

     Common
Stock
    Surplus     Retained
Earnings
    Accumulated
Other
Comprehensive
Loss
    Noncontrolling
Interests
    Total
Stockholder’s
Equity
 
     (In thousands)  

Balance at December 31, 2008

   $ 174,160      $ 2,224,287      $ 1,737,707      $ (209,076   $ 250,000      $ 4,177,078   

Stock option exercise

            1,841                             1,841   

Tax benefit from stock option exercise

            2,914                             2,914   

Net (loss) income

                   (121,250            18,438        (102,812

Dividends — preferred stock of
subsidiary

                                 (18,438     (18,438

Other comprehensive income

                          112,024               112,024   

Issuance of common stock and contribution to capital surplus

     3,850        161,165                             165,015   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2009

   $ 178,010      $ 2,390,207      $ 1,616,457      $ (97,052   $ 250,000      $ 4,337,622   

Stock option exercise

            1,669                             1,669   

Tax benefit from stock option
exercise

            4,295                             4,295   

Net income

                   5,458               18,438        23,896   

Dividends — preferred stock of
subsidiary

                                 (18,438     (18,438

Other comprehensive loss

                          (39,307            (39,307

Issuance of common stock and contribution to capital surplus

     24,550        968,556                             993,106   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

   $ 202,560      $ 3,364,727      $ 1,621,915      $ (136,359   $ 250,000      $ 5,302,843   

Stock option exercise

            1,556                             1,556   

Tax benefit from stock option
exercise

            461                             461   

Net income

                   337,410               19,072        356,482   

Dividends - preferred stock of
subsidiary

                                 (19,845     (19,845

Redemption-preferred stock of subsidiary

             (6,050     (6,050

Other comprehensive income

                          38,051               38,051   

Issuance of common stock and contribution to capital surplus

     301,745        7,959,422                             8,261,167   

Change in noncontrolling interest ownership

                                 17,543        17,543   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

   $ 504,305      $ 11,326,166      $ 1,959,325      $ (98,308   $ 260,720      $ 13,952,208   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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BMO Harris Bank N.A. and Subsidiaries

Consolidated Statements of Cash Flows

 

     For the Years Ended December 31  
     2011     2010     2009  
     (In thousands)  

Cash Flows from Operating Activities:

      

Net income (loss)

   $ 356,482      $ 23,896      $ (102,812

Less: noncontrolling interests

     19,072        18,438        18,438   
  

 

 

   

 

 

   

 

 

 

Net income (loss) available for common stockholder

   $ 337,410      $ 5,458      $ (121,250

Adjustments to determine net cash flows provided by operating activities:

      

Provision for loan losses

     343,213        318,622        566,696   

Depreciation and amortization, including intangibles

     207,734        111,946        99,651   

Deferred tax expense (benefit)

     129,817        (73,311     24,490   

Tax benefit from stock options exercise

     461        4,295        2,914   

Other-than-temporary impairment on securities

     1,062        5,217        1,350   

Net gains on securities, other than trading

     (27,485     (6,573     (35,772

Net equity investment gains

     (16,432     (7,490     (8,365

Increase in bank-owned insurance

     (59,046     (33,442     (35,342

Net decrease (increase) in trading assets

     520,834        182,365        (6,367

Decrease in accrued interest receivable

     32,014        21,713        43,061   

Decrease (increase) in prepaid expenses

     136,495        (49,249     (113,397

Decrease in accrued interest payable

     (36,817     (865     (68,381

Increase in other accrued expenses

     115,593        158,329        137,960   

Net change in pension and post retirement benefits

     (75,200     (50,255     (54,912

Origination of loans held for sale

     (1,276,212     (821,386     (1,379,863

Proceeds from sale of loans held for sale

     1,358,675        840,476        1,401,113   

Net gains on loans held for sale

     (29,029     (19,031     (21,680

Net gains on sale of premises and equipment

     (618     (866     (2,605

Net decrease in foreign exchange contracts

     (10,490     (4,676     (25,907

Net decrease in marked to market hedging derivatives

     (28,916     (690     (92,250

Net change in due from parent

     (2,179     (2,701     3,845   

Visa indemnification reversal

     (11,122     (7,500     (3,000

Other, net

     (40,319     (41,422     22,669   
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

   $ 1,569,443      $ 528,964      $ 334,658   
  

 

 

   

 

 

   

 

 

 

Cash Flows from Investing Activities:

      

Proceeds from sales of securities available-for-sale

   $ 2,143,594      $ 523,168      $ 3,454,572   

Proceeds from maturities of securities available-for-sale

     5,719,327        4,323,687        4,482,249   

Purchases of securities available-for-sale

     (9,183,299     (4,667,657     (4,777,802

Net decrease in loans

     1,801,684        1,712,378        2,885,481   

Proceeds from loans sold to affiliates

            273,522        502,711   

Net proceeds from FDIC loss share agreement

     108,887        75,706          

Purchases of premises and equipment

     (124,055     (81,792     (85,019

Proceeds from sales of premises and equipment

     9,727        4,726        28,699   

Net proceeds from sales of OREO

     180,700        13,472        13,679   

Acquisitions, net of cash acquired

     2,906,140        176,492        (681,442
  

 

 

   

 

 

   

 

 

 

Net cash provided by investing activities

   $ 3,562,705      $ 2,353,702      $ 5,823,128   
  

 

 

   

 

 

   

 

 

 

Cash flows from Financing Activities:

      

Net increase (decrease) in deposits

   $ 2,781,024      $ 3,310,374      $ (23,619,494

Net increase in deposits measured at fair value

     377,416        608,436        629,767   

Net decrease in Federal funds purchased and securities sold under agreement to repurchase

     (481,516     (1,652,420     (901,694

Net (decrease) increase in other short-term borrowings

     (1,074,427     781,368        390,714   

Net decrease in short-term senior notes

                   (75,000

Proceeds from issuance long-term notes - senior/unsecured

                   550,000   

Repayment of long-term notes - senior/unsecured

     (1,924,012     (137,409     (250,000

Repayment of long-term notes - senior/secured

     (2,291,580              

Repayment of long-term notes - subordinated

     (275,084     (92,750       

Net proceeds from stock options exercise

     1,556        1,669        1,841   

Excess tax expense from stock options exercise

     (545     (584     (639

Issuance of common stock

            24,550          

Capital contributions from parent

     2,600,000        968,556        165,015   

Cash distributions on preferred stock

     (25,895     (18,438     (18,438
  

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

   $ (313,063   $ 3,793,352      $ (23,127,928
  

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

   $ 4,819,085      $ 6,676,018      $ (16,970,142

Cash and cash equivalents at January 1

     17,007,993        10,331,975        27,302,117   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at December 31

   $ 21,827,078      $ 17,007,993      $ 10,331,975   
  

 

 

   

 

 

   

 

 

 

 

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     For the Years Ended December 31  
     2011     2010     2009  
     (In thousands)  

Supplemental Disclosures of Cash Flow Information:

      

Cash paid (received) during the year for:

      

Interest

   $ 366,742      $ 315,203      $ 534,152   

Income taxes

   $ (32,422   $ (135,893   $ (167,848

Financing activity affecting assets and liabilities but not resulting in cash flows:

      

Net (decrease) increase in assets and liabilities due to contribution of parent’s banking assets

   $ (2,906,140   $ (176,492   $ 681,442   

Supplemental Disclosures of Noncash Activities:

In 2011, the fair values of noncash assets acquired and liabilities assumed were $43.8 billion and $41.0 billion, respectively, in the acquisition of M&I.

In 2010, the fair values of noncash assets acquired and liabilities assumed were $2.1 billion and $2.3 billion, respectively, in the acquisition of AMCORE

In 2009, the fair values of noncash assets acquired and liabilities assumed were $0.4 million and zero, respectively, in the acquisition of Pierce Givens, $654.0 million and $82.3 million, in the acquisition of Diners Club.

Noncash transfers to OREO totaled $78.3 million, $64.1 million and $7.8 million in 2011, 2010 and 2009, respectively.

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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TABLE OF CONTENTS

 

Note

 

Topic

   Page  
1   Summary of Significant Accounting Policies      56   
2   Business Combinations      65   
3   Securities      67   
4   Loans      70   
5   Allowance for Loan Losses      72   
6   Premises and Equipment      76   
7   Goodwill and Other Intangible Assets      77   
8   Deposits      79   
9   Securities Purchased Under Agreement to Resell, Securities Sold Under Agreement to Repurchase and Federal Funds, Purchased and Sold      80   
10   Short, Medium and Long-Term Notes and Unused Lines of Credit      81   
11   Fair Value of Financial Instruments and Fair Value Measurements      87   
12   Financial Instruments with Off-Balance-Sheet Risk      88   
13   Derivative Financial Instruments      90   
14   Concentration of Credit Risk      95   
15   Employee Benefit Plans      96   
16   Stock-Based Compensation Plans      104   
17   Lease Expense and Obligations      108   
18   Income Taxes      109   
19   Regulatory Capital      111   
20   Investments in Subsidiaries and Statutory Restrictions      113   
21   Contingent Liabilities and Litigation      113   
22   Accumulated Other Comprehensive Income      113   
23   Foreign Activities (by Domicile of Customer)      114   
24   Interest in Variable Interest Entities      114   
25   Related Party Transactions      115   
26   Restructuring Charge      118   
27   Visa Indemnification Charge      118   
28   Other Assets      119   
29   Subsequent Events      120   

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    Summary of Significant Accounting Policies

Principles of consolidation and nature of operations

BMO Harris Bank N.A. (“BHB”), formerly Harris N.A., is a wholly-owned subsidiary of BMO Financial Corp., formerly Harris Financial Corp., (“BFC”), a Delaware Corporation which is a wholly-owned U.S. subsidiary of Bank of Montreal (“BMO”). Throughout these Notes to Consolidated Financial Statements, the term “Bank” refers to BMO Harris Bank N.A. and subsidiaries.

Prior to November 30, 2011, BHB was a wholly-owned subsidiary of BMO Bankcorp, Inc., formerly Harris Bankcorp, Inc., (“Bankcorp”), a wholly-owned subsidiary of BFC. Bankcorp was dissolved into BFC on November 30, 2011 and is reflected in the current and prior year consolidated financial statements. In addition, The Harris Bank N.A. (a former subsidiary of Bankcorp) merged with and into BHB in July 2011. The merger was between entities under common control. As a result, the consolidated financial statements and related notes have been recast to reflect the combined historical financial results at historical carrying values for all periods presented. On July 5, 2011, BMO completed the acquisition of Milwaukee-based Marshall & Ilsley Corporation (“M&I”). M&I merged with and into BFC, and M&I Marshall and Ilsley Bank and M&I Bank N.A. merged with and into the Bank. The results of operations for M&I Marshall and Ilsley Bank and M&I Bank N.A. have been included in BHB’s consolidated financial statements since July 5, 2011. See Note 2 to the Consolidated Financial Statements for additional information on business combinations.

The consolidated financial statements include the accounts of the Bank, its subsidiaries that are wholly or majority owned and/or over which it exercises substantive control and significant variable interest entities for which the Bank has determined that, based on the variable interests it holds, it is the primary beneficiary. The primary beneficiary of a variable interest entity is the party that has both the power to direct the activities of the entity that most significantly impact the entity’s economic performance and the obligation to absorb losses of the entity that could potentially be significant to the entity or the right to receive benefits from the entity that could potentially be significant to the entity. Variable interests are the ownership, contractual or other pecuniary interests in an entity. Investments in unconsolidated affiliates, in which the Bank has 20% or more ownership interest and has the ability to exercise significant influence, but not substantive control, over the affiliates’ operating and financial policies, are accounted for using the equity method of accounting, unless the investment has been determined to be temporary. All intercompany balances and transactions are eliminated in consolidation.

Significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to conform prior year’s consolidated financial statements to the current year’s presentation. See Note 2 to the Consolidated Financial Statements for additional information on business combinations and Note 25 to the Consolidated Financial Statements for additional information on related party transactions.

The Bank provides banking, trust and other services domestically and internationally through the main banking facility and thirty-one nonbank subsidiaries. The Bank provides a variety of banking and financial services to commercial and industrial companies, financial institutions, governmental units, not-for-profit organizations and individuals throughout the U.S., primarily the Midwest, and abroad. Services rendered and products sold to customers include demand and time deposit accounts and certificates; various types of loans; sales and purchases of foreign currencies; interest rate management products; cash management services; investment banking services; underwriting of municipal bonds; financial consulting; and personal trust and trust-related services.

Basis of accounting

The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).

 

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Noncontrolling interests in subsidiaries

Noncontrolling interests held by parties other than BHB are reported as equity in the consolidated financial statements. Included in noncontrolling interests at December 31, 2011 and 2010 were preferred stock issued by subsidiaries of the Bank. The noncontrolling interests in subsidiaries are included within stockholder’s equity in the Consolidated Statements of Condition. Net income (loss) attributable to the noncontrolling interests is separately presented in the Consolidated Statements of Operations, outside of net (loss) income and is not included in net income (loss) available for common stockholder.

Foreign currency and foreign exchange contracts

Assets and liabilities denominated in foreign currencies have been translated into United States dollars at respective period-end rates of exchange. Foreign exchange trading positions are revalued monthly using prevailing market rates. Exchange adjustments relating to such transactions during the period are included with noninterest income in the Consolidated Statements of Operations.

Derivative financial instruments

All derivative instruments are recognized at fair value in the Bank’s Consolidated Statements of Condition. All derivative instruments are designated either as hedging or trading.

Realized and unrealized gains and losses on trading derivatives are recognized in noninterest income in the Bank’s Consolidated Statements of Operations. Unrealized gains on trading derivatives are recorded as assets and unrealized losses are recorded as liabilities in the Bank’s Consolidated Statements of Condition.

Derivative instruments that are used in the management of the Bank’s risk strategy may qualify for hedge accounting if the derivatives are designated as hedges and applicable hedge criteria are met. In order for a derivative to qualify as an accounting hedge, the hedging relationship must be designated and formally documented at its inception, detailing the particular risk management objective and strategy for the hedge and the specific asset, liability or cash flow being hedged, as well as how its effectiveness is being assessed. Changes in the fair value of the derivative must be highly effective in offsetting either changes in the fair value of on-balance sheet items caused by the risk being hedged or changes in the amount of future cash flows.

Hedge effectiveness is evaluated at the inception of the hedging relationship and on an ongoing basis, retrospectively and prospectively, primarily using quantitative statistical measures of correlation. Any ineffectiveness in the hedging relationship is recognized in other noninterest income in the Bank’s Consolidated Statements of Operations as it arises.

The Bank records interest receivable or payable on interest rate hedge derivative instruments as an adjustment to interest income/expense in the Bank’s Consolidated Statements of Operations over the life of the hedge.

For cash flow hedges, to the extent that changes in the fair value of the derivative offset changes in the fair value of the hedged item, they are recorded in other comprehensive income and then recognized in income as the hedged item impacts income or expense. Any portion of the change in fair value of the derivative that does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge) is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.

For cash flow hedges that are discontinued before the end of the original hedge term, the unrealized gain or loss in accumulated other comprehensive income (loss) is amortized to interest income/expense in the Bank’s Consolidated Statements of Operations consistent with how the hedged item affects earnings. If the hedged item is sold or settled, the entire unrealized gain or loss is recognized in interest income/expense in the Bank’s Consolidated Statements of Operations.

For fair value hedges, the hedging derivative is recorded at fair value and the related hedge item, either fixed rate assets or liabilities, is adjusted for the changes in value of the risk being hedged. To the extent that the change in the fair value of the derivative does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge), the net amount is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.

 

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For fair value hedges that are discontinued, the Bank stops adjusting the hedged item for changes in fair value that are attributable to the hedged risk. The fair value adjustment of the hedged item is amortized to the interest income/expense on the hedged item over its remaining term to maturity. If the hedged item is sold or settled, any remaining fair value adjustment is included in the determination of the gain or loss on sale or settlement.

Securities

The Bank classifies marketable securities as either trading account assets or available-for-sale securities. Trading account assets include securities acquired as part of trading activities and are typically purchased with the expectation of near-term profit on disposition. These assets consist primarily of municipal bonds and U.S. government securities. Available-for-sale securities consist of debt and equity securities that may be sold in response to or in anticipation of changes in interest rates, changes in regulatory capital requirements, changes in foreign currency risk, changes in funding sources or terms, or to meet liquidity needs. Nonmarketable securities are classified as other assets on the Bank’s Consolidated Statements of Condition. See Note 28 to the Consolidated Financial Statements for additional information on other assets.

Trading account assets are reported at fair value with unrealized gains and losses included in noninterest income, which also includes realized gains and losses from closing such positions.

Available-for-sale securities are reported at fair value with unrealized gains and losses included, on an after-tax basis in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms to maturity of the securities. Realized gains and losses, as a result of securities sales, are included in net securities gains (losses) in the Consolidated Statements of Operations, with the cost of securities sold determined on a specific identification basis.

Available-for-sale securities and other investments are subject to quarterly other-than-temporary impairment reviews. In determining whether a loss is temporary, factors considered include, but are not limited to, the severity of the unrealized loss, the length of time that the security has been in an unrealized loss position, the financial condition and near-term prospects of the issuer, and whether the Bank has the intent to sell the security or it is more likely than not that the Bank will be required to sell the security before the recovery of the security’s amortized cost basis. If a decline is considered to be other-than-temporary, a write-down is recorded in the Consolidated Statements of Operations as other-than-temporary impairment on securities, and a new cost basis is established. In the event an available-for-sale debt security is considered to be other-than-temporarily impaired and the Bank does not intend to sell the security and it is more likely than not that it will not be required to sell the security, then the amount of the impairment charge equal to the credit loss is recorded in earnings and the remaining non credit-related impairment charge is recorded in other comprehensive income.

Loans

The Bank’s accounting methods for loans depends on whether the loans are originated or purchased and whether the loans are classified as held for sale or held for investment.

Originated Loans Held for Investment

Loans the Bank originates for investment are reported at the principal amount outstanding, net of unearned income, net deferred loan fees or costs, and any direct principal chargeoffs. This amount is the Bank’s recorded investment in the loan. Net deferred loan fees include loan fees collected net of certain incremental direct costs, primarily salary and employee benefit expenses. Net deferred loan fees are amortized over the contractual term of the loan or lease as an adjustment to the yield over the life of the loan and/or commitment period. Interest on loans, other than direct financing leases, is recognized as income based on the loan principal outstanding during the period.

Loans include the Bank’s investment in leases. Leases are carried at the aggregate of rental payments receivable plus estimated residual values less unearned income. Unearned income is amortized to interest income using a method that approximates a level rate of return.

 

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Originated Loans Held for Sale

In conjunction with its mortgage banking activities, the Bank will originate loans with the intention of selling them in the secondary market. These loans are classified as held for sale on the Bank’s Consolidated Statements of Condition and are carried at the lower of cost or fair value on a portfolio basis. Any excess of the cost of loans held for sale over fair value is recognized as a valuation allowance. Changes in the valuation allowance and realized gains and losses are recognized in noninterest income in the Consolidated Statements of Operations. Premiums, discounts and/or other loan basis adjustments on loans held for sale are deferred upon acquisition, included in the cost basis of the loan, and are not amortized. In the event that loans held for sale are reclassified to loans held for investment, the loans are transferred at the lower of cost or fair value on the date of transfer, forming the new cost basis of such loans. Any adjustment recognized upon transfer is recognized an adjustment to yield over the remaining life of the loan.

Originated Loans Held for Investment Transferred to Held for Sale

When a determination is made at the time of commitment to originate a loan as held for investment, it is the Bank’s intent to hold the loan to maturity, payoff or for the foreseeable future, subject to periodic review. In determining the foreseeable future for these loans, management considers (1) the current economic environment and market conditions, (2) its business strategy and current business plans, (3) collection strategies and (4) the nature and type of the loan receivable. If a decision has been made to sell loans not previously classified as held for sale, such loans are reclassified to loans held for sale. Upon reclassification, the loan is transferred at the lower of cost or fair value. If the change in fair value on these loans is due to credit concerns on such loans, the loans are reclassified net of the portion of the allowance for loan losses that is attributable to the transferred loans, with a corresponding reduction in the allowance for loan losses. Any lower of cost or fair value adjustment for commercial loans held for investment transferred to loans held for sale is generally determined on a loan-by-loan basis. The lower of cost or fair value adjustment for consumer loans held for investment which are transferred to loans held for sale is generally determined on a pool basis. The cash proceeds from the sale of loans that were reclassified from loans held in portfolio to loans held for sale are classified as investing activities in the Consolidated Statements of Cash Flows.

Purchased or Acquired Loans

In addition to originating loans, the Bank also acquires loans through portfolio purchases or acquisitions of other financial services companies. Loans that are purchased or acquired are initially measured at fair value as of the acquisition date. Determining the fair value of the loans involves estimating the amount and timing of principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest. The Bank estimates the cash flows expected to be collected using internal models that incorporate management’s best estimate of current key assumptions, such as default rates, loss severity and payment speeds and certain loan renewals. Collateral values are also incorporated into cash flow estimates. Late fees, which are contractual but not expected to be collected, are excluded from expected future cash flows.

Acquired loans are classified into the following categories, those that on the acquisition date continued to make timely principal and interest payments, (“the purchased performing loans”) and those for which on the acquisition date the timely collection of interest and principal was no longer probable (the “purchased credit impaired loans” or “PCI” loans). Because PCI loans are recorded at fair value at acquisition based on the amount expected to be collected, PCI loans are not considered to be impaired at the acquisition date. Loans that are acquired with