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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 evidence of deterioration of credit quality between origination date and acquisition date and where it is probable that not all amounts due according to contractual terms will be collected are subject to certain recognition and reporting requirements in accordance with ASC 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.”

As permitted, the Bank accounts for all loans acquired in the AMCORE Bank N.A. (“AMCORE”) acquisition and PCI loans acquired from M&I as PCI loans. For these purchased loans, the excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield. PCI loans generally met the criteria for nonaccrual of interest prior to the acquisition but are considered performing upon acquisition and the accretable yield is recognized in interest income over the remaining life of the loan using the constant

 

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effective yield method, regardless of whether the customer is contractually delinquent, if the amount and timing of the cash flows is reasonably estimable. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference.

PCI loans are aggregated into one or more pools with common risk characteristics. A pool is then accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. Homogeneous commercial, commercial real estate, consumer and residential real estate loans were aggregated into pools with common risk characteristics using criteria such as loan type, delinquency status, internal loan grade or FICO score at acquisition.

Accounting for changes in the actual or expected cash flows on PCI loans after the acquisition date depends on the direction of the change. Subsequent decreases to expected cash flows generally result in impairment of the loan or pool of loans and a provision for credit losses, resulting in an increase to the allowance for loan losses, and a reclassification from accretable yield to nonaccretable difference. Subsequent increases in estimated cash flows will result in a recovery of any previously recorded allowance, to the extent applicable, and a reclassification from nonaccretable difference to accretable yield for any remaining improvement, which is recognized prospectively as interest income over the remaining lives of the loans or pool of loans. Decreases in cash flows expected to be collected resulting from prepayments and interest rate decreases for variable rate notes reduce the yield prospectively. Disposals of loans, which may include sales of loans or foreclosures, result in removal of the loan from the purchased impaired loan portfolio at its carrying amount.

Purchased performing term loans and loans with revolving privileges are reported at the principal amount outstanding, net of unearned income, net premiums or discounts, and any direct principal chargeoffs. Net premiums and discounts 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.

Impaired Loans

The Bank considers an originated loan or purchased performing loan to be impaired when, based on current information and events, it determines that it is probable it will be unable to collect all amounts due, including scheduled interest, according to the loan’s original loan contract, regardless of payment status. When an originated loan or purchased performing loan is considered impaired, it is placed on nonaccrual status and all accrued but unpaid interest is charged against interest income in the current year and amortization of premiums, discounts and any deferred net fees or costs ceases. Commercial and commercial real estate loans are placed on non accrual status when the collection of interest is doubtful or when principal or interest is 90 days past due, unless the credit is adequately collateralized and the loan is in process of collection. Consumer installment and consumer revolving loans are not normally placed on nonaccrual status. Interest on nonaccrual loans is recognized as income only when cash is received and the Bank expects to collect the entire principal balance of the loan; otherwise, cash collections reduce the recorded investment. Originated loans and purchased performing loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

PCI loan pools are reported as impaired loans if it becomes probable after initial recognition that the expected cash flows for the pool of loans are less than those expected at acquisition plus any additional cash flows expected to be collected arising from changes in estimate after acquisition. PCI loans are generally not reported as nonaccrual unless the timing and amount of future cash flows is not reasonably estimable.

Loans are classified as troubled debt restructurings (“TDR”) when the borrower has experienced financial difficulties and the Bank has made certain concessionary modifications to the contractual terms of the loan and the concessions are for economic or legal reasons related to the borrower’s financial difficulty that the Bank would not otherwise consider. All TDRs meet the definition of impaired loans. The Bank considers one or a combination of the following to be concessions: (1) a reduction of the stated interest rate, (2) an extension of the maturity date or dates at a stated interest rate lower than the current market rate for a new loan with a similar term, or (3) forgiveness of principal or accrued interest. Renegotiated loans are permitted to remain on accrual status or are returned to accrual status when receipt of principal and interest payments as they become contractually due is not in doubt based on the preponderance of evidence from a current credit assessment, the

 

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borrower’s successful past performance, or successful performance under the modified terms for periods ranging from three months to over nine months depending on the borrower and type of loan restructured. PCI loans are excluded from TDR designation as changes in expected cash flows resulting from loan modifications are considered in the evaluation of the PCI loan pool for possible impairment.

Charge-Off Policy

Charge-offs for originated loans are taken when specific loans, or portions thereof, are considered uncollectible. The Bank’s policy is to charge these loans off in the period the uncollectible loss amount is reasonably determined. The Bank charges-off commercial loans, or portions thereof, when available information confirms that specific loans are uncollectible based on information that includes, but is not limited to, (1) the deteriorating financial condition of the borrower, (2) declining collateral values, and/or (3) legal action, including bankruptcy, that impairs the borrower’s ability to adequately meet its obligations. For impaired loans that are considered to be solely collateral dependent, a partial charge-off is generally recorded when a loss has been confirmed by an updated appraisal or other appropriate valuation of the collateral. The Bank promptly charges-off consumer-related loans, or portions thereof, when the Bank reasonably determines the amount of the loss. Consumer installment loans charge-off at 120 days past due. Consumer revolving loans, including credit card loans and consumer real estate secured loans, are charged-off at 180 days past due.

The Bank periodically reviews the residual values associated with its leasing portfolios. Declines in residual values that are judged to be other than temporary are recognized as a loss resulting in a reduction in the net investment in the lease.

For PCI loans, uncollectible amounts on individual loans remain in the pools and are considered when estimating expected cash flows for the whole but are not reported as charge-offs. Any required charge-off of a pool level recorded investment will occur at the end of the life of the pool.

Commitments to Extend Credit

Unfunded loan commitments on residential mortgage loans that the Bank intends to sell or securitize in connection with its mortgage banking activities (“rate locks”) are derivatives and recorded on the Consolidated Statements of Condition at fair value. Changes in fair value are recorded in noninterest income in the Consolidated Statements of Operations. The expected net future cash flows related to loan servicing are included in the fair value measurement of the written loan commitments. See Note 13 to the Consolidated Financial Statements for additional information on derivative instruments. All other unfunded loan commitments are not considered derivatives.

Commercial loan commitments and letters of credit are executor contracts and the notional balances are not reflected in the Bank’s Consolidated Statements of Condition. Fees collected are earned over the life of the facility.

Allowance for loan losses / Losses on commitments

The allowance for loan losses recorded in the Consolidated Statements of Condition is maintained at a level considered adequate to absorb probable losses. The allowance is increased by charges to the provision for loan losses 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 under current economic conditions and management’s estimate of losses inherent in the portfolio. Such estimates are reviewed periodically and adjustments, if necessary, are recorded during the periods in which they become known.

An allowance for probable credit losses associated with off-balance sheet credit exposures on unfunded loan commitments other than rate locks is recorded on the Consolidated Statements of Condition in Accrued Expenses and Other Liabilities. The provision for these probable credit losses is reported in Other Expense in the Consolidated Statements of Operations. The Bank utilizes similar processes to estimate the allowance for probable credit losses associated with unfunded loan commitments other than rate locks as the allowance for loan

 

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and lease losses because business processes and credit risks associated with those loan commitments are essentially the same as for loans. However, since many of those loan commitments are expected to expire without being drawn upon, the allowance for probable credit losses associated with those unfunded loan commitments incorporates an estimate of the probability of those loan commitments being funded. The liability is periodically revised for changes in estimates and actual losses or recoveries with charges to other noninterest expense.

Mortgage Servicing

The Bank engages in servicing of mortgage loans and acquires mortgage servicing rights (“MSR”) by originating mortgage loans and then selling those loans with srevicing rights retained. See Note 7 to the Consolidated Financial Statements for additional information on mortgage servicing rights.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed on the straight-line basis over the estimated useful lives of the assets. Estimated useful lives range from 3 years to 10 years for equipment and from 10 to 50 years for buildings. The Bank reviews the carrying value of its premises and equipment for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. If the carrying value exceeds the related undiscounted cash flows, an impairment loss is recognized. Long-lived assets that are impaired are written down to fair value and long-lived assets to be disposed of are carried at the lower of cost or fair value less estimated selling costs. Maintenance and repairs are charged to noninterest expense.

Leases

Rental expense associated with operating leases is recognized on a straight-line basis over the lease term. Escalation clauses that specify scheduled rent increases over the lease term are recognized on a straight-line basis over the lease term.

Bank-owned insurance

The Bank has purchased life insurance coverage on certain employees. The one-time premiums paid for the policies, which coincide with the initial cash surrender value, are recorded as assets on the Consolidated Statements of Condition. Increases or decreases in cash surrender value (other than proceeds from death benefits) are recorded as bank-owned insurance income in the Consolidated Statements of Operations. Proceeds from death benefits first reduce the cash surrender value attributable to the individual policy and any additional proceeds are recorded as noninterest income.

Intangible Assets

Intangible assets with finite lives are amortized on either an accelerated or straight-line basis depending on the character of the acquired asset. Original lives range from 3 to 15 years. Intangible assets subject to amortization are reviewed for impairment when events or future assessments of profitability indicate that the carrying value may not be recoverable. If the carrying value is not expected to be recovered and the carrying value exceeds the fair value, an impairment loss is recognized. Intangible assets with indefinite useful lives are not amortized and are reviewed for impairment annually or more frequently if events indicate impairment. The excess of carrying value over fair value, if any, is recorded as an impairment loss.

FDIC Indemnification Asset

The acquisition of AMCORE from the Federal Deposit Insurance Corporation (“FDIC”) includes a loss share agreement with the FDIC. The loss share agreement provides for reimbursement from the FDIC for a portion of losses on loans and foreclosed real estate (covered assets, collectively) over a defined period of time subsequent to the acquisition date. An indemnification asset was recorded at fair value at acquisition based on the present value of expected cash flows to be received from the FDIC for loss reimbursements covered by the

 

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agreement. The loss assumptions used in determining the FDIC indemnification asset are consistent with those used in valuing the related covered loans. Subsequent to acquisition, the indemnification asset is adjusted for changes in estimated cash flows and reduced for payments for reimbursement of losses from the FDIC. The indemnification asset is separate from the covered assets, is not contractually embedded in the covered assets and is not transferrable with the covered assets in the event of a sale or disposition of the covered assets. It is included in Other Assets on the Consolidated Statements of Condition and accretion is recognized in other noninterest income in the Bank’s Consolidated Statements of Operations. See Note 28 to the Consolidated Financial Statements for additional information.

Diners Club Rewards Liability

The Diners Club Rewards program provides cardholders the opportunity to earn points that can be redeemed for a variety of rewards including air and travel, retail certificates and merchandise. The rewards liability represents the estimated cost of points earned to date that are expected to be redeemed. The rewards liability is included in Other Liabilities on the Consolidated Statements of Condition and the associated cost is recorded as an offset to charge card income.

Other Real Estate Owned

Other real estate owned (“OREO”) received in satisfaction of debt is included in Other Assets and recorded at the lower of the recorded investment in the loan or the fair value of the real estate received, less estimated selling costs. Any write-down to the fair value of OREO at the time of acquisition is charged to the allowance for loan losses. Losses to OREO arising from subsequent write-downs to fair value are charged to noninterest expense and recognized as a valuation allowance against the OREO.

Income Taxes

The Bank is included in the consolidated Federal income tax return of BFC. Federal income tax return liabilities or benefits for all the consolidated entities are not materially different than they would have been if computed on a separate return basis.

The Bank files separate state tax returns in certain states and is included in combined state tax returns with other affiliates in other states.

Deferred tax assets and liabilities, as determined by the temporary differences between financial reporting and tax bases of assets and liabilities, are computed using enacted tax rates and laws. The effect on deferred tax assets and liabilities of a change in tax rates or law is recognized as income or expense in the period including the enactment date. In addition, the Bank assesses the likelihood that deferred tax assets will be realized in future periods and recognizes a valuation allowance for those assets unlikely to be realized. Management’s assessment of the Bank’s ability to realize these deferred tax assets includes the use of management’s judgment and estimates of items such as future taxable income, future reversal of existing temporary differences, carrybacks to prior years and, if appropriate, the use of future tax planning strategies.

Cash flows

In the Consolidated Statements of Cash Flows, cash and cash equivalents include cash and demand balances due from banks, interest-bearing deposits at banks and federal funds sold and securities purchased under agreement to resell, as these meet the definition of cash and cash equivalents.

Management’s estimates

The preparation of financial statements in conformity with GAAP 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The areas requiring significant management judgment include fair value of assets and liabilities acquired, provision and allowance for loan losses, valuation

 

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of income tax assets and liabilities, pension cost, postretirement and postemployment benefits, valuation of goodwill and intangible assets, valuation of Diners Club rewards liability, estimation of expected cash flows for purchased credit-impaired loans and loss reimbursements, fair values of derivatives, mortgage servicing rights, and securities, and temporary vs. other-than-temporary impairment of securities.

Recent accounting standards

The Bank adopted Accounting Standards Update (“ASU”) 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses,” as of January 1, 2011. The ASU amended ASC 310-10-50, Receivables—Overall—Disclosure, in order to expand the requirements for separate reporting and disclosure of allowances for credit losses and the policies for managing credit exposures. The update requires companies to significantly increase disclosures about the credit quality of financing receivables and the credit reserves held against them. The additional disclosures include aging of past due receivables, credit quality information such as credit risk scores or external credit agency ratings and the modification of financing receivables. Further disaggregation of information by certain classification of the total portfolio is also required. The objective of enhancing these disclosures is to improve financial statement users’ understanding of (1) the nature of the credit risk associated with an entity’s financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The adoption of this update had no impact on the Bank’s financial position or results of operations. See Notes 4 and 5 to the Consolidated Financial Statements for the additional disclosures on loans and the allowance for loan losses required by this ASU.

The FASB issued ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring,”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 amendment will be effective for the Bank for the annual reporting period ending December 31, 2012. The Bank does not expect there to be a significant impact on its financial position or results of operations.

The FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements,” in April 2011. The amendments in this ASU remove from the assessment of effective control (1) 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 (2) the collateral maintenance implementation guidance related to that criterion. The amendment will be effective for the Bank for the annual reporting period ending December 31, 2012. The Bank does not expect there to be a significant impact on its financial position or results of operations.

The FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs,” in May 2011. The amendment will be effective for the Bank for the annual reporting period ending December 31, 2012. The amendments in this Update are the result of the work by the FASB and the IASB to develop common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The Bank does not expect there to be a significant impact on its financial position or 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 Bank for the annual reporting period ending December 31, 2012. The Bank does not expect there to be a significant impact on its financial position or results of operations. In December 2011, the FASB issued ASU 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Account Standards Update No. 2011-05”. This ASU indefinitely defers the requirement in ASU 2011-05 related to reclassification adjustments. The deferral does not impact the other requirements in this ASU.

 

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The FASB issued ASU 2011-08, “Testing Goodwill for Impairment,” in September 2011. The update permits an entity to perform a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before performing the two-step goodwill impairment test. If an entity determines that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, then it is not necessary to perform the two-step impairment test. The amendment will be effective for annual and interim goodwill impairment tests performed by the Bank for the year ending December 31, 2012. The Bank does not expect there to be a significant impact on its financial position or results of operations.

The FAB issued ASU 2011-09, “Compensation—Retirement Benefits—Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer’s Participation in a Multiemployer Plan,” in September 2011. The amendments in this Update require additional disclosures about an employer’s participation in a multiemployer plan. The amendment will be effective for the Bank for the annual reporting period ending December 31, 2012. The Bank does not expect there to be a significant impact on its financial position or results of operations.

The FASB issued ASU 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities,” in December 2011. The amendment require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that may be offset or are subject to an enforceable master netting arrangement or similar agreement.

2.    Business Combinations

Marshall & Ilsley Corporation

On July 5, 2011, BMO completed the acquisition of Milwaukee-based Marshall & Ilsley Corporation (“M&I”) for consideration of approximately $4.3 billion paid in BMO common shares, with fractional entitlements to BMO common shares paid in cash. Each common share of M&I was exchanged for 0.1257 of a BMO common share, resulting in the issuance of approximately 67 million common shares. The value of the common shares was arrived at using the average of BMO common share price prevailing during the day the business combination closed. BMO contributed the net assets of M&I to BFC in exchange for 105 BFC common shares. BFC then contributed cash and shares of M&I Marshall and Ilsley Bank and M&I Bank N.A. to BHB in exchange for $30.2 million BHB common shares, which increased BHB’s surplus by $5.7 billion. In addition, immediately prior to the completion of the transaction, BFC purchased M&I’s Troubled Asset Relief Program (“TARP”) preferred shares and warrants from the U.S. Treasury for approximately $1.7 billion. BFC subsequently recorded the cancellation of the TARP preferred shares and warrants.

Immediately upon acquisition, M&I merged with and into BFC, and M&I Marshall and Ilsley Bank and M&I Bank N.A. merged with and into BHB. In addition, The Harris Bank N.A. (a subsidiary of Bankcorp) merged with and into BHB. At that time, Harris N.A. changed its name to BMO Harris Bank N.A. BHB assumed approximately $46.7 billion in assets, including approximately $30.5 billion in loans, and $35.5 billion in deposits from M&I. BHB recorded goodwill of $1,921.0 million which is not deductible for tax purposes. As part of the acquisition, BHB recorded a core deposit intangible asset of $483.9 million to be amortized on an accelerated basis over a period of 10 years, a customer relationship intangible asset of $45.5 million to be amortized on an accelerated basis over a period of 15 years and a credit card portfolio intangible asset of $24.6 million to be amortized over a period of 15 years. The results of operations for M&I Bank have been included in BHB’s consolidated financial statements since July 5, 2011. This acquisition substantially increased BHB’s assets, geographic presence, scope of operations and customer base.

AMCORE Bank N.A.

On April 23, 2010, BHB acquired certain assets and liabilities of Rockford, Illinois-based, AMCORE from the FDIC for $221.5 million. BHB assumed approximately $2.5 billion in assets, including approximately $2.1 billion in loans, and $2.2 billion in deposits. BHB recorded a core deposit intangible of $21.1 million to be amortized over 10 years on an accelerated basis and a customer relationship intangible of $1.3 million to be amortized over 13 years on an accelerated basis. The acquisition includes a loss share agreement with the FDIC which provides for reimbursement from the FDIC for 80% of losses incurred on covered assets, including loans and other real estate owned, subsequent to acquisition date. An indemnification asset estimated at a fair value of $427.5 million was recorded at acquisition based on the present value of expected cash flows to be received from

 

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the FDIC for loss reimbursements covered by the agreement. BHB recorded goodwill of $84.6 million which is deductible for tax purposes. As part of the acquisition, BHB obtained the option to purchase certain AMCORE branches after the close of the transaction. BHB increased the purchase price by $19.9 million as a result of exercising the option to purchase certain of these branches. Acquisition costs of $6.2 million were recorded to noninterest expense for the year ended December 31, 2010. The acquisition provided BHB with an opportunity to expand its branch network into communities in northern Illinois and southern Wisconsin. The results of AMCORE’s operations have been included in BHB’s consolidated financial statements since April 23, 2010.

Diners Club

On December 31, 2009, BMO and the Bank completed the acquisition of the net cardholder receivables and other assets and obligations of the Diners Club North American franchise from an unrelated bank for initial cash consideration of $678 million, subject to a post-closing adjustment based on all parties’ final agreement of the net asset value transferred. Based on a post-closing adjustment of $48.4 million, the final purchase price was reduced to $629.6 million during 2010. The acquisition of the net cardholder receivables of Diners Club gives the Bank the right to issue Diners Club cards to corporate and professional clients in the United States and will accelerate the Bank’s initiative to expand in the travel-and-entertainment card sector. As part of this acquisition, the Bank recorded a purchased credit card relationship intangible asset estimated at $46.3 million which will be amortized on an accelerated basis over 15 years. The Bank recorded goodwill of $11.5 million which is deductible for tax purposes. The gross contractual amount of receivables was $743.2 million. Acquisition-related costs of $0.6 million for the year ended December 31, 2009 were recorded to noninterest expense. The results of the operations of Diners Club have been included in the Bank’s consolidated financial statements since January 1, 2010.

The following table summarizes the adjusted estimated fair value of the assets acquired and liabilities assumed of M&I, AMCORE and Diners Club at their respective dates of acquisition. The allocation of the purchase price for M&I is subject to refinement as BHB completes the valuation of assets acquired and liabilities assumed.

 

     2011      2010      2009  
     M&I      AMCORE      Diners Club  
     (In thousands)  

Cash and cash equivalents (2)

   $ 2,903,052       $ 413,568       $   

Trading accounts and trading derivatives

     216,657                   

Securities

     5,592,094         9,931           

Loans

     30,485,090         1,525,626         647,942   

Premises and equipment

     446,381         20,857         4,394   

Goodwill

     1,975,961         84,572         11,492   

FDIC Indemnification asset

             427,521           

Identifiable intangible assets

     679,251         22,353         46,311   

Other real estate owned

     321,601         23,011           

Other assets

     4,771,551         38,058         1,710   
  

 

 

    

 

 

    

 

 

 

Total assets

   $ 47,391,638       $ 2,565,497       $ 711,849   
  

 

 

    

 

 

    

 

 

 

Deposits

   $ 35,374,553       $ 2,172,542       $ 9,511   

Borrowings

     4,855,288         137,409           

Accrued expenses

     503,507                   

Other liabilities

     668,679         14,163         72,750   
  

 

 

    

 

 

    

 

 

 

Total liabilities

   $ 41,402,027       $ 2,324,114       $ 82,261   
  

 

 

    

 

 

    

 

 

 

Cancellation of TARP

     1,718,250                   
  

 

 

    

 

 

    

 

 

 

Purchase price

   $ 4,271,361       $ 241,383       $ 629,588   
  

 

 

    

 

 

    

 

 

 

 

(1) Assets and liabilities of M&I were acquired by BFC. BFC contributed 95% of the above net assets acquired to BHB.
(2) Cash and cash equivalents includes interest-bearing deposits at banks.

 

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3.    Securities

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

 

    December 31, 2011     December 31, 2010  
    Amortized
Cost
    Unrealized
Gains
    Unrealized
Losses
    Fair
Value
    Amortized
Cost
    Unrealized
Gains
    Unrealized
Losses
    Fair
Value
 
    (In thousands)  

U.S. Treasury

  $ 166,998      $      $      $ 166,998      $ 388,761      $ 5      $ (3   $ 388,763   

U.S. government agency

    2,213,150        13,685        (124     2,226,711        1,985,293        11,449        (397     1,996,345   

U.S. government sponsored mortgage-backed

    5,836,711        100,029        (1,643     5,935,097        633,296        23,966        (2,060     655,202   

State and municipal

    1,199,807        61,631        (9,345     1,252,093        1,587,556        31,982        (9,575     1,609,963   

Non-mortgage asset backed

    1,419,180        5,137        (1,810     1,422,507        726,677        1,929        (158     728,448   

Corporate debt securities

    239,180        247        (472     238,955        10,253                      10,253   

Foreign corporate debt securities

    1,152,968        441        (12,141     1,141,268        300,000        69               300,069   

Foreign government debt securities

    195,622        3        (853     194,772        250                      250   

Other

    21,729                      21,729                               
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total securities

  $ 12,445,345      $ 181,173      $ (26,388   $ 12,600,130      $ 5,632,086      $ 69,400      $ (12,193   $ 5,689,293   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table summarizes, for available-for-sale 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. As of December 31, 2011, the Bank had 678 available-for-sale securities (1,018 in 2010) with unrealized losses totaling $26.4 million (unrealized losses of $12.2 million in 2010). Of these available-for-sale securities, 18 have been in an unrealized loss position continuously for more than twelve months (23 in 2010), amounting to an unrealized loss position of $0.1 million (unrealized loss position of $0.5 million in 2010). These unrealized losses are primarily attributable to changes in interest rates and not from deterioration in the creditworthiness of the issuers. It is the Bank’s intention to not sell and it does not believe it will be required to sell these securities before any anticipated recovery of their amortized cost basis. Based on these factors, management has determined that the unrealized losses are not other-than-temporary in nature. However, due to market and economic conditions there is the potential for other-than-temporary impairment charges in future periods.

 

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

December 31, 2011

     

U.S. government agency

  $ 976,524      $ (124   $      $             $ 976,524      $ (124

U.S. government sponsored mortgage-backed

    603,367        (1,643                          603,367        (1,643

State and municipal

    187,427        (9,221     5,130        (124     18        192,557        (9,345

Non-mortgage asset backed

    746,653        (1,810                          746,653        (1,810

Corporate debt securities

    71,917        (472                          71,917        (472

Foreign corporate debt securities

    978,367        (12,141                          978,367        (12,141

Foreign government debt securities

    193,369        (853                          193,369        (853
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Temporarily impaired securities — available-for-sale

  $ 3,757,624      $ (26,264   $ 5,130      $ (124     18      $ 3,762,754      $ (26,388
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2010

     

U.S. Treasury

  $ 105,773      $ (3   $      $             $ 105,773      $ (3

U.S. government agency

    149,810        (191     224,794        (206     1        374,604        (397

U.S. government sponsored mortgage-backed

    82,301        (2,060                          82,301        (2,060

State and municipal

    458,017        (9,308     6,759        (267     22        464,776        (9,575

Non-mortgage asset backed

    163,574        (158                          163,574        (158
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Temporarily impaired securities — available-for-sale

  $ 959,475      $ (11,720   $ 231,553      $ (473     23      $ 1,191,028      $ (12,193
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

During 2011, the Bank recorded other-than-temporary impairment of $0.5 million on 9 auction rate securities (“ARS”). During 2010, the Bank recorded other-than-temporary impairment of $0.6 million on 24 municipal bonds and $4.4 million on 20 auction rate securities. The losses were all credit-related and recorded in the Consolidated Statements of Operations as other-than-temporary impairment on securities. Impairment losses in 2011 were recorded on securities that were impaired at December 31, 2010. Impairment losses in 2010 were recorded on securities determined to be newly impaired. See Note 28 to the Consolidated Financial Statements for additional information on other-than-temporary impairment losses on other investments.

The amortized cost and estimated fair value of 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

   $ 1,894,560       $ 1,898,985   

1 to 5 years

     8,742,430         8,811,316   

5 to 10 years

     1,185,805         1,245,067   

Over 10 years

     600,821         623,033   

Other securities without stated maturity

     21,729         21,729   
  

 

 

    

 

 

 

Total securities

   $ 12,445,345       $ 12,600,130   
  

 

 

    

 

 

 

 

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ARS are typically short-term notes issued in the United States to fund long-term, fixed rate debt instruments (corporate or municipal bonds primarily issued by municipalities, student loan authorities and other sponsors). The interest rate on ARS is regularly reset every 7 to 35 days through auctions managed by financial institutions. A disruption in the market for ARS occurred in 2008. Certain customer-managed portfolios held these securities, which were no longer liquid. Certain of the Bank’s subsidiaries purchased such securities from customers, at par value.

The gross par value of ARS holdings purchased by the Bank during 2008 and 2009 was $108.8 million plus accrued interest. A discounted cash flow valuation methodology was applied to estimate the fair value of the securities. The methodology included management assumptions about future cash flows, discount rates, market liquidity and credit spreads. The ARS purchased are classified as available-for-sale and are included within the “state and municipal” and “non-mortgage asset backed” categories.

There was no liability relating to the purchase of ARS as of December 31, 2011 and 2010.

For the year ended December 31, 2009, gains of $4.1 million were recorded on ARS securities held as available-for-sale which were called either at par or at amounts that exceeded carrying value. Redemptions of ARS totaled $14.9 million for the year ended December 31, 2009. The carrying value of ARS was $77.8 million as of December 31, 2009.

For the year ended December 31, 2010, ARS held as available-for-sale with a gross par value of $54.7 million were sold or called and a gain of $6.3 million was recorded to net securities gains, other than trading in the Consolidated Statements of Operations. During 2010 a credit-related impairment charge of $4.4 million was recorded to other-than-temporary impairment on ARS on the Consolidated Statements of Operations. The carrying value of remaining ARS was $17.4 million as of December 31, 2010 and the securities were classified as available-for-sale.

On July 5, 2011, as part of BMO’s acquisition of M&I, BHB acquired $26.4 million of ARS, which are classified as available-for-sale and are included within the “state and municipal” category.

For the year ended December 31, 2011, ARS held as available-for-sale with a gross par value of $30.3 million were either sold or called and a gain of $5.1 million was recorded to net securities gains, other than trading in the Consolidated Statements of Operations. During 2011 a credit-related impairment charge of $0.5 million was recorded to other-than-temporary impairment on securities in the Consolidated Statements of Operations. The carrying value of remaining ARS was $21.5 million as of December 31, 2011 and the securities were classified as available-for-sale.

At December 31, 2011, 2010 and 2009, available-for-sale and trading account securities having a carrying amount of $4.5 billion, $5.3 billion and $3.3 billion, respectively, were pledged as collateral for certain liabilities, securities sold under agreement to repurchase, public and trust deposits, trading account activities and for other purposes where permitted or required by law. The Bank maintains effective control over the securities sold under agreement to repurchase and accounts for the transactions as secured borrowings.

In 2011, 2010, and 2009, proceeds from the sale of securities available-for-sale amounted to $2.1 billion, $0.5 billion and $3.5 billion, respectively. Gross gains of $38.5 million and gross losses of $11.0 million were realized on these sales in 2011. Gross gains of $6.6 million and gross losses of $50 thousand were realized on these sales in 2010, while gross gains of $37.5 million and gross losses of $1.8 million were realized in 2009. Net realized and unrealized gains on trading securities during 2011, 2010 and 2009 were $12.3 million, $29.6 million and $20.3 million, respectively. $7.0 million and $2.8 million of net unrealized gains were related to trading securities still held as of December 31, 2011 and 2010, respectively.

 

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4.    Loans

The following table summarizes loan balances by category:

 

     December 31  
     2011      2010  
     (In thousands)  

Commercial

     

Commercial and Industrial (1)

   $ 15,011,699       $ 3,557,579   

Commercial Real estate mortgages

     11,125,272         3,792,737   

Construction and development

     2,140,036         372,488   
  

 

 

    

 

 

 

Total commercial

   $ 28,277,007       $ 7,722,804   
  

 

 

    

 

 

 

Consumer

     

Residential real estate mortgages

     9,539,439         5,087,328   

Home equity

     7,329,357         5,061,755   

Other consumer

     5,979,889         5,014,734   
  

 

 

    

 

 

 

Total consumer

   $ 22,848,685       $ 15,163,817   
  

 

 

    

 

 

 

Total loans (2)

   $ 51,125,692       $ 22,886,621   

Less unearned income

     65,630         6,495   
  

 

 

    

 

 

 

Loans, net of unearned income

   $ 51,060,062       $ 22,880,126   

Less allowance for loan losses

     760,851         721,888   
  

 

 

    

 

 

 

Loans, net of allowance for loan losses

   $ 50,299,211       $ 22,158,238   
  

 

 

    

 

 

 

 

 

(1) Includes $454.1 million and $12.7 million of lease financing receivables net of unearned income at December 31, 2011 and December 31, 2010, respectively.

 

(2) Includes $0.9 billion and $1.2 billion of acquired loans subject to loss share agreement at December 31, 2011 and December 31, 2010, respectively.

The following table summarizes payment status of loans and leases by category as of December 31, 2011. The measurement of delinquency is based on the contractual terms of each loan. Loans that are 30 days or more past due in terms of payment are considered past due. Loan delinquencies exclude loans held for sale.

 

    December 31, 2011  
    (In thousands)  
    Current     30-89 Days
Past Due  and
Still Accruing
    90+ Days
Past Due and
Still Accruing
    Nonaccrual     PCI Loans     Total  

Commercial

           

Commercial and industrial

  $ 14,456,772      $ 98,253      $ 9,598      $ 118,319      $ 328,757      $ 15,011,699   

Commercial real estate mortgages

    9,197,353        214,381        24,520        410,482        1,278,536        11,125,272   

Construction and development

    1,395,976        65,062               106,843        572,155        2,140,036   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial

  $ 25,050,101      $ 377,696      $ 34,118      $ 635,644      $ 2,179,448      $ 28,277,007   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Consumer

           

Residential real estate mortgages

  $ 8,700,988      $ 265,992      $ 48,608      $ 272,502      $ 251,349      $ 9,539,439   

Home equity

    7,027,859        83,803        6,431        147,993        63,271        7,329,357   

Other consumer

    5,891,115        48,873        9,669        5,044        25,188        5,979,889   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer

  $ 21,619,962      $ 398,668      $ 64,708      $ 425,539      $ 339,808      $ 22,848,685   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 46,670,063      $ 776,364      $ 98,826      $ 1,061,183      $ 2,519,256      $ 51,125,692   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Nonperforming assets include nonaccrual loans, nonperforming restructured loans and other nonperforming assets. Nonperforming assets as of December 31, 2010 are summarized below:

 

     December 31, 2010  
     (In thousands)  

Nonaccrual loans

   $ 800,338   

Nonperforming restructured loans

     115,278   
  

 

 

 

Total nonperforming loans

   $ 915,616   

Other real estate owned

     39,730   
  

 

 

 

Total nonperforming assets

   $ 955,346   
  

 

 

 

90-day past due loans, still accruing interest

   $ 148,139   
  

 

 

 

At December 31, 2011 there were $141.3 million of nonperforming troubled debt restructured loans and $82.9 million of performing restructured loans. At December 31, 2010, nonperforming and performing restructured loans totaled $115.3 million and $22.5 million, respectively. Commitments to lend additional funds on nonperforming restructured loans totaled $13.6 million at December 31, 2011 and $22.6 million at December 31, 2010.

At December 31, 2011 and 2010, the Bank had no aggregate public or private sector outstandings to any single foreign country experiencing liquidity problems which exceeded one percent of the Bank’s consolidated assets. At December 31, 2011 and 2010 commercial loans with a carrying value of $12.8 billion and $5.4 billion, respectively, were pledged to secure potential borrowings with the Federal Reserve. At December 31, 2011 and 2010, first mortgage loans on 1-4 family homes with a carrying value of $6.5 billion and $3.9 billion, respectively, were pledged to secure borrowings from the Federal Home Loan Bank.

Purchased Credit-Impaired Loans

On July 5, 2011, BMO and the Bank acquired M&I which included PCI loans. On April 23, 2010, the Bank acquired certain assets and liabilities of AMCORE from the FDIC that included both PCI loans and purchased performing loans. As permitted the Bank accounts for all loans acquired from Amcore and loans with deteriorated credit quality acquired from M&I as PCI loans. The following information includes all loans accounted for as PCI loans. On December 31, 2009, BMO and the Bank completed the acquisition of the net cardholder receivables of the Diners Club North American franchise from an unrelated bank. The cardholder receivables within the scope of ASC 310-30 were not material to the Bank’s financial statements and, as a result, are not included in the following information about purchased credit-impaired loans. See Note 2 to the Consolidated Financial Statements for additional information on business combinations.

The following table provides details on loans accounted for as PCI as of the respective acquisition dates.

 

     M&I      AMCORE  
     (In thousands)  

Contractually required payments including interest

   $ 4,753,687       $ 2,231,354   

Nonaccretable difference

     2,584,702         509,753   
  

 

 

    

 

 

 

Cash flows expected to be collected (undiscounted)

   $ 2,168,985       $ 1,721,601   

Accretable yield

     178,506         195,975   
  

 

 

    

 

 

 

Fair value of purchased loans

   $ 1,990,479       $ 1,525,626   
  

 

 

    

 

 

 

 

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The following table presents the change in accretable yield related to the acquired PCI loans.

 

     2011     2010  
     (In thousands)  

Accretable yield, beginning of year

   $ 193,345      $   

Additions

     178,506        195,975   

Removals

     (66,729     (15,022

Accretion

     (136,700     (44,689

Reclassification from nonaccretable difference

     282,440        57,081   
  

 

 

   

 

 

 

Accretable yield, end of year

   $ 450,862      $ 193,345   
  

 

 

   

 

 

 

The carrying amount and outstanding balance of all PCI loans are presented in the table below.

 

     December 31  
     2011      2010  
     (In thousands)  

Contractual outstanding balance

   $ 4,396,112       $ 1,911,784   

Carrying amount

   $ 2,519,256       $ 1,239,445   

The carrying amount of all nonaccreting purchased credit-impaired loans at December 31, 2011 and 2010 was $7.5 million and $12.6 million, respectively.

The following table reflects the changes in the allowance for loan losses associated with purchased credit-impaired loans and other acquired loans.

 

     2011     2010  
     (In thousands)  

Balance, beginning of year

   $ 12,722      $ 6,679   

Provisions charged to expense

     29,730        2,018   

Reductions

     (10,754     (4,047

Losses partially recoverable under loss share agreement

     12,561        8,072   
  

 

 

   

 

 

 

Balance, end of year

   $ 44,259      $ 12,722   
  

 

 

   

 

 

 

5. Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio as well as probable losses related to specific loans. The allowance is maintained at a level that is considered adequate to absorb all estimated or inherent losses in the loan portfolio. A determination of the allowance is based upon a quantitative analysis of the portfolio, adjusted for management’s current judgments about credit quality of the loan portfolio. Management considers known relevant qualitative factors that affect loan collectability. Internal factors include credit quality trends and changes in portfolio concentration. External factors include industry, economic and regional trends and areas of stress, legal and regulatory legislation affecting account management processes, and changes in lending practice.

The loan portfolio is segmented based upon risk characteristics that are common to groups of loans. Risk characteristics considered within the commercial loan portfolio include borrower credit history, delinquencies, risk ratings, loan-to-value measures, liquidity, debt service and cash flow coverage, market risk exposure, competitive position, cyclicality, and trends in operations. Risk characteristics considered within the consumer loan portfolio include borrower credit history, product type, collateral type, loan-to-value measures, seasoning and delinquencies.

The Bank uses separate internal risk rating systems to identify commercial credit risk and consumer credit risk. The systems are designed to provide a consistent method to assess the credit risk of the Bank’s loan customers. An assessment of the overall performance of each risk rating system is completed at least annually to confirm that credit risk measures react to changes in the credit environment in a manner consistent with the

 

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Bank’s rating philosophy. Commercial risk ratings are used to determine the frequency of review of credit exposures and to evaluate and determine the allowance for commercial loan losses. The risk rating system measures the probability of default of a borrower and the loss given default of the credit facilities. Risk ratings are based on an assessment of the borrower’s capacity to meet its financial obligations over a one-year horizon which incorporates a wide range of possible economic conditions. The consumer risk rating system identifies consumer credit risk based on the segmentation of the consumer portfolio into pools with homogeneous risk characteristics. The homogeneity of the pools enables accurate and consistent estimation of default or loss characteristics at the pool level. Defaulted credit facilities are segmented separately from non-defaulted credit facilities. The system uses the measurement of expected loss based on probability of default and loss given default or a roll rate model based on trends in delinquency, charge-offs and recoveries including statistical analysis to identify relationships between key economic variables and portfolio loss.

Pass ratings represent commercial exposures that exhibit low probabilities of default and the borrowers have the strongest credit quality. Watch list ratings represent exposures that exhibit potential weaknesses and early warning signals to significant default risk. Impaired risk ratings represent exposures that have been classified as in default and include all nonperforming loans.

Impaired loans are defined as those where it is probable that amounts due for principal or interest according to contractual terms will not be collected. Impaired loans include commercial loans designated nonaccrual and both commercial and consumer loans modified in trouble debt restructurings.

The changes in the allowance for loan losses for the year ended December 31, 2011 are as follows:

 

    Commercial
and  Industrial
    Commercial
Real Estate
Mortgages
    Construction
and  Development
    Residential
Real Estate
Mortgages
    Home
Equity
    Other
Consumer
    Total  
    (In thousands)  

Balance, beginning of year

  $ 195,394      $ 179,493      $ 20,297      $ 113,954      $ 149,500      $ 63,250      $ 721,888   

Charge-offs

    (80,233     (29,489     (14,899     (77,823     (143,728     (74,762   $ (420,934

Recoveries

    43,462        765        1,363        7,410        7,010        44,113      $ 104,123   

Provisions charged to expense

    45,360        36,281        25,897        57,589        153,340        24,746      $ 343,213   

Losses partially recoverable under loss share agreement

    (72     (3,648            15,181        (21     1,121      $ 12,561   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of year

  $ 203,911      $ 183,402      $ 32,658      $ 116,311      $ 166,101      $ 58,468      $ 760,851   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses

             

Specifically evaluated for impairment

  $ 16,106      $ 40,587      $ 7,912      $ 24,706      $      $      $ 89,311   

Collectively evaluated for impairment

    187,805        142,815        24,746        91,605        166,101        58,468        671,540   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for loan losses

  $ 203,911      $ 183,402      $ 32,658      $ 116,311      $ 166,101      $ 58,468      $ 760,851   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loans and leases

             

Specifically evaluated for impairment

  $ 125,072      $ 410,481      $ 106,844      $ 272,949      $ 147,994      $ 5,320      $ 1,068,660   

Collectively evaluated for impairment

    14,886,627        10,714,791        2,033,192        9,266,490        7,181,363        5,974,569        50,057,032   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans and leases

  $ 15,011,699      $ 11,125,272      $ 2,140,036      $ 9,539,439      $ 7,329,357      $ 5,979,889      $ 51,125,692   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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The changes in the allowance for loan losses for the year ended December 31, 2010 are as follows:

 

     (In thousands)  

Balance, beginning of year

   $ 698,603   

Charge-offs

     (382,542

Recoveries

     79,133   
  

 

 

 

Net charge-offs

   $ (303,409

Provisions charged to expense

     318,622   

Losses partially recoverable under loss share agreement

     8,072   
  

 

 

 

Balance, end of year

   $ 721,888   
  

 

 

 

 

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The following table presents information related to impaired loans as of December 31, 2011.

 

     Recorded
Investment
     Unpaid
Principal  Balance
     Specific
Reserve
 
     (In thousands)  

With a specific allowance:

        

Commercial

        

Commercial and industrial

   $ 16,213       $ 20,661       $ 16,106   

Commercial real estate mortgages

     150,777         179,695         40,587   

Construction and development

     23,890         28,924         7,912   
  

 

 

    

 

 

    

 

 

 

Total commercial

   $ 190,880       $ 229,280       $ 64,605   
  

 

 

    

 

 

    

 

 

 

Consumer

        

Residential real estate mortgages

   $ 93,669       $ 108,075       $ 24,706   

Home equity

                       

Other consumer

                       
  

 

 

    

 

 

    

 

 

 

Total consumer

   $ 93,669       $ 108,075       $ 24,706   
  

 

 

    

 

 

    

 

 

 

Total with a specific allowance

   $ 284,549       $ 337,355       $ 89,311   
  

 

 

    

 

 

    

 

 

 

With no specific allowance:

        

Commercial

        

Commercial and industrial

   $ 108,859       $ 166,567       $   

Commercial real estate mortgages

     259,704         339,880           

Construction and development

     82,954         93,716           
  

 

 

    

 

 

    

 

 

 

Total commercial

   $ 451,517       $ 600,163       $   
  

 

 

    

 

 

    

 

 

 

Consumer

        

Residential real estate mortgages

     179,280         233,655           

Home equity

     147,994         141,785           

Other consumer

     5,320         4,625           
  

 

 

    

 

 

    

 

 

 

Total consumer

   $ 332,594       $ 380,065       $   
  

 

 

    

 

 

    

 

 

 

Total with no specific allowance

   $ 784,111       $ 980,228       $   
  

 

 

    

 

 

    

 

 

 

Total:

        

Commercial

        

Commercial and industrial

   $ 125,072       $ 187,228       $ 16,106   

Commercial real estate mortgages

     410,481         519,575         40,587   

Construction and development

     106,844         122,640         7,912   
  

 

 

    

 

 

    

 

 

 

Total commercial

   $ 642,397       $ 829,443       $ 64,605   
  

 

 

    

 

 

    

 

 

 

Consumer

        

Residential real estate mortgages

   $ 272,949       $ 341,730       $ 24,706   

Home equity

     147,994         141,785           

Other consumer

     5,320         4,625           
  

 

 

    

 

 

    

 

 

 

Total consumer

   $ 426,263       $ 488,140       $ 24,706   
  

 

 

    

 

 

    

 

 

 

Total

   $ 1,068,660       $ 1,317,583       $ 89,311   
  

 

 

    

 

 

    

 

 

 

 

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The following table presents details on impaired loans and the related allowance as of December 31, 2010. The table does not include purchased impaired loans that are recognized in accordance with ASC 310-30.

 

     Impaired Loans
for Which  There
is a Related
Allowance
     Impaired Loans
for Which  There
is No Related
Allowance
     Total
Impaired
Loans
 
     (In thousands)  

December 31, 2010

        

Balance

   $ 223,529       $ 188,236       $ 411,765   

Related allowance

     102,644                 102,644   
  

 

 

    

 

 

    

 

 

 

Balance, net of allowance

   $ 120,885       $ 188,236       $ 309,121   
  

 

 

    

 

 

    

 

 

 

 

     Years Ended December 31  
     2011      2010  
     (In thousands)  

Average impaired loans

   $ 430,647       $ 331,194   
  

 

 

    

 

 

 

Total interest income on impaired loans recorded on a cash basis

   $ 13,304       $ 4,896   
  

 

 

    

 

 

 

The allowance for off-balance-sheet credit losses was $244.1 million and $16.1 million at December 31, 2011 and 2010, respectively. The reserve is recorded in other liabilities on the Consolidated Statements of Condition.

The following table details credit exposure by credit quality indicator for loans and leases at December 31, 2011.

 

    December 31, 2011  
    (In thousands)  
    Commercial
and Industrial
    Commercial
Real Estate
Mortgages
    Construction
and Development
    Residential
Real Estate
Mortgages
    Home
Equity
    Other
Consumer
    Total  

Commercial risk stratum

             

Impaired

  $ 125,072      $ 410,481      $ 106,844      $      $      $      $ 642,397   

Watch list

    2,214,356        3,660,914        841,286                             6,716,556   

Pass

    12,672,271        7,053,877        1,191,906                             20,918,054   

Consumer credit score

             

620 or less

                         430,663        281,789        73,726        786,178   

621-720

                         2,729,131        2,432,360        979,627        6,141,118   

721 or greater

                         5,386,702        4,180,401        4,254,755        13,821,858   

Not rated

                         992,943        434,807        671,781        2,099,531   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans and leases

  $ 15,011,699      $ 11,125,272      $ 2,140,036      $ 9,539,439      $ 7,329,357      $ 5,979,889      $ 51,125,692   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

6.    Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. A summary of these accounts is set forth below:

 

     December 31  
     2011      2010  
     (In thousands)  

Land

   $ 231,886       $ 108,689   

Buildings

     542,961         329,711   

Computer equipment and software

     588,729         519,883   

Other equipment

     138,748         98,810   

Leasehold improvements

     127,829         103,505   
  

 

 

    

 

 

 

Total

   $ 1,630,153       $ 1,160,598   

Accumulated depreciation and amortization

     663,239         609,848   
  

 

 

    

 

 

 

Premises and equipment

   $ 966,914       $ 550,750   
  

 

 

    

 

 

 

 

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Depreciation and amortization expense was $104.3 million, $72.1 million and $67.5 million in 2011, 2010 and 2009, respectively.

The Bank recognized gains in noninterest income of $0.6 million, $0.9 million and $2.6 million in 2011, 2010 and 2009, respectively, from the sale of property previously held for use. Property held for sale is recorded in other assets at the lower of cost or fair value less estimated selling costs. See Note 28 to the Consolidated Financial Statements for additional information on the other assets.

7.    Goodwill and Other Intangible Assets

Goodwill

The Bank records acquisitions by allocating the purchase price paid to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their fair values at the date of acquisition. Any excess of the amount paid over the fair value of those net assets is considered to be goodwill.

Goodwill is not amortized; however, it is assessed for impairment at least annually. The impairment test consists of allocating goodwill to the Bank’s reporting units (groups of businesses with similar characteristics) and then comparing the book value of the reporting units, including goodwill, to their fair values. Fair value is determined primarily using discounted cash flows. If the carrying value of a reporting unit is determined to be in excess of its fair value, a second test is required to measure the amount of impairment. There were no write-downs of goodwill due to impairment during the years ended December 31, 2011, 2010 and 2009.

The valuation of goodwill requires significant management judgment. Management makes estimates and assumptions in performing goodwill impairment analyses and actual results could differ from the estimates. While the potential impact from a noncash goodwill impairment loss could be material, such a charge would not affect the ongoing operation of the Bank, its liquidity or its regulatory Tier 1 capital or total capital ratios since goodwill is generally excluded from regulatory capital.

Changes in the carrying amount of the Bank’s goodwill for the years ended December 31, 2011 and 2010 are included in the following table:

 

     2011      2010  
     (In thousands)  

Goodwill at beginning of year

   $ 799,118       $ 721,099   

Acquisitions during the year

     1,921,008         84,572   

Other (1)

             (6,553
  

 

 

    

 

 

 

Goodwill at end of year

   $ 2,720,126       $ 799,118   
  

 

 

    

 

 

 

 

(1) Includes the effect of accounting adjustments related to prior year acquisitions.

Intangibles

There were no write-downs of intangible assets due to impairment during the years ended December 31, 2011, 2010 and 2009.

The total amount of intangible assets acquired during the year ended December 31, 2011 is $554 million (see Note 2 to the Consolidated Financial Statements for additional information on intangible assets acquired). The weighted-average amortization periods for intangible assets acquired during 2011 are as follows: 4.28 years for core deposit premium, 4.89 years for customer relationship intangible assets and 4.36 years for purchased credit card relationship.

 

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As of December 31, 2011 and 2010, the gross carrying amount and accumulated amortization of the Bank’s amortizable intangible assets are included in the following tables:

 

     December 31, 2011  
     Gross Carrying      Accumulated     Net Carrying  
     Amount      Amortization     Value  
     (In thousands)  

Branch network

   $ 145,000       $ (145,000   $   

Core deposits

     651,722         (164,649     487,073   

Purchased credit card relationships

     70,931         (9,539     61,392   

Customer relationships

     49,800         (4,960     44,840   

Other

     1,310         (1,310       
  

 

 

    

 

 

   

 

 

 

Total finite life intangibles

   $ 918,763       $ (325,458   $ 593,305   
  

 

 

    

 

 

   

 

 

 

 

     December 31, 2010  
     Gross Carrying      Accumulated     Net Carrying  
     Amount      Amortization     Value  
     (In thousands)  

Branch network

   $ 145,000       $ (140,167   $ 4,833   

Core deposits

     167,833         (108,692     59,141   

Purchased credit card relationships

     46,311         (2,002     44,309   

Customer relationships

     4,300         (1,819     2,481   

Other

     1,310         (1,310       
  

 

 

    

 

 

   

 

 

 

Total finite life intangibles

   $ 364,754       $ (253,990   $ 110,764   
  

 

 

    

 

 

   

 

 

 

Total amortization expense for the Bank’s intangible assets was $71.7 million, $26.0 and $25.4 million in 2011, 2010 and 2009, respectively.

At December 31, 2011, estimated intangible asset amortization expense for existing intangible assets, excluding mortgage servicing rights, in each of the next five years and thereafter is as follows:

 

Year

   Amount  
     (In thousands)  

2012

   $ 109,397   

2013

     89,109   

2014

     73,911   

2015

     62,666   

2016

     56,059   

Thereafter

     202,163   
  

 

 

 

Total

   $ 593,305   
  

 

 

 

Mortgage servicing rights

The Bank engages in the servicing of mortgage loans and acquires mortgage servicing rights (“MSR”) by purchasing or originating mortgage loans and then selling those loans with servicing rights retained. The Bank initially records MSR at estimated fair value and then measures the MSR using the amortization method. Fair value of MSR is estimated using discounted cash flow analyses. The analyses consider portfolio characteristics, servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenues, costs to service and other economic factors such as levels of supply and demand for servicing and interest rate trends. The estimated fair value of MSR is sensitive to changes in interest rates, including their effect on prepayment speeds. Prepayment assumptions are based on dealer consensus prepayment estimates and adjusted for geographical factors. The Bank stratifies its portfolio based on the predominant risk characteristics of loan type, term and

 

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origination date. MSR are amortized in proportion to, and over the period of, estimated net servicing income. MSR are periodically evaluated for impairment (and subsequent write-down) based on the fair value of those rights.

Serviced loans were $3.8 billion and $3.7 billion at December 31, 2011 and 2010, respectively. Servicing fees, late fees and ancillary fees are recorded in other noninterest income and totaled $10.0 million, $9.0 million and $7.9 million in 2011, 2010 and 2009, respectively. As additions to MSR from loan sales are recorded, income from these sales is recognized as other noninterest income. Amortization of MSR is recorded to other noninterest expense. MSR impairment is recognized as other noninterest expense through a valuation allowance to the extent that the carrying value exceeds estimated fair value. MSR is recorded in Other Assets on the Consolidated Statements of Condition.

Changes in the carrying amount of the Bank’s MSR for the years ended December 31, 2011, 2010 and 2009 are included in the following table:

 

     2011     2010     2009  
     (In thousands)  

MSR at beginning of year

   $ 32,182      $ 30,598      $ 22,063   

Originations

     7,703        8,426        14,309   

Acquired in acquisitions

     2,000                 

Amortization

     (7,631     (6,842     (5,774
  

 

 

   

 

 

   

 

 

 

MSR at end of year

   $ 34,254      $ 32,182      $ 30,598   
  

 

 

   

 

 

   

 

 

 

Valuation allowance at beginning of year

   $ 3,898      $      $   

Addition, net

     6,306        3,898          
  

 

 

   

 

 

   

 

 

 

Valuation allowance at end of year

   $ 10,204      $ 3,898      $   
  

 

 

   

 

 

   

 

 

 

MSR, net

   $ 24,050      $ 28,284      $ 30,598   
  

 

 

   

 

 

   

 

 

 

Fair value at beginning of year

   $ 30,526      $ 31,210      $ 26,129   

Fair value at end of year

     24,472        30,526        31,210   

8.    Deposits

The following table summarizes deposit balances by category:

 

     December 31  
     2011      2010  
     (In thousands)  

Demand deposits

   $ 24,932,593       $ 9,265,697   

Demand deposits in foreign offices

     2,628,071         2,718,059   

Interest-bearing checking deposits

     825,340         289,762   

Money market accounts

     29,950,585         13,820,812   

Statement savings accounts

     3,524,773         2,442,302   

Savings certificates

     11,348,628         5,552,547   

Time deposits

     1,743,427         1,338,347   

Time deposits in foreign offices

     671,226         1,518,884   
  

 

 

    

 

 

 

Total deposits

   $ 75,624,643       $ 36,946,410   
  

 

 

    

 

 

 

 

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At December 31, 2011, the scheduled maturities of savings certificates and time deposits are as follows:

 

Year

   Amount  
     (In thousands)  

2012

   $ 7,461,529   

2013

     2,432,209   

2014

     890,668   

2015

     1,043,332   

2016

     243,925   

Thereafter

     1,691,618   
  

 

 

 

Total

   $ 13,763,281   
  

 

 

 

Time deposits, including certificates of deposit, in denominations of $100,000 or more issued by domestic offices totaled $4.1 billion and $2.5 billion at December 31, 2011 and 2010, respectively. All time deposits in foreign offices were in denominations of $100,000 or more and totaled $0.7 million and $1.5 billion at December 31, 2011 and 2010, respectively.

The Bank issues structured interest rate certificates of deposit and records these instruments at fair value, consistent with the election allowed under GAAP. The Bank enters into interest rate derivatives, which manage exposure to changes in the fair value of structured certificates of deposit caused by changes in interest rates. Structured interest rate certificates of deposit may have callable features that provide for higher returns to the investor, step-up features that provide for one or more increases in the interest rate, adjustments to the interest rate based on a predetermined benchmark rate or a link to the performance of a reference index. The Bank also issues structured certificates of deposit that are interest rate-linked, equity-linked, foreign currency-linked, debt-linked and commodity-linked and the Bank holds equity derivatives and foreign exchange derivatives and commodity derivates in order to economically hedge changes in the fair value of the structured certificates of deposit. See Note 13 to the Consolidated Financial Statements for additional information on derivatives. The Bank elected the fair value option for all of the structured certificates of deposit in order to align the economic impact of changes in fair value of the structured certificates of deposits with the related derivative instruments. See Note 11 to the Consolidated Financial Statements for additional information on fair value measurements. The structured certificates of deposit are classified as deposits and interest is measured based on contractual interest rates and recorded as interest expense. At December 31, 2011, the fair value of the structured certificates of deposit was $17.9 million less than the principal balance of $1.7 billion. At December 31, 2010, the fair value of the structured certificates of deposit was $3.5 million greater than the principal balance of $1.3 billion. The impact of recording the structured certificates of deposit at fair value was an increase in noninterest revenue of $19.6 million, a decrease in noninterest revenue of $6.5 million, and an increase in noninterest revenue of $1.2 million for the years ended December 31, 2011, 2010, and 2009 respectively. There was no change in fair value attributable to changes in the Bank’s credit risk for the years ended December 31, 2011 and 2010.

 

9. Securities Purchased Under Agreement to Resell, Securities Sold Under Agreement to Repurchase and Federal Funds, Purchased and Sold

The Bank enters into purchases of securities, primarily U.S. Treasury and Federal agency securities under agreements to resell identical securities. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the Consolidated Statements of Condition. Securities purchased under agreement to resell totaled $1.7 billion and $1.2 billion at December 31, 2011 and 2010, respectively.

The Bank also enters into sales of securities, primarily U.S. Treasury and Federal agency securities under agreements to repurchase identical securities. The amounts received under these agreements represent short-term borrowings and are reflected as liabilities in the Consolidated Statements of Condition. Securities sold under agreement to repurchase totaled $469.4 million and $864.9 million at December 31, 2011 and 2010, respectively.

The Bank monitors the market value of the securities on a daily basis and adjusts the level of collateral, as appropriate. The Bank’s policy is to take possession of securities purchased under agreements to resell.

 

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The Bank purchases and sells federal funds to other banks, typically in unsecured transactions. Federal funds sold are recorded as assets and federal funds purchased are recorded as liabilities in the Consolidated Statements of Condition. Federal funds sold totaled $12.4 million and $9.5 million at December 31, 2011 and 2010, respectively. Federal funds purchased totaled $244.9 million and $131.3 million at December 31, 2011 and 2010, respectively.

10.    Short and Long-Term Notes

The following table summarizes the Bank’s long-term notes:

 

     December 31            
     2011      2010     

Rate

   Reprice
     (In thousands)            

Floating rate senior note to BMO subsidiary due June 13, 2011

   $       $ 746,500       14bps + 90 day LIBOR    Quarterly

Floating rate senior note to BMO subsidiary due September 29, 2011

             550,000       14bps + 90 day LIBOR    Quarterly

Floating rate senior note to BMO subsidiary due September 29, 2011

             50,000       145bps + 90 day LIBOR    Quarterly

Floating rate senior note to BMO branch due August 14, 2012

     1,100,000         1,100,000       14bps + 90 day LIBOR    Quarterly
  

 

 

    

 

 

       

Total long-term notes — senior/unsecured

   $ 1,100,000       $ 2,446,500         
  

 

 

    

 

 

       

Floating rate secured note to FHLB due October 30, 2017

   $ 1,000,000       $ 1,000,000       30 day LIBOR    Monthly

Floating rate secured note to FHLB due November 13, 2017

     500,000         500,000       30 day LIBOR    Monthly

Floating rate secured note to FHLB due November 28, 2017

     500,000         500,000       30 day LIBOR    Monthly

Floating rate secured note to FHLB due February 20, 2018

     375,000         375,000       30 day LIBOR    Monthly
  

 

 

    

 

 

       

Total long-term notes — senior/secured

   $ 2,375,000       $ 2,375,000         
  

 

 

    

 

 

       

Floating rate subordinated bank note due December 4, 2012

     195,524               27bps + 90 day LIBOR    Quarterly

Floating rate subordinated note to BFC due May 31, 2014

     100,000         100,000       35bps + 90 day LIBOR    Quarterly

Floating rate subordinated note to BFC due May 31, 2016

     100,000         100,000       38bps + 90 day LIBOR    Quarterly

Fixed rate subordinated bank notes (1)

     968,278               4.85% - 5.87%    Fixed
  

 

 

    

 

 

       

Total long-term notes — subordinated

   $ 1,363,802       $ 200,000         
  

 

 

    

 

 

       

Total long-term notes

   $ 4,838,802       $ 5,021,500         
  

 

 

    

 

 

       

At December 31, 2011 and 2010 the current portion of total long-term notes was $1.6 billion and $1.3 billion, respectively.

 

(1) The fixed rate bank notes are due from September 4, 2012 to June 28, 2020

The scheduled principal payments on long-term notes for the years ending December 31, 2012, 2013, 2014, 2015, 2016 and thereafter are $1.6 billion, $0, $0.1 million, $0.4 million, $0.1 million and $2.7 billion, respectively.

The Bank’s subordinated notes are unsecured obligations, ranking on parity with all unsecured and subordinated indebtedness of the Bank. The Bank’s notes are prepayable at any time at the option of the Bank, subject to regulatory approval. In addition, both the Bank and the notes’ holder may extend maturity of the notes for up to five years subject to approval. At year-end 2011, 30-day and 90-day LIBOR rates were 0.29 percent and 0.56 percent, respectively.

 

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The interest rate on the long-term secured notes due from BHB to the Federal Home Loan Bank of Chicago (“FHLB”) reprices monthly at 30 day LIBOR, with a weighted average rate of 0.23 percent for the year ended December 31, 2011. The notes are not prepayable. At December 31, 2011 and 2010, first mortgage loans on 1-4 family homes with a carrying value of $3.5 billion and $3.3 billion, respectively, were pledged to secure these borrowings.

The Bank offers to institutional investors from time to time, unsecured short-term and medium-term bank notes in an aggregate principal amount of up to $1.5 billion outstanding at any time. The term of each note could range from 14 days to 15 years. These senior notes are subordinated to deposits and rank on parity as per above with all other unsecured senior indebtedness of the Bank. As of December 31, 2011 there were $1.2 billion outstanding notes, which are included in the table above within long-term notes – subordinated. As of December 31, 2010 there were no outstanding notes.

The following table summarizes the Bank’s short-term senior notes:

 

     December 31               
     2011      2010      Rate     Reprice  

Short-term senior notes

   (In thousands)               

Fixed rate senior note to investors due February 22, 2012

   $ 80,956                 5.15     Fixed   
  

 

 

    

 

 

      

Total short-term senior notes

   $ 80,956       $        
  

 

 

    

 

 

      

11.    Fair Value of Financial Instruments and Fair Value Measurements

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 Bank’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 Bank could realize in an actual transaction. The fair value estimation methodologies employed by the Bank were as follows:

Fair value was assumed to equal carrying value for cash and demand balances due from banks along with short-term money market assets and liabilities (including interest-bearing deposits at banks, Federal funds sold, Federal funds purchased, securities purchased under agreement to resell and securities sold under agreement to repurchase), securities borrowed and loaned, accrued interest receivable and payable, commercial paper outstanding, short-term borrowings and short-term senior notes due to their short term nature.

Trading account assets and liabilities, securities available-for-sale, derivative assets and liabilities and structured certificates of deposit are recorded on the Consolidated Statements of Condition at fair value. The methods used to determine fair value are provided in the Fair Value Measurements section of this Note.

Changes in estimated fair value of loans reflect changes in credit risk and general interest rates which have occurred since the loans were originated. Fair value of floating rate loans was assumed to equal carrying value since the loans’ interest rates automatically reprice to market. Fair value of residential mortgages was based on current prices for securities backed by similar loans. For other fixed rate loans, fair value was estimated based on future cash flows discounted at current rates at which the Bank would have originated the loan at December 31. Additionally, management considered estimated values of collateral for nonperforming loans secured by real estate. The estimated fair values are not intended to represent estimated exit price fair values as defined under ASC 820.

The fair value of loans held for sale was based on current mortgage-backed security prices corresponding to the mortgage loan pools.

The fair value of demand deposits, savings accounts, interest-bearing checking deposits, and money market accounts was the amount payable on demand at the reporting date, or the carrying amount. The fair value of time deposits was estimated using a discounted cash flow calculation at current market rates offered by the Bank.

 

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The fair value of floating rate long-term notes was assumed to equal carrying value since the notes’ interest rates automatically reprice to market. The fair value of fixed rate subordinated notes was estimated using a discounted cash flow calculation at current market rates.

The fair values of loan commitments and standby letters of credit approximates their carrying value (i.e. deferred income) or estimated cost that would be incurred to induce third parties to assume these commitments.

The estimated fair values of the Bank’s financial instruments at December 31, 2011 and 2010 are presented in the following table. See Note 12 to the Consolidated Financial Statements for additional information regarding fair values of off-balance-sheet financial instruments.

     December 31  
     2011     2010  
     Carrying
Value
    Fair Value     Carrying
Value
    Fair Value  
     (In thousands)  

Assets

        

Cash and demand balances due from banks

   $ 1,604,779      $ 1,604,779      $ 737,227      $ 737,227   

Money market assets:

        

Interest-bearing deposits at banks

     18,535,041        18,535,041        15,015,453        15,015,453   

Federal funds sold and securities purchased under agreement to resell

     1,687,258        1,687,258        1,255,313        1,255,313   

Securities available-for-sale

     12,600,130        12,600,130        5,689,293        5,689,293   

Trading account assets

     379,008        379,008        866,719        866,719   

Loans, net of unearned income and allowance for loan losses

     50,299,211        50,433,704        22,158,238        22,296,882   

Accrued interest receivable

     198,466        198,466        90,808        90,808   

Loans held for sale

     98,888        102,550        29,915        30,223   

Derivative instruments (1)

     539,517        539,517        298,532        298,532   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total on-balance-sheet financial assets

   $ 85,942,298      $ 86,080,453      $ 46,141,498      $ 46,280,450   
  

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities

        

Deposits:

        

Demand deposits

   $ 61,861,362      $ 61,861,362      $ 28,536,633      $ 28,536,633   

Time deposits

     13,763,281        13,974,423        8,409,777        8,487,076   

Federal funds purchased

     244,914        244,914        131,251        131,251   

Securities sold under agreement to repurchase

     469,443        469,443        864,918        864,918   

Short-term borrowings

     279,344        279,344        1,353,761        1,353,761   

Short-term senior notes

     80,956        80,956                 

Derivative instruments (2)

     635,906        635,906        432,289        432,289   

Trading account liabilities

     4,103        4,103        74,033        74,033   

Accrued interest payable

     83,746        83,746        24,003        24,003   

Long-term notes — senior/unsecured

     1,100,000        1,100,000        2,446,500        2,446,500   

Long-term notes — senior/secured

     2,375,000        2,375,000        2,375,000        2,375,000   

Long-term notes — subordinated

     1,363,802        1,331,925        200,000        200,000   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total on-balance-sheet financial liabilities

   $ 82,261,857      $ 82,441,122      $ 44,848,165      $ 44,925,464   
  

 

 

   

 

 

   

 

 

   

 

 

 

Off-Balance-Sheet Credit Facilities ((obligations)/positive positions)

        

Loan commitments

   $ 4,211      $ 4,211      $ 11,510      $ 11,510   

Standby letters of credit

     (1,243     (1,243     (1,520     (1,520
  

 

 

   

 

 

   

 

 

   

 

 

 

Total off-balance-sheet credit facilities

   $ 2,968      $ 2,968      $ 9,990      $ 9,990   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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(1) Includes $8.5 million and $3.3 million of derivative instruments recorded in other assets at December 31, 2011 and 2010, respectively.
(2) Includes $112.2 million and $142.1 million of derivative instruments recorded in other liabilities at December 31, 2011 and 2010, respectively.

Fair Value Measurements

The Bank 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.

The Bank records securities, derivatives and certain financial assets and liabilities at fair value on a recurring basis and uses the following inputs and valuation methodologies to measure fair value. While the Bank believes the valuation methodologies for its financial instruments carried at fair value are appropriate and consistent with other market participants, the use of different assumptions or methodologies, particularly as applied to Level 3 financial instruments, could have a material effect on their estimated fair values.

Level 1 primarily includes U.S. Treasury securities, exchange-traded debt and equity securities and exchange-traded derivatives.

Level 2 includes U.S. government agency securities, state and municipal bonds, corporate debt securities, money market funds, structured rate certificates of deposit and over-the-counter derivatives. External vendors typically use pricing models to determine fair values for securities. The Bank validates the prices obtained from external pricing vendors to ensure that the Bank’s fair value determination is reasonable. The Bank evaluates the methodology of external pricing vendors as well as the asset or liability class and security level information the vendors supply. The Bank often has multiple sources to support fair value pricing, and discrepancies among sources are vetted for consistency with ASC 820. Standard market inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets and additional market reference data. Certain securities are priced based on quotes from brokers. Fair values for over-the-counter derivatives are determined using multi-contributor prices or zero coupon valuation techniques further adjusted for credit, model and liquidity risks. Inputs are based on the type of derivative instrument and include interest rate yield curves, foreign exchange rates and contract terms. Fair values of derivative liabilities also include a credit risk component for both the counterparty and the Bank. The Bank’s methodology for derivative valuation is also used to estimate the fair values for structured certificates of deposit.

Level 3 includes auction-rate securities, certain corporate debt securities, and certain foreign government debt securities, all of which are classified in securities available-for-sale, and mortgage derivatives. A discounted cash flow valuation methodology is applied to value the auction-rate securities and includes management assumptions about future cash flows, discount rates, market liquidity and credit spreads. Mortgage derivatives include rate lock commitments for residential mortgage loans and forward sales of those loans. Inputs to valuation models used for mortgage derivatives include changes in interest rates, changes in related MBS prices, and fallout assumptions.

 

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Assets and liabilities measured at fair value on a recurring basis are presented in the following table:

 

     December 31, 2011  
     Fair Value Measurements Using      Total at  
     Level 1      Level 2      Level 3      Fair Value  
     (In thousands)  

Assets

           

Securities available-for-sale

           

U.S. Treasury

   $ 166,998       $       $       $ 166,998   

U.S. government agency

             2,226,711                 2,226,711   

U.S. government sponsored mortgage-backed

             5,935,097                 5,935,097   

State and municipal

             1,230,144         21,949         1,252,093   

Non-mortgage asset backed

             1,421,822         685         1,422,507   

Foreign corporate debt securities

     1,141,268                         1,141,268   

Foreign government debt securities

             194,474         298         194,772   

Corporate debt securities

             228,484         10,471         238,955   

Other

             21,729                 21,729   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total securities available-for-sale

   $ 1,308,266       $ 11,258,461       $ 33,403       $ 12,600,130   
  

 

 

    

 

 

    

 

 

    

 

 

 

Trading account assets

           

U.S. Treasury

   $ 3,498       $       $       $ 3,498   

U.S. government agency

             4,720                 4,720   

State and municipal

             15,993                 15,993   

Corporate debt securities

             354,797                 354,797   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total trading account assets

   $ 3,498       $ 375,510       $       $ 379,008   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative instruments

           

Trading derivatives

           

Interest rate contracts

   $       $ 595,815       $ 6,542       $ 602,357   

Foreign exchange contracts

             12,089                 12,089   

Equity contracts

             40,915                 40,915   

Hedging derivatives

                

Interest rate contracts/cash flow hedges

             682                 682   

Interest rate contracts/fair value hedges

             877                 877   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative instruments

   $       $ 650,378       $ 6,542       $ 656,920   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 1,311,764       $ 12,284,349       $ 39,945       $ 13,636,058   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Structured CDs (included in interest-bearing deposits)

   $       $ 1,685,190       $       $ 1,685,190   

Trading account liabilities

           

U.S. Treasury

     4,103                         4,103   

Derivative instruments

           

Trading derivatives

           

Interest rate contracts

             571,462         1,771         573,233   

Foreign exchange contracts

             10,934                 10,934   

Equity contracts

             52,453                 52,453   

Hedging derivatives (included in other liabilities)

           

Interest rate contracts/cash flow hedges

             107,893                 107,893   

Interest rate contracts/fair value hedges

             4,139                 4,139   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative instruments

   $       $ 746,881       $ 1,771       $ 748,652   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities

   $ 4,103       $ 2,432,071       $ 1,771       $ 2,437,945   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents
     December 31, 2010  
     Fair Value Measurements Using      Total at  
     Level 1      Level 2      Level 3      Fair Value  
     (In thousands)  

Assets

           

Securities available-for-sale

           

U.S. Treasury

   $ 388,763       $       $       $ 388,763   

U.S. government agency

             1,996,345                 1,996,345   

U.S. government sponsored mortgage-backed

             655,202                 655,202   

State and municipal

             1,593,288         16,675         1,609,963   

Non-mortgage asset backed

             727,674         774         728,448   

Foreign corporate debt securities

     300,069                         300,069   

Foreign government debt securities

             250                 250   

Corporate debt securities

             10,253                 10,253   

Other

                               
  

 

 

    

 

 

    

 

 

    

 

 

 

Total securities available-for-sale

   $ 688,832       $ 4,983,012       $ 17,449       $ 5,689,293   
  

 

 

    

 

 

    

 

 

    

 

 

 

Trading account assets

           

U.S. government agency

   $       $ 830,016       $       $ 830,016   

Corporate debt securities

             36,703                 36,703   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total trading account assets

   $       $ 866,719       $       $ 866,719   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative instruments

           

Trading derivatives

           

Interest rate contracts

   $       $ 268,990       $ 3,312       $ 272,302   

Foreign exchange contracts

             13,389                 13,389   

Equity contracts

             156,701                 156,701   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative instruments

   $       $ 439,080       $ 3,312       $ 442,392   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 688,832       $ 6,288,811       $ 20,761       $ 6,998,404   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Structured CDs (included in interest-bearing deposits)

   $       $ 1,307,774       $       $ 1,307,774   

Trading account liabilities

           

U.S. Treasury

     74,033                         74,033   

Derivative instruments

           

Trading derivatives

           

Interest rate contracts

             293,827         14         293,841   

Foreign exchange contracts

             12,924                 12,924   

Equity contracts

             127,379                 127,379   

Commodity contracts

             637                 637   

Hedging derivatives (included in other liabilities)

           

Interest rate contracts/cash flow hedges

             139,389                 139,389   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative instruments

   $       $ 574,156       $ 14       $ 574,170   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities

   $ 74,033       $ 1,881,930       $ 14       $ 1,955,977   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following tables present changes in Level 3 assets and liabilities:

 

     Securities
Available-
for-sale
    Derivative
Assets
    Derivative
Liabilities
 
     (In thousands)  

Fair value at January 1, 2010

   $ 77,779      $ 1,407      $ 103   

Realized and unrealized gains and losses included in earnings (1)

     1,871        16,312        (89

Unrealized gains and losses included in OCI

     (12,732              

Purchases, sales, issuances, settlements

     (49,469     (14,407       
  

 

 

   

 

 

   

 

 

 

Fair value at December 31, 2010

   $ 17,449      $ 3,312      $ 14   
  

 

 

   

 

 

   

 

 

 

Gains and losses included in earnings related to assets and liabilities held at December 31, 2010

   $ (4,425   $ 3,312      $ (14
  

 

 

   

 

 

   

 

 

 

Fair value at January 1, 2011

   $ 17,449      $ 3,312      $ 14   

Realized and unrealized gains and losses included in earnings (1)

     4,409        19,992        1,757   

Unrealized gains and losses included in OCI

     (3,334              

Accretion/amortization

     366                 

Purchases (2)

     167,700                 

Sales

     (130,485              

Issuances

                     

Settlements

     (22,702     (16,762       

Transfers into Level 3

                     

Transfers out of Level 3

                     
  

 

 

   

 

 

   

 

 

 

Fair value at December 31, 2011

   $ 33,403      $ 6,542      $ 1,771   
  

 

 

   

 

 

   

 

 

 

Gains and losses included in earnings related to assets and liabilities held at December 31, 2011

   $      $ 6,542      $ (1,771
  

 

 

   

 

 

   

 

 

 

 

(1) Included in net securities gains (losses) for AFS securities and other noninterest income for derivative assets and liabilities.

 

(2) All purchases during the year are a result of the M&I acquisition.

There were no transfers of assets or liabilities between Level 1 and Level 2 for the year ended December 31, 2011.

Nonrecurring Fair Value Measurements

Certain assets and liabilities are measured at fair value on a nonrecurring basis, such as assets carried at lower of cost or market. During 2011 and 2010, the Bank recorded adjustments to fair value for nonmarketable securities, certain impaired loans and other real estate owned. The fair values of nonmarketable securities are generally estimated using financial performance results and forecasts and are classified as Level 3. Fair value adjustments are not recorded for these securities if there are not identified events or changes in circumstances that may have a significant adverse effect on their fair value. The fair values of certain impaired loans, including those acquired in business combinations, are based on appraised values of supporting collateral and management’s estimates of realizable value and are classified Level 3. The fair values of other real estate owned are based on appraised values and management’s estimates of realizable value and are classified Level 3.

 

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The fair value measurements recorded at December 31, 2011 and 2010 for assets and liabilities measured at fair value on a nonrecurring basis are presented in the following tables:

 

     December 31, 2011  
     Fair Value Measurements Using  
     Level 1      Level 2      Level 3      Losses  
     (In thousands)  

Assets

           

Nonmarketable securities (included in other assets)

   $       $       $ 1,300       $ 553   

Collateral-dependent impaired loans

                     329,113         274,416   

Other real estate owned

                     58,987         9,362   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $       $       $ 389,400       $ 284,331   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2010  
     Fair Value Measurements Using  
     Level 1      Level 2      Level 3      Losses  
     (In thousands)  

Assets

           

Nonmarketable securities (included in other assets)

   $       $       $ 1,077       $ 239   

Collateral-dependent impaired loans

                     221,092         62,506   

Other real estate owned

                     19,009         15,363   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $       $       $ 241,178       $ 78,108   
  

 

 

    

 

 

    

 

 

    

 

 

 

12.    Financial Instruments with Off-Balance-Sheet Risk

The Bank utilizes various financial instruments with off-balance-sheet risk in the normal course of business to meet its customers’ financing and risk management needs. The Bank’s major categories of financial instruments with off-balance-sheet risk include credit facilities, financial guarantees and various securities-related activities.

Credit facilities

Credit facilities with off-balance-sheet risk include commitments to extend credit and commercial letters of credit.

Commitments to extend credit are contractual agreements to lend to a customer as long as contract terms have been met. They generally require payment of a fee and have fixed expiration dates or other termination clauses. The Bank’s commitments serve both business and individual customer needs, and include commercial loan commitments, home equity lines, commercial real estate loan commitments, mortgage loan commitments and credit card lines. The maximum potential amount of undiscounted future payments the Bank could be required to make is represented by the total contractual amount of commitments, which was $22.4 billion and $13.1 billion at December 31, 2011 and 2010, respectively. Since only a portion of commitments will ultimately be drawn down, the Bank does not expect to provide funds for the total contractual amount. Risks associated with certain commitments are reduced by participations to third parties, which were zero at December 31, 2011 and $37.5 million at December 31, 2010.

Qualifying residential mortgage loan commitments are considered derivative instruments and are recorded at fair value on the Bank’s Consolidated Statements of Condition. See Note 13 to the Consolidated Financial Statements for additional information on derivative instruments.

Commercial letters of credit are commitments to make payments on behalf of customers when letter of credit terms have been met. Maximum risk of accounting loss is represented by total commercial letters of credit outstanding. Letters of credit outstanding were $45.5 million at December 31, 2011 and $6.6 million at December 31, 2010.

 

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Credit risks associated with all of these facilities are mitigated by reviewing customers’ creditworthiness on a case-by-case basis, obtaining collateral, limiting loans to individual borrowers, setting restrictions on long-duration maturities and establishing stringent covenant terms outlining performance expectations which, if not met, may cause the Bank to terminate the contract. Credit risks are further mitigated by monitoring and maintaining portfolios that are well-diversified.

Collateral is required to support certain of these credit facilities when they are drawn down and may include equity and debt securities, commodities, inventories, receivables, certificates of deposit, savings instruments, fixed assets, real estate, life insurance policies and memberships on national or regional stock and commodity exchanges. Requirements are based upon the risk inherent in the credit and are more stringent for firms and individuals with greater default risks. The Bank monitors collateral values and appropriately perfects its security interest.

Letters of credit and commitments to extend credit are reviewed periodically for probable loss. Accruals for probable credit losses on letters of credit and commitments to extend credit are recorded in other liabilities on the Bank’s Consolidated Statements of Condition. The liability is increased or decreased by changes in estimates through noninterest expense and reduced by net charge-offs. The liability balance was $244.1 million at December 31, 2011 and $16.1 million at December 31, 2010. See Note 1 to the Consolidated Financial Statements for additional information on the liability for off-balance-sheet credit losses.

The fair value of credit facilities (i.e. deferred income net of deferred expense) approximates their carrying value of $4.2 million at December 31, 2011 and $11.5 million at December 31, 2010.

Financial Guarantees

Financial guarantees with off-balance-sheet risk include standby letters of credit, loans sold with recourse and written put options.

Standby letters of credit are unconditional commitments which guarantee the obligation of a customer to a third party should that customer default. They are issued to support financial and performance-related obligations. At December 31, 2011 and 2010, the Bank’s maximum risk of accounting loss for these items is represented by the total commitments outstanding of $3.4 billion and $2.3 billion, respectively. Risks associated with standby letters of credit are reduced by participations to third parties which totaled $0.6 billion at both December 31, 2011 and 2010. In most cases, these commitments expire within three years without being drawn upon. The fair value of standby letters of credit (i.e. deferred income) approximates their carrying value of $1.2 million at December 31, 2011 and $1.5 million at December 31, 2010.

The Bank sells residential mortgage loans with limited recourse. The recourse provisions require the Bank to reimburse the buyer upon the occurrence of certain credit-related events that typically include delinquency or foreclosure within certain time periods and losses based on pre-determined rates. The maximum amount payable under the limited recourse provisions was $267.0 million at December 31, 2011 and $149.2 million at December 31, 2010. The Bank also sells residential mortgage loans subject to certain representations and warranties that including underwriting standards and validity of documentation. If the representations and warranties are not met, the Bank is usually required to repurchase the loan or reimburse the buyer for realized losses on liquidated collateral. The carrying amount of the recourse and representation and warranty liability was $9.6 million at December 31, 2011 and $1.1 million at December 31, 2010, which is included in Other Liabilities in the Consolidated Statements of Condition.

Written put options are contracts that provide the buyer the right (but not the obligation) to sell a financial instrument at a specified price, either within a specified period of time or on a certain date. The Bank writes put options, providing the buyer the right to require the Bank to buy the specified assets per the contract terms. The maximum amount payable for the written put options was equal to their notional amount of $1.3 billion and $1.2 billion at December 31, 2011 and 2010, respectively. The fair value of the derivative liability was $164.0 million at December 31, 2011 and $54.0 million at December 31, 2010.

 

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Securities activities

The Bank’s securities activities that have off-balance-sheet risk include underwriting and when-issued securities.

Through its underwriting activities, the Bank commits to buy and offer for resale newly issued securities. The Bank is exposed to market risk because it may be unable to resell its inventory of securities profitably as a result of unfavorable market conditions. In syndicate arrangements, the Bank is obligated to fulfill syndicate members’ commitments should they default. The syndicates of which the Bank was a member had no underwriting commitments at December 31, 2011 and December 31, 2010.

The Bank trades securities that have been authorized for issuance but have not actually been issued (“when-issued” securities). Since market values are subject to change, the Bank is exposed to market and credit risk because it may incur a loss to replace a position if a counterparty defaults and market values have changed unfavorably for the counterparty. Changes in the fair value of commitments to purchase and sell when-issued securities are recognized in the current period. There was no commitment to purchase or sell securities on a when-issued basis at December 31, 2011 or 2010.

Commitments to Invest in Equity Securities

The Bank’s commitments to invest in non-marketable equity securities have off-balance-sheet risk related to the uncalled capital commitments. The Bank’s commitment to invest in equity securities was $53.3 million at December 31, 2011 and $30.3 million at December 31, 2010.

 

13. Derivative Financial Instruments

Derivative instruments are financial contracts that derive their value from underlying changes in interest rates, foreign exchange (“FX”) rates or other financial or commodity prices or indices. Derivative instruments are either regulated exchange-traded contracts or negotiated over-the-counter contracts. The Bank uses various derivative financial instruments, primarily interest rate and foreign exchange derivative contracts, as part of its trading activities or in the management of its risk strategy.

All derivative instruments are recognized at fair value in the Consolidated Statements of Condition. Fair value represents point-in-time estimates that may change in subsequent reporting periods due to market conditions or other factors. See Note 11 to the Consolidated Financial Statements for additional information on fair value measurement. All derivative instruments are designated either as hedging or trading.

The Bank enters into derivative contracts with BMO to facilitate a more efficient use of combined resources and to better serve customers. See Note 25 to the Consolidated Financial Statements for additional information on related party transactions.

Types of Derivatives

Swaps

Swaps are contractual agreements between two parties to exchange a series of cash flows. The various swap agreements that the Bank may enter into are as follows:

Interest rate swaps — counterparties generally exchange fixed and floating rate interest payments based on a notional value in a single currency.

Cross-currency swaps — fixed rate interest payments and principal amounts are exchanged in different currencies.

Cross-currency interest rate swaps — fixed and floating rate interest payments and principal amounts are exchanged in different currencies.

Commodity swaps — counterparties generally exchange fixed and floating rate payments based on a notional value of a single commodity.

Equity swaps — counterparties exchange the return on an equity security or a group of equity securities for the return based on a fixed or floating interest rate or the return on another equity security or a group of equity securities.

 

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Total return swaps — one counterparty agrees to pay or receive from the other cash amounts based on changes in the value of a reference asset or group of assets, including any returns such as interest earned on these assets, in exchange for amounts that are based on prevailing market funding rates.

The main risks associated with these instruments are related to exposure to movements in interest rates, foreign exchange rates, credit quality, securities values or commodities prices, as applicable, and the possible inability of counterparties to meet the terms of the contracts.

Forwards and Futures

Forwards and futures are contractual agreements to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a specific price and at a specific future date. Forwards are customized contracts transacted in the over-the-counter market. Futures are transacted in standardized amounts on regulated exchanges and are subject to daily cash margining.

The main risks associated with these instruments arise from the possible inability of over-the-counter counterparties to meet the terms of the contracts and from movements in commodities prices, securities values, interest rates and foreign exchange rates, as applicable.

Options

Options are contractual agreements that convey to the buyer the right but not the obligation to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a fixed future date or within a fixed future period. As a writer of options, the Bank receives a premium from the purchaser for accepting market risk. As a purchaser of options, the Bank pays a premium for the right to exercise the option. Since the Bank has no obligation to exercise the option, its primary exposure to risk is the potential credit risk if the writer of an over-the-counter contract fails to meet the terms of the contract.

Caps, collars and floors are specialized types of written and purchased options. They are contractual agreements where the writer agrees to pay the purchaser, based on a specified notional amount, the difference between the market rate and the prescribed rate of the cap, collar or floor. The writer receives a premium for selling this instrument.

Derivative-Related Risks

Over-the-counter derivative instruments are subject to credit risk arising from the possibility that counterparties may default on their obligations. The credit risk associated with derivatives is normally a small fraction of the notional amount of the derivative instrument. Derivative contracts generally expose the Bank to potential credit loss if changes in market rates affect a counterparty’s position unfavorably and the counterparty defaults on payment. Credit risk is represented by the positive fair value of the derivative instrument. Replacement risk, the primary component of credit risk, is the risk of loss should a counterparty default following unfavorable market movements and represents the Bank’s cost of replacing contracts that have a positive fair value using current market rates. The Bank strives to limit credit risk by dealing with counterparties that are considered to be creditworthy, and by managing credit risk for derivatives using the same credit risk process that is applied to loans. Netting agreements provide for netting of contractual receivables and payables and apply to situations where the Bank is engaged in more than one outstanding derivative transaction with the same counterparty and also has a legally enforceable master netting agreement with that counterparty. Netting agreements also provide for the application of cash collateral received or paid against derivative assets or liabilities. The Bank’s derivative contracts with BMO are transacted under the terms of a master netting agreement. Derivative assets and liabilities recorded on the Consolidated Statements of Condition were each reduced by $113.6 million and $142.0 million as of December 31, 2011 and 2010, respectively, as a result of master netting agreements in place. At December 31, 2011 and 2010, cash collateral was not exchanged between the parties to the master netting agreement. Exchange-traded derivatives have no potential for credit exposure as they are settled net with each exchange.

Derivative instruments are subject to market risk. Market risk arises from the potential for loss resulting from adverse changes in the value of derivative instruments as a result of changes in certain market variables.

 

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These variables include interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, as well as credit spreads, credit migration and default. The Bank strives to limit market risk by employing comprehensive governance and management processes for all market risk-taking activities.

Uses of Derivatives

Trading Derivatives

Trading derivatives include derivatives entered into with customers to accommodate their risk management needs, derivatives transacted to generate trading income from the Bank’s trading positions, and derivatives used in the management of the Bank’s risk strategy that do not qualify as hedges for accounting purposes (“economic hedges”).

Trading derivatives are marked to fair value. Realized and unrealized gains and losses are recognized in trading 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.

The Bank and BMO combined their U.S. foreign exchange (“FX”) activities. Under this arrangement, FX net profit is shared by the Bank and BMO in accordance with a specific formula set forth in the agreement. This agreement expires on September 30, 2012 but may be extended at that time. Either party may terminate the arrangement at its option. FX revenues are reported net of expenses. During 2011, 2010 and 2009, foreign exchange revenues were $7.1 million, $4.8 million and $11.5 million, respectively, under this agreement.

At December 31, 2011 and 2010, approximately 97 and 92 percent, respectively, of the Bank’s gross notional positions in foreign currency contracts are represented by seven currencies: Euro, Canadian dollar, British pound, Australian dollar, Swiss franc, Japanese yen and the Mexican peso.

The Bank enters into risk participation agreements whereby it assumes credit risk on behalf of unrelated counterparties that arises from interest rate and foreign currency swap transactions. In a risk participation agreement, one counterparty pays the other a fee in exchange for the second counterparty agreeing to make a payment if a credit event, that is contingent on a swap transaction, occurs. The amount payable under an agreement is based on the market value of the swap at the time of the credit event. The notional amount of the risk participation agreements was $2.6 million and $38.0 million at December 31, 2011 and 2010, respectively. The contracts mature within four years at December 31, 2011. The fair value of the derivative liabilities was $172 thousand at December 31, 2011 and $37 thousand at December 31, 2010.

Certain customers enter into lending transactions and derivative transactions with the Bank. As the counterparty, BMO bears the risk of loss associated with the derivative obligations of those customers in the event of default.

The Bank has issued certain financial instruments containing embedded derivatives. The embedded derivatives are separated from the host contracts and recorded at fair value when the economic characteristics of the derivatives are not clearly and closely related to those of the host contracts. Embedded derivatives in certain of the Bank’s equity linked certificates of deposit are accounted for separately from the host instruments.

The following derivatives are used in the management of the Bank’s risk strategy but do not qualify as hedges for accounting purposes.

The Bank has qualifying mortgage loan commitments that are intended to be sold in the secondary market. These loan commitments are derivatives and are recorded at fair value. The Bank enters into forward sales of mortgage-backed securities to minimize its exposure to interest rate volatility. These forward sales of mortgage-backed securities are also derivatives and are accounted for at fair value. Changes in fair value are recognized in other noninterest income in the Bank’s Consolidated Statements of Operations.

The Bank uses total return swaps to minimize exposure to currency exchange rate and equity price fluctuations associated with certain obligations under the mid-term incentive plan, which is a stock-based compensation plan. The swap contracts are derivatives and are accounted for at fair value. Changes in fair value are recognized in compensation expense in the Bank’s Consolidated Statements of Operations. See Note 16 to the Consolidated Financial Statements for additional information on stock-based compensation plans.

 

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The Bank issues certificates of deposit that are structured interest rate, equity-linked, foreign currency-linked, debt-linked and commodity-linked under the fair value option and enters into interest rate, equity and foreign exchange derivatives to manage exposure to changes in the fair value of structured certificates of deposit. Changes in fair value of the certificates of deposit and the derivatives are recognized in trading noninterest income in the Bank’s Consolidated Statements of Operations. See Note 8 to the Consolidated Financial Statements for additional information on structured certificates of deposit.

Hedging Derivatives

In accordance with its risk management strategy, the Bank enters into various derivative contracts to hedge its interest rate exposures.

The Bank uses interest rate contracts, primarily swaps, to reduce the level of financial risk inherent in mismatches between the interest rate sensitivities of certain assets and liabilities. The risk management strategy incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that may be caused by interest rate volatility. The Bank manages interest rate sensitivity by modifying the repricing or maturity characteristics of certain assets and liabilities so that net interest margin is not adversely affected, on a material basis, by movements in interest rates. As a result of interest rate fluctuations, fixed rate assets will appreciate or depreciate in market value. The effect of the unrealized appreciation or depreciation will generally be offset by the gains or losses on the derivative instruments.

Hedge Accounting

Cash Flow Hedges

Cash flow hedges modify exposure to variability in cash flows for variable rate, interest bearing instruments. The Bank’s cash flow hedges, which have a maximum term of 6.1 years at December 31, 2011, are hedges of floating rate loans, available-for-sale securities and long-term debt obligations.

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. 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 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. At December 31, 2011, the amount of other comprehensive income that is expected to be reclassified to interest income/expense in the Bank’s Consolidated Statements of Operations over the next 12 months is $1.5 million.

Fair Value Hedges

Fair value hedges modify exposure to changes in a fixed rate instrument’s fair value caused by changes in interest rates. The hedges convert fixed rate assets and liabilities to floating rate. The Bank’s fair value hedges include hedges of fixed rate available-for-sale securities and deposits.

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.

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.

 

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The following table presents the impact of fair value hedges on the Bank’s financial results for the years ended December 31, 2011 and 2010.

 

     Pretax gain  (loss)
recorded
in other  noninterest
income
 
     2011     2010  
     (In thousands)  

Hedging derivatives :

    

Interest rate contracts

   $ (939   $   

Hedged items :

    

Fixed rate AFS securities

     936          
  

 

 

   

 

 

 

Net Impact

   $ (3   $   
  

 

 

   

 

 

 

The following table presents the impact of cash flow hedges on the Bank’s financial results for the years ended December 31, 2011 and 2010.

 

     Effective portion  of
pre-tax gain (loss)
recorded in OCI
     Ineffective portion  of
gain (loss) recorded in
other noninterest
income
     Reclassification of  gain
(loss) from AOCI to
interest income or
interest expense
 
           2011                  2010                  2011                  2010                2011             2010      
     (In thousands)      (In thousands)      (In thousands)  

Interest rate contracts

   $ 27,330       $ 40       $       $       $ (3,166   $ (6,096

Net revenue from trading derivative instruments is presented below for the years ended December 31, 2011 and 2010.

 

     2011     2010     

Location of gain (loss) recognized in income

     (In thousands)       

Interest rate contracts

   $ 31,396      $ 14,850       Net money market, bond and derivative trading income

Interest rate contracts

     (210     1,994       Other non-interest income

Foreign exchange contracts

     7,087        4,821       Foreign exchange trading gains, net

Equity contracts

     (42,899     25,019       Net money market, bond and derivative trading income

Equity contracts

     45        2,855       Salaries and other compensation expense

Commodity contracts

     (145     305       Net money market, bond and derivative trading income
  

 

 

   

 

 

    

Total

   $ (4,726   $ 49,844      
  

 

 

   

 

 

    

The fair value of the Bank’s derivative instruments are as follows at December 31:

 

     Gross Assets      Gross Liabilities  
     2011      2010      2011      2010  
     (In thousands)      (In thousands)  

Trading derivatives (1):

           

Interest rate contracts

   $ 602,357       $ 272,302       $ 573,233       $ 293,841   

Foreign exchange contracts

     12,089         13,389         10,934         12,924   

Equity contracts

     40,915         156,701         52,453         127,379   

Commodity contracts

                             637   

Hedging derivatives (2):

           

Interest rate contracts/cash flow hedges

     682                 107,893         139,389   

Interest rate contracts/fair value hedges

     877                 4,139           
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fair value

   $ 656,920       $ 442,392       $ 748,652       $ 574,170   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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(1) Trading derivatives are recorded in trading account assets and derivative instruments and in trading account liabilities and derivative instruments.

 

(2) Hedging derivatives are recorded in other assets and other liabilities.

The notional amounts of the Bank’s derivative instruments are as follows at December 31:

 

     2011      2010  
     (In thousands)  

Trading derivatives:

     

Interest rate contracts

   $ 20,199,981       $ 18,000,087   

Foreign exchange contracts

     788,748         620,865   

Equity contracts

     1,794,158         1,406,412   

Commodity contracts

             5,416   

Hedging derivatives:

     

Interest rate contracts/cash flow hedges

     1,865,000         2,221,000   

Interest rate contracts/fair value hedges

     1,068,830           
  

 

 

    

 

 

 

Total

   $ 25,716,717       $ 22,253,780   
  

 

 

    

 

 

 

14.     Concentrations of Credit Risk in Financial Instruments

 

The Bank had one major concentration of credit risk arising from financial instruments at December 31, 2011 and 2010. This concentration was the Midwest geographic area. This concentration exceeded 10 percent of the Bank’s total credit exposure, which is the total potential accounting loss should all customers and counterparties fail to perform according to contract terms and all collateral prove to be worthless.

Midwestern geographic area

A majority of the Bank’s customers and counterparties are located in the Midwestern region of the United States, defined here to include Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Ohio and Wisconsin. The Bank has credit exposure to these customers and counterparties through a broad array of banking and trade financing products including loans, loan commitments, standby and commercial letters of credit, investment securities and banker’s acceptances. The financial viability of customers and counterparties in the Midwest is, in part, dependent on the region’s economy. The Midwestern concentration was approximately $82.5 billion or 73 percent of the Bank’s total credit exposure at December 31, 2011 and $44.5 billion or 72 percent of the Bank’s total credit exposure at December 31, 2010.

The Bank manages this exposure by continually reviewing local market conditions and customers and counterparties, adjusting individual and industry exposure limits within the region and by obtaining or closely monitoring collateral values. See Note 12 to the Consolidated Financial Statements for information on collateral supporting credit facilities.

 

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The following table presents a geographical summary of loans and leases as a percent of total consolidated loans and leases at December 31, 2011 and 2010.

 

     2011     2010  

Illinois

     27.9     62.3

Wisconsin

     27.3        7.1   

Minnesota

     8.1        2.2   

Arizona

     7.1        3.0   

Indiana

     5.2        5.9   

Missouri

     4.7        2.0   

Florida

     3.7        2.8   

Michigan

     1.5        2.4   

Ohio

     1.0        0.2   

Iowa

     0.9        1.2   

Others (1)

     12.6        10.9   
  

 

 

   

 

 

 

Total

     100.0     100.0
  

 

 

   

 

 

 

 

(1) No individual state amount exceeds 1.5% in 2011 or 2010.

15.    Employee Benefit Plans

BHB sponsors noncontributory defined benefit pension plans covering virtually all the Bank’s employees as of December 31, 2011. Most of the employees participating in retirement plans are included in one primary plan (“plan”). The plan is a multiple-employer plan covering the Bank’s employees as well as persons employed by certain affiliated entities. Comparability of pension and 401K employee benefit plans in the current year over prior years presented is impacted by the effect of the acquisition of M&I.

Certain employees participating in the plan are also covered by a supplemental unfunded retirement plan. The purpose of the supplemental plan is to extend full retirement benefits to individuals without regard to statutory limitations for qualified funded plans.

Effective January 1, 2002, the plan’s benefit formula for new employees was changed to an account-based formula from a final average pay formula. The account-based benefit formula is based upon eligible pay, age and length of service. Prior to January 1, 2002, the plan’s benefit formula was a final average pay formula, based upon length of service and an employee’s highest qualifying compensation during five consecutive years of active employment less an amount determined by formula using an estimated Social Security benefit. For employees who were employed as of December 31, 2001 and leave the Bank on or after January 1, 2002, benefits are initially calculated two ways: under the account-based formula for service beginning January 1, 2002 and under the final average pay formula for all service. This latter group of employees will receive that retirement benefit which yields the highest return.

The policy for this plan is to have the participating employers, at a minimum, fund annually an amount necessary to satisfy the requirements under the Employee Retirement Income Security Act (“ERISA”), without regard to prior years’ contributions in excess of the minimum. For 2012 (plan year 2012), the estimated pension contribution is approximately $19.5 million. The total consolidated pension expense of the Bank, including the supplemental unfunded retirement plan, for 2011, 2010 and 2009 was $32.1 million, $9.5 million and $18.1 million, respectively. Those amounts include settlement gains for the supplemental unfunded retirement plan of $1.1 million recorded in 2010 and $0.7 million recorded in 2009. No settlement gains for the supplemental unfunded retirement plan were recorded in 2011. The qualified pension accumulated benefit obligation as of December 31, 2011, 2010 and 2009 was $580.5 million, $466.8 million and $404.6 million, respectively.

In addition to pension benefits, BHB sponsors a postretirement medical plan that provides medical care benefits for the Bank’s retirees (and their dependents) who have attained age 55 and have at least 10 years of service. The Bank also provides medical care benefits for disabled employees and widows of former employees (and their dependents). The Bank provides these medical care benefits through a self-insured plan. Under the terms of the plan, the Bank contributes to the cost of coverage based on employees’ length of service. Cost

 

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sharing with plan participants is accomplished through deductibles, coinsurance and out-of-pocket limits. Funding for the plan largely comes from the general assets of the Bank supplemented by contributions to a trust fund created under Internal Revenue Code Section 401(h). Effective December 31, 2007 the plan was changed to reflect expanded coverage available through Medicare and supplemental plans for retirees age 65 and older. Post-65 benefits for new hires and employees under age 35 were eliminated and corporate contributions for post-65 benefits for certain other employees were reduced.

Under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, an employer is eligible for a federal subsidy if the prescription drug benefit available under its postretirement medical plan is “actuarially equivalent” to the Medicare Part D benefit. The Bank recorded a reduction to postretirement medical expense in the amount of $1.9 million in 2011, $1.7 million in 2010 and $2.0 million in 2009, as determined by the Bank’s actuarial consultants. Based on their analysis, the Bank’s postretirement benefit medical plan passes the test for actuarial equivalence and qualifies for the subsidy. In March 2010, new health care legislation (The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act) was enacted that changed the tax treatment of the subsidy associated with postretirement medical benefits. The legislation reduced the tax deductions for the cost of providing postretirement prescription drug coverage by the amount of subsidies received. With enactment of the legislation, the Bank was required to write off any deferred tax asset as a tax expense through the income statement, even if a portion of such asset had initially been established through OCI. As a result of this legislation, the Bank recorded additional tax expense of $5.5 million in 2010.

The Bank has a defined contribution plan that is available to virtually all employees. The 401(k) matching contribution is based on the amount of eligible employee contributions. The Bank’s total expense for the plan was $21.9 million, $15.1 million and $14.4 million in 2011, 2010 and 2009, respectively.

 

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The following tables set forth the change in benefit obligation and plan assets for the pension and postretirement medical care benefit plans:

 

     Pension Benefits     Postretirement Medical Benefits  
     2011**     2010**     2009**     2011**     2010**     2009**  
     (In thousands)  

Change in benefit obligation*

            

Benefit obligation at beginning of year

   $ 497,406      $ 432,015      $ 425,555      $ 74,284      $ 69,397      $ 61,839   

Service cost

     28,108        19,689        19,767        1,841        1,813        1,984   

Interest cost

     26,017        24,642        25,551        3,911        3,985        3,712   

Benefits paid

     (24,222     (29,952     (33,629     (3,563     (3,391     (3,242

Medicare drug legislation

                          (2,345     (2,415     (1,230

Actuarial loss (gain)

     81,588        51,012        (5,229     15,728        4,895        6,334   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Benefit obligation at end of year

   $ 608,897      $ 497,406      $ 432,015      $ 89,856      $ 74,284      $ 69,397   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in plan assets

            

Fair value of plan assets at beginning of year

   $ 614,146      $ 426,934      $ 316,684      $ 59,839      $ 54,020      $ 43,843   

Actual return on plan assets

     40,478        68,338        71,805        4,189        5,819        10,177   

Employer contribution

     15,527        148,826        72,074                        

Benefits paid

     (24,222     (29,952     (33,629                     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value of plan assets at end of
year ***

   $ 645,929      $ 614,146      $ 426,934      $ 64,028      $ 59,839      $ 54,020   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Funded Status at end of year

   $ 37,032      $ 116,740      $ (5,081   $ (25,828   $ (14,445   $ (15,377
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Assets (liabilities) recognized in the Statements of Condition consist of:

            

Other assets

   $ 37,041      $ 116,980      $ 25,434      $ 4,643      $ 4,643      $ 4,643   

Accrued pension and post-retirement liabilities

     (9     (240     (30,515     (30,471     (19,088     (20,020
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net assets (liabilities) recognized

   $ 37,032      $ 116,740      $ (5,081   $ (25,828   $ (14,445   $ (15,377
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Amounts recognized in Accumulated Other Comprehensive Income (Loss) consist of:

            

Net loss

   $ 187,780      $ 123,354      $ 107,843      $ 17,904      $ 4,522      $ 3,538   

Prior service cost

     2,356        3,097        2,055                        

Transition obligation

                          275        824        1,374   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Amounts recognized in AOCI

   $ 190,136      $ 126,451      $ 109,898      $ 18,179      $ 5,346      $ 4,912   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Components of net periodic benefit cost

            

Service cost

   $ 28,108      $ 19,689      $ 19,767      $ 1,841      $ 1,813      $ 1,984   

Interest cost

     26,017        24,642        25,551        3,911        3,985        3,712   

Expected return on plan assets

     (37,755     (41,792     (32,192     (4,189     (4,322     (3,507

Amortization of prior service cost

     742        742        524                        

Amortization of transition obligation

                          550        550        547   

Amortization of actuarial loss

     14,440        7,171        3,636                        
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 31,552      $ 10,452      $ 17,286      $ 2,113      $ 2,026      $ 2,736   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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     Pension Benefits     Postretirement Medical Benefits  
     2011**     2010**     2009**     2011**     2010**     2009**  
     (In thousands)  

Other Changes in Plan Assets and Benefit Obligations recognized in Other Comprehensive Income

            

Net loss (gain)

   $ 78,865      $ 22,639      $ (44,843   $ 13,383      $ 984      $ (1,565

Amortization of loss

     (14,440     (7,171     (3,636                     

Prior service cost

            1,827                               

Amortization of prior service cost

     (742     (742     (524                     

Amortization of transition obligation

                     (550     (550     (547
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recognized in OCI

   $ 63,683      $ 16,553      $ (49,003   $ 12,833      $ 434      $ (2,112
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

    * Benefit obligation is projected for Pension Benefits and accumulated for Postretirement Medical Benefits.

 

  ** Plan assets and obligation measured as of December 31.

 

*** The actual allocation of plan assets at fair value is as follows:

 

     Pension     Postretirement Medical  
     2011     2010     2009     2011     2010     2009  

Equity securities

     48     55     50     48     55     50

Fixed income securities

     49     43     49     49     43     49

Cash equivalents

     3     2     1     3     2     1

At December 31, 2011 approximately 24% of the plan assets consisted of investments in funds administered by Virtus Investment Partners, Inc. (“Virtus”). At December 31, 2010 approximately 26% of the plan assets consisted of investments in funds administered by Virtus. Virtus is a provider of investment management products and services to individuals and institutions. At January 1, 2010 BFC owned convertible preferred shares in Virtus that represented 23% ownership in the company. During 2010, BFC converted approximately one-fourth of its convertible preferred shares to common shares and still retains a 23% ownership in the company based on the combined shares.

Investment objectives include the achievement of a total account return that meets or exceeds the expected return on plan assets, the inflation rate, and peer balanced funds over a market cycle. The Bank’s assumption for the expected long-term (in excess of 20 years) rate of return on plan assets is based on the target allocation of plan assets by category and the estimated rates of return for each asset category. The assumption includes management’s review of the current rate environment, historical trend analysis and the mix of asset categories represented in the plan’s portfolio. The current portfolio target allocation is as follows:

 

Equity securities

     50

Fixed income securities

     50

 

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The weighted-average assumptions used to determine the benefit obligation and net benefit cost are as follows:

 

     Pension Benefits     Postretirement  Medical
Benefits
 
     2011     2010     2009     2011     2010     2009  

Weighted-average assumptions used to determine benefit obligation as of December 31

            

Discount rate

     4.50     5.40     5.90     4.50     5.40     5.90

Rate of compensation increase

     3.80     3.80     3.85     N/A        N/A        N/A   

Weighted-average assumptions used to determine net benefit cost for years ended December 31

            

Discount rate

     5.40     5.90     6.20     5.40     5.90     6.20

Expected return on plan assets

     7.00     8.00     8.00     7.00     8.00     8.00

Rate of compensation increase

     3.80     3.80     3.85     N/A        N/A        N/A   

For 2012, the Bank intends to keep the expected return on plan assets at 7%.

The Bank’s pension and postretirement plan assets are measured at fair value on a recurring basis. See Note 11 to the Consolidated Financial Statements for information on the hierarchy of inputs and the primary valuation methodologies used to measure fair value.

Level 1 plan assets primarily include exchange-traded equity securities, exchange-traded mutual funds, exchange-traded derivatives, U.S. Treasury securities and money market funds. Mutual funds are valued at quoted market prices. Money market funds are stated at cost plus accrued interest. Level 2 plan assets include U.S. government agency securities and corporate debt securities. External vendors typically use pricing models to determine fair values for these securities. Standard market inputs include yield curves and indices and market-corroborated pricing. There are no plan assets classified Level 3 at December 31, 2011 or 2010.

While the Bank believes the valuation methodologies for its plan assets are appropriate and consistent with other market participants, the use of different assumptions or methodologies could have a material effect on their estimated fair values.

 

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The fair value of the pension and postretirement benefit plan assets are presented in the following tables:

 

     Pension Plan Assets at December 31, 2011  
     Fair Value Measurements Using      Total at
Fair Value
 
     Level 1     Level 2     
     (In thousands)  

Asset category

       

Cash and money market funds

   $ 17,569      $       $ 17,569   

Equity securities

     207,466                207,466   

U.S. Treasury securities

     34,084                34,084   

U.S. government agency securities

            4,084         4,084   

Corporate debt securities

            186,923         186,923   

Mutual funds

     162,973        32,005         194,978   

Derivative instruments

     825                825   
  

 

 

   

 

 

    

 

 

 

Total plan assets at fair value

   $ 422,917      $ 223,012       $ 645,929   
  

 

 

   

 

 

    

 

 

 
     Pension Plan Assets at December 31, 2010  
     Fair Value Measurements Using      Total at
Fair Value
 
     Level 1     Level 2     
     (In thousands)  

Asset category

       

Cash and money market funds

   $ 10,520      $       $ 10,520   

Equity securities

     196,485                196,485   

U.S. Treasury securities

     20,821                20,821   

U.S. government agency securities

            9,944         9,944   

Corporate debt securities

            172,968         172,968   

Mutual funds

     203,611                203,611   

Derivative instruments

     (203             (203
  

 

 

   

 

 

    

 

 

 

Total plan assets at fair value

   $ 431,234      $ 182,912       $ 614,146   
  

 

 

   

 

 

    

 

 

 
     Postretirement Medical Plan Assets at
December 31, 2011
 
     Fair Value Measurements Using      Total at
Fair Value
 
     Level 1     Level 2     
     (In thousands)  

Asset category

       

Cash and money market funds

   $ 1,741      $       $ 1,741   

Equity securities

     20,565                20,565   

U.S. Treasury securities

     3,379                3,379   

U.S. government agency securities

            405         405   

Corporate debt securities

            18,529         18,529   

Mutual funds

     16,155        3,172         19,327   

Derivative instruments

     82                82   
  

 

 

   

 

 

    

 

 

 

Total plan assets at fair value

   $ 41,922      $ 22,106       $ 64,028   
  

 

 

   

 

 

    

 

 

 

 

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     Postretirement Medical Plan Assets at
December 31, 2010
 
     Fair Value Measurements Using      Total at
Fair Value
 
           Level 1                 Level 2           
     (In thousands)  

Asset category

       

Cash and money market funds

   $ 1,025      $       $ 1,025   

Equity securities

     19,144                19,144   

U.S. Treasury securities

     2,029                2,029   

U.S. government agency securities

            969         969   

Corporate debt securities

            16,853         16,853   

Mutual funds

     19,839                19,839   

Derivative instruments

     (20             (20
  

 

 

   

 

 

    

 

 

 

Total plan assets at fair value

   $ 42,017      $ 17,822       $ 59,839   
  

 

 

   

 

 

    

 

 

 

For measurement purposes, an 7.8 percent annual rate of increase for pre 65 and an 7.8 percent annual rate of increase for post 65 in the per capita cost of covered health care benefits were assumed for 2011. The rate will be graded down to 4.5 percent for pre 65 and 4.5 percent for post 65 in 2029 and remain level thereafter.

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects.

 

2011

   1 Percentage
Point Increase
     1 Percentage
Point Decrease
 
     (In thousands)  

Effect on total of service and interest cost components

   $ 660       $ (566

Effect on postretirement benefit obligation

   $ 11,223       $ (9,507

 

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The following table sets forth the status of the supplemental unfunded retirement plan:

 

     Supplemental Unfunded Retirement
Benefits
 
     2011     2010     2009  
     (In thousands)  

Change in benefit obligation

      

Benefit obligation at beginning of year

   $ 7,825      $ 5,035      $ 10,367   

Service cost

     559        506        883   

Interest cost

     342        235        540   

Benefits paid

     (1,323     (3,129     (3,492

Actuarial loss (gain)

     3,928        5,178        (3,263
  

 

 

   

 

 

   

 

 

 

Benefit obligation at end of year

   $ 11,331      $ 7,825      $ 5,035   
  

 

 

   

 

 

   

 

 

 

Change in plan assets

      

Fair value of plan assets at beginning of year

   $      $      $   

Employer contribution

     1,323        3,129        3,492   

Benefits paid

     (1,323     (3,129     (3,492
  

 

 

   

 

 

   

 

 

 

Fair value of plan assets at end of year

   $      $      $   
  

 

 

   

 

 

   

 

 

 

Funded Status at end of year

   $ (11,331   $ (7,825   $ (5,035
  

 

 

   

 

 

   

 

 

 

Liabilities recognized in the Statements of Condition consist of:

      

Accrued pension and post-retirement liabilities

   $ (11,331   $ (7,825   $ (5,035
  

 

 

   

 

 

   

 

 

 

Net liabilities recognized

   $ (11,331   $ (7,825   $ (5,035
  

 

 

   

 

 

   

 

 

 

Amounts recognized in Accumulated Other Comprehensive Income (Loss) consist of:

      

Net loss or (gain)

   $ 8,077      $ 4,149      $ (2,407

Prior service credit

     (618     (951     (1,285
  

 

 

   

 

 

   

 

 

 

Amounts recognized in AOCI

   $ 7,459      $ 3,198      $ (3,692
  

 

 

   

 

 

   

 

 

 

Components of net periodic benefit cost

      

Service cost

   $ 559      $ 506      $ 883   

Interest cost

     342        235        540   

Amortization of prior service credit

     (334     (334     (330

Amortization of actuarial gain

            (310       
  

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 567      $ 97      $ 1,093   
  

 

 

   

 

 

   

 

 

 

Other Changes in Plan Assets and Benefit Obligations recognized in Other Comprehensive Income

      

Net loss (gain)

   $ 3,928      $ 6,245      $ (2,579

Amortization of gain

            310          

Amortization of prior service credit

     334        334        330   
  

 

 

   

 

 

   

 

 

 

Total recognized in OCI

   $ 4,262      $ 6,889      $ (2,249
  

 

 

   

 

 

   

 

 

 

 

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     Supplemental
Unfunded  Retirement
Benefits
 
     2011     2010     2009  

Weighted-average assumptions used to determine benefit obligation as of December 31

      

Discount rate

     4.00     4.70     5.20

Rate of compensation increase

     3.80     3.80     3.85

Weighted-average assumptions used to determine net benefit cost for years ended December 31

      

Discount rate

     4.70     5.20     5.50

Rate of compensation increase

     3.80     3.80     3.85

The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year are $17.9 million and $0.7 million, respectively. The estimated net gain and transition obligation for the postretirement medical plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year is $0.3 million and $0.3 million, respectively. The net loss and prior service cost for the supplemental unfunded retirement benefit plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year is $0.2 million and $0.3 million, respectively

The benefits expected to be paid in each of the next five years and the aggregate for the five years thereafter are as follows:

 

            Postretirement Medical Benefits      Supplemental
Retirement
Benefits
 

Year

   Pension
Benefits
     Before Medicare
Subsidy
    

 

   Medicare
Subsidy (1)
    
     (In thousands)  

2012

   $ 38,964       $ 4,647          $ 509       $ 1,040   

2013

     35,644         4,909            562         1,002   

2014

     40,904         5,231            626         1,247   

2015

     40,357         5,497            695         1,275   

2016

     41,577         5,857            768         1,324   

Thereafter

     226,632         34,225            5,205         7,231   

 

(1) Medicare subsidies expected to be received.

16.     Stock-Based Compensation Plans

The Bank has four types of stock-based compensation plans: a stock option program, a mid-term incentive plan, a deferred incentive plan and an employee share purchase plan. The Bank determines expense based on the fair value of stock-based compensation. Stock-based compensation expense is recognized based on the estimated number of shares for which service is expected to be rendered and over the period during which employees are required to provide service in exchange for the shares. Stock-based compensation granted to retirement-eligible employees is expensed fully at the time of grant.

Stock Option Program

The BFC Stock Option Program was established under the BMO Stock Option Plan for certain designated executives and other employees of the Bank and affiliated companies in order to provide incentive to attain long-term strategic goals and to attract and retain services of key employees.

Options to acquire BMO stock are granted at an exercise price equal to the closing price of BMO’s common shares on the day prior to the grant date. Options vest 25% per year over a four-year period starting from their grant date. The vesting of a portion of the options granted is subject to achieving certain performance targets. All options expire 10 years from their grant date.

The expense recorded for this program is adjusted for estimated forfeitures. Cash flows resulting from realized tax deductions in excess of recognized compensation cost are financing cash flows.

 

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The compensation expense related to this program totaled $1.6 million, $1.7 million, and $1.8 million in 2011, 2010, and 2009, respectively. The excess tax benefits recognized for the years ended 2011, 2010, and 2009 were $0.5 million, $0.6 million, and $0.7 million, respectively. At December 31, 2011, the total unrecognized compensation cost related to nonvested stock option awards was $1.9 million, and the weighted average period over which it is expected to be recognized is approximately 3.1 years.

The fair value of the stock options granted has been estimated using a trinomial option pricing model. The weighted average per share fair value of options granted during 2011, 2010, and 2009 was $2.63, $10.46, and $9.48, respectively; of which, the weighted-average fair value of options granted as part of the M&I acquisition was $2.32, for a total of 2,865,236 stock options. The total intrinsic value of stock options exercised during the years ended December 31, 2011, 2010, and 2009 was $12.3 million, $12.8 million, and $9.8 million, respectively. Cash proceeds from options exercised under the plan totaled $28.6 million, $33.6 million, and $24.9 million for the years ended December 31, 2011, 2010, and 2009, respectively. The tax benefits from stock options realized during 2011, 2010, and 2009 were $5.9 million, $4.3 million, and $2.9 million, respectively.

The following table summarizes the stock option activity for 2011 and 2010 and provides details of stock options outstanding at December 31, 2011 and 2010:

 

     Year Ended December 31, 2011  

Options

   Shares     Wtd. Avg.
Exercise Price
     Aggregate Intrinsic
Value
     Wtd. Avg.
Remaining
Contractual Life
 
     (In millions)  

Outstanding at beginning of year

     2,092,418      $ 49.36       $ 20.5         5.12 years   

Granted

     269,775        55.06         

Granted as part of the M&I acquisition

     2,865,236        189.89         

Exercised

     (532,901     36.63         

Forfeited, cancelled

     (363,495     173.28         

Transferred (1)

     (349,977     163.23         
  

 

 

         

Outstanding at December 31, 2011

     3,981,056        125.53       $ 11.2         5.01 years   
  

 

 

         

Options exercisable at December 31, 2011

     3,122,216      $ 145.11       $ 8.2         4.36 years   

 

(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.

 

     Year Ended December 31, 2010  

Options

   Shares     Wtd. Avg.
Exercise Price
     Aggregate Intrinsic
Value
     Wtd. Avg.
Remaining
Contractual Life
 
     (In millions)  

Outstanding at beginning of year

     2,198,806      $ 43.67       $ 24.0         4.66 years   

Granted

     196,329        58.09         

Exercised

     (577,242     38.20         

Transferred (1)

     274,525        45.74         
  

 

 

         

Outstanding at December 31, 2010

     2,092,418        49.36       $ 20.5         5.12 years   
  

 

 

         

Options exercisable at December 31, 2010

     1,261,405      $ 46.06       $ 16.4         3.57 years   

 

(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.

 

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The following table summarizes the nonvested stock option activity for 2011:

 

Options

   Shares     Wtd. Avg.
Grant Date
Fair Value
per Share
 

Nonvested at beginning of year

     831,013      $ 8.08   

Granted

     269,775        5.88   

Vested

     (185,422     8.65   

Transferred (1)

     (56,526     7.74   
  

 

 

   

Nonvested at December 31, 2011

     858,840      $ 7.43   
  

 

 

   

 

(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.

The following table summarizes the nonvested stock option activity for 2010:

 

Options

   Shares     Wtd. Avg.
Grant Date
Fair Value
per Share
 

Nonvested at beginning of year

     720,096      $ 7.32   

Granted

     196,329        10.46   

Vested

     (148,419     7.25   

Forfeited, cancelled

              

Transferred (1)

     63,007        7.40   
  

 

 

   

Nonvested at December 31, 2010

     831,013      $ 8.08   
  

 

 

   

 

(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.

The following weighted-average assumptions were used to determine the fair value of options on the date

of grant:

 

     2011     2010  

Risk-free interest rate

     1.70     2.90

Expected life

     4.8 years        6.5 years   

Expected volatility

     21.79     24.00

Expected dividend yield

     7.10     4.71

Mid-Term Incentive Plan

The Bank maintains mid-term incentive plans in order to enhance the Bank’s ability to attract and retain high quality employees and to provide a strong incentive to employees to achieve BMO’s governing objective of maximizing value for its shareholders.

The mid-term incentive plans have a three year performance cycle. The right to receive distributions under the plans depends on the achievement of specific performance criteria that are set at the grant date such as the current market value of BMO’s common shares and BMO’s total shareholder return compared with that of its competitors. Distribution rights are subject to either cliff vesting at the end of the three year period or graded vesting of one-third per year over the three year period. Depending on the plan, participants receive either a single cash payment at the end of the three year period or three annual cash payments over the three year period.

The Bank was party to agreements made between BMO and third parties to assume a portion of the Bank’s obligations related to the 2007 and 2008 mid-term incentive plans. The Bank was not party to similar agreements for the 2009, 2010 or 2011 mid-term incentive plans. Amounts paid by the Bank under the agreements were capitalized and recognized as compensation expense over the performance cycles of the plans on a straight-line

 

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basis, including calendar years 2010 and 2011. Amounts related to units granted to employees who are eligible to retire are expensed at the time of grant. Any future obligations to participants required under these plans will be the responsibility of the third parties.

For the obligations relating to the 2010 and 2011 plans for which BMO has not entered into agreements with third parties, the amount of compensation expense is amortized over the service period to reflect the current estimate of ultimate employer liability, which is a function of the current market value of BMO’s common shares and BMO’s total shareholder return compared with those of its competitors. Adjustments for changes in estimates of ultimate payments to participants are recognized in current and future periods. The Bank enters into certain total return swap contracts to minimize exposure to currency exchange rate and equity price fluctuations. The contracts are derivative instruments accounted for at fair value and do not qualify for hedge accounting.

The compensation expense related to the plans totaled $21.6 million, $24.2 million and, $25.2 million for the years ended December 31, 2011, 2010, and 2009, respectively. The related tax benefits recognized for the years ended December 31, 2011, 2010, and, 2009, totaled $8.2 million, $9.2 million, and $9.6 million, respectively. The total unrecognized compensation cost related to nonvested awards was $0.4 million at December 31, 2011. The weighted average period over which it is expected to be recognized is approximately 1.8 years.

Deferred Incentive Plans

The Bank offers deferred incentive plans for certain employees. Under these plans, fees and annual incentive payments can be deferred as stock units of BMO common shares. These stock units are fully vested on the grant date. The value of these stock units is adjusted to reflect reinvested dividends and changes in the market value of our common shares.

Deferred incentive payments, which can be made in cash or shares, are paid upon retirement or resignation.

Expenses for these plans are recorded in the year the fees and incentive payments are earned. Changes in the amount of the incentive payments as a result of dividends and share price movements are recorded as expense in the period of the change.

Deferred incentive plan units granted during the years ended December 31, 2011, 2010 and 2009 totaled 9,494, 2,466 and 5,411, respectively. The weighted average grant date fair value of the units granted during the years ended December 31, 2011, 2010 and 2009 was $0.3 million, $0.1 million and $0.1 million, respectively.

Liabilities related to these plans are recorded in other liabilities in the Consolidated Statements of Condition and totaled $2.3 million and $2.2 million as of December 31, 2011 and 2010, respectively. Payments made under these plans for the years ended December 31, 2011 and 2010 were zero and $0.7 million, respectively.

Expenses related to these plans for the years ended December 31, 2011, 2010 and 2009 were $0.3 million, $0.3 million and $1.0 million before tax, respectively ($0.2 million, $0.2 million and $0.6 million after tax, respectively).

A total of 48,212 and 30,928 deferred incentive plan units were outstanding at December 31, 2011 and 2010, respectively.

Employee Share Purchase Plan

The BMO Employee Share Purchase Plan offers employees the opportunity to purchase BMO common shares at a discount of 15 percent from market value. Full-time and part-time employees of the Bank are eligible to participate in the plan. Employees can elect to contribute up to 15 percent of their salary toward the purchase of BMO common shares. The Bank contributes the difference between the employee cost and the market price. The shares in the plan are purchased on the open market and the plan reinvests all cash dividends in additional common shares. The Bank’s contribution is recorded as compensation expense over each three-month offering period. Compensation expense for the employee share purchase plan totaled $0.9 million, $0.8 million, and $0.8 million in 2011, 2010, and 2009, respectively.

 

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17.    Lease Expense and Obligations

Rental expense for all operating leases was $66.0 million in 2011, $46.9 million in 2010, and $45.8 million in 2009. Lease commitments are primarily for office space.

In March 2005, the Bank sold the land and building located at 111 West Monroe Street, Chicago, Illinois to a third party. Upon sale, the Bank entered into a leaseback agreement for approximately 50 percent of the building space with an average lease term of 16 years. The leaseback agreement meets the criteria to be recorded as an operating lease. The sale resulted in a gain which was deferred and is being amortized into income over the term of the leaseback. The remaining deferred gain resulting from the sale was $34.9 million and $38.2 million, at December 31, 2011 and 2010, respectively. $3.2 million of deferred gain was amortized into income in each of 2011, 2010 and 2009.

In December 2001, the Bank closed on the sale of its operations center containing approximately 415,000 gross square feet located at 311 West Monroe Street, Chicago, Illinois, and leased back approximately 259,000 rentable square feet. The lease is recorded as an operating lease and the original term ended on December 31, 2011. The Bank has rights of first offering to lease additional space and options to extend to December 31, 2026. The lease was extended until December 31, 2014 with the option of returning half of the leased space at December 31, 2013. The remaining deferred gain resulting from the sale, which was being amortized into income over the original term of the lease, was $0 and $1.7 million as of December 31, 2011 and 2010 respectively. $1.7 million of deferred gain was amortized into income in each of 2011, 2010 and 2009.

In addition, the Bank and other subsidiaries own or lease premises at other locations to conduct branch banking activities.

Minimum rental commitments as of December 31, 2011 for all non-cancelable operating leases are as follows:

 

Year

   Amount  
     (In thousands)  

2012

   $ 60,907   

2013

     56,678   

2014

     52,352   

2015

     47,527   

2016

     41,710   

Thereafter

     284,160   
  

 

 

 

Total minimum future rentals

   $ 543,334   
  

 

 

 

Occupancy expenses have been reduced by $6.8 million, $3.4 million, and $3.4 million in 2011, 2010 and 2009, respectively for rental income from leased premises.

 

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18.    Income Taxes

The 2011, 2010 and 2009 applicable income tax expense (benefit) were as follows:

 

     Federal     State     Total  
     (In thousands)  

2011:

      

Current

   $ (23,473   $ (2,551   $ (26,024

Deferred

     128,071        1,746        129,817   
  

 

 

   

 

 

   

 

 

 

Total

   $ 104,598      $ (805   $ 103,793   
  

 

 

   

 

 

   

 

 

 

2010:

      

Current

   $ 23,093      $ 3,080      $ 26,173   

Deferred

     (69,682     (3,629     (73,311
  

 

 

   

 

 

   

 

 

 

Total

   $ (46,589   $ (549   $ (47,138
  

 

 

   

 

 

   

 

 

 

2009:

      

Current

   $ (150,041   $ 3,791      $ (146,250

Deferred

     30,850        (6,360     24,490   
  

 

 

   

 

 

   

 

 

 

Total

   $ (119,191   $ (2,569   $ (121,760
  

 

 

   

 

 

   

 

 

 

Net deferred tax assets are comprised of the following at December 31, 2011, 2010 and 2009:

 

     December 31  
     2011     2010     2009  
     (In thousands)  

Deferred tax assets:

      

Allowance for loan losses

   $ 356,639      $ 291,359      $ 271,799   

Deferred employee compensation

     38,717        27,986        26,121   

Deferred expense and prepaid income

     120,373        16,004        19,240   

Intangible assets and purchase accounting valuations

     1,048,013        13,781          

Federal tax loss carryforward

     895,327                 

State tax loss carryforward

     175,853        34,553        29,905   

Tax credit carryforward

     115,126        46,459        1,947   

Other assets

     12,646        7,065        5,784   
  

 

 

   

 

 

   

 

 

 

Gross deferred tax assets

   $ 2,762,694      $ 437,207      $ 354,796   

Valuation allowance

     (193,372     (46,739     (38,215
  

 

 

   

 

 

   

 

 

 

Deferred tax assets, net of valuation allowance

   $ 2,569,322      $ 390,468      $ 316,581   
  

 

 

   

 

 

   

 

 

 

Deferred tax liabilities:

      

Depreciable assets

     (186,055     (50,997     (47,605

Intangible assets and purchase accounting valuations

                   (10,011

Pension and medical trust

     (71,152     (86,925     (79,716

Other liabilities

     (1,186     (1,154     (1,376
  

 

 

   

 

 

   

 

 

 

Gross deferred tax liabilities

   $ (258,393   $ (139,076   $ (138,708
  

 

 

   

 

 

   

 

 

 

Deferred tax assets

   $ 2,310,929      $ 251,392      $ 177,873   

Tax effect of fair value adjustments on available-for-sale securities, pension liabilities and hedging transactions recorded directly to stockholder’s equity

     59,961        81,962        57,929   
  

 

 

   

 

 

   

 

 

 

Net deferred tax assets

   $ 2,370,890      $ 333,354      $ 235,802   
  

 

 

   

 

 

   

 

 

 

 

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Federal tax credit carryforwards at December 31, 2011 of approximately $115.1 million consist of approximately $41.2 million of AMT tax credits which do not expire and $73.9 million of general business credits that will expire in varying amounts in the years 2026 through 2031.

Federal tax loss carryforwards at December 31, 2011 of approximately $2,558.1 million will expire in varying amounts in the years 2020 through 2031.

State tax loss carryforwards at December 31, 2011 of approximately $3,667.8 million will expire in varying amounts in the years 2012 through 2031.

A valuation allowance of $193.4 million and $46.7 million exists at December 31, 2011 and 2010, respectively, to offset deferred tax assets related to the Bank’s state tax loss carryforwards and certain state deferred tax assets. During 2011, the valuation allowance increased as a result of the M&I acquisition and subsequently decreased by $5.7 million in the year, due in part to the expiration of state net operating loss carryforwards relating to M&I.

In evaluating deferred taxes for recoverability, the Bank considers the relative impact of positive and negative evidence, including historical financial performance and projections of future taxable income. In addition, future reversals of taxable temporary differences, tax planning strategies and tax recoveries are analyzed. Although realization in not assured, the Bank has concluded there is sufficient positive evidence to overcome any negative evidence and support its conclusion that the federal deferred tax asset along with state deferred tax assets, except those noted above, will more likely than not be realized. The positive evidence includes two means by which the Bank is able to realize its net deferred tax asset. First, the Bank forecasts sufficient taxable income in the tax carryforward period, exclusive of tax planning strategies, to support the net deferred tax asset. Second, the Bank has identified tax planning strategies that would be employed, if necessary, to prevent a tax carryforward from expiring.

Based on the foregoing discussion, the federal tax loss carryforward period of 20 years provides enough time to utilize deferred tax assets relating to the existing net operating loss carryforwards and any tax loss that would be created by the reversal of the future net deductions that have not been taken on a tax return.

The Bank estimates future taxable income based on the Bank’s business plans. The Bank’s planning and forecasting process is part of BMO’s overall process. In consultation with BMO’s economics department, these forecasts include assumptions on interest rates, GDP growth, unemployment rates, housing prices and the consumer price index. In addition, one-time items such as integration and restructuring costs associated with the M&I transaction are included in the projections.

In accordance with ASC 740, the Bank has examined tax planning strategies available to the Bank that would be acted upon, if required. These strategies which support some, but not all, of the deferred tax asset include selling certain assets that produce tax exempt income, while re-investing the proceeds in assets that produce fully taxable income. In addition, BMO has indicated that they remain fully committed to supporting the Bank and have the capacity and willingness to implement tax planning strategies to ensure that the Bank’s tax loss carryforwards do not expire. Only those tax planning strategies that the Bank and BMO management consider prudent and feasible, and which management has the ability and intent to implement, have been incorporated into the Bank’s assessment. The primary and most significant parental support planning strategy is BMO’s commitment to infuse funds into the Bank by means of an interest free loan or capital into the Bank. Such a strategy would allow the Bank to reduce medium and long term borrowings and/or otherwise invest in assets that produce taxable income.

 

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A reconciliation of the U.S. federal statutory income tax rate to the actual income tax rate is provided below.

 

     Years Ended December 31  
     2011     2010     2009  

Federal statutory rate:

     35.0     35.0     35.0

Increase (reduction) in income tax benefits due to:

      

Bank-owned insurance

     (5.3     38.6        6.4   

Valuation allowance change for state deferred taxes, net of federal effect

     (1.3     (17.8     (4.6

State income taxes, excluding valuation allowance, net of federal effect

     1.2        18.6        5.3   

Tax-exempt municipal income

     (3.5     38.6        7.2   

Other, net

     (3.5     0.1        0.8   
  

 

 

   

 

 

   

 

 

 

Actual income tax rate

     22.6     113.1     50.1
  

 

 

   

 

 

   

 

 

 

The balance of gross unrecognized tax benefits may decrease between zero and $7.4 million during the next twelve months depending upon the settlement of federal, state, and local audits.

With few exceptions, the Bank is no longer subject to U.S. federal, state or local income tax exams for years prior to 2008. The Bank joins in filing a consolidated Federal income tax return with its parent, BMO Financial Corp. During 2011, the Internal Revenue Service completed its examination of the 2006, 2007 and 2008 consolidated Federal income tax returns of BMO Financial Corp.; there were no significant adjustments that had a material impact on the effective tax rate. As of December 31, 2011, no significant adjustments have been proposed for the Bank’s federal or state tax positions.

The Bank recognizes penalties and the accrual of interest related to unrecognized tax benefits in its income tax expense. During the years ended December 31, 2011, 2010 and 2009, the interest and penalties recognized by the Bank were not significant and did not affect the annual effective tax rate. The Bank had approximately $0.1 million and $0.2 million accrued for the payment of interest and penalties at December 31, 2011 and 2010, respectively.

19.    Regulatory Capital

The Bank, as a federally-chartered bank, must adhere to the capital adequacy guidelines of the Federal Reserve Board (the “Board”) and the Office of the Comptroller of the Currency (“OCC”). The guidelines specify minimum ratios for Tier 1 capital to risk-weighted assets of 4 percent and total regulatory capital to risk-weighted assets of 8 percent.

Risk-based capital guidelines define total capital to consist primarily of Tier 1 (core) and Tier 2 (supplementary) capital. In general, Tier 1 capital is comprised of stockholder’s equity, including certain types of preferred stock, less goodwill and certain other intangibles. Core capital must comprise at least 50 percent of total capital. Tier 2 capital basically includes subordinated debt (less a discount factor during the five years prior to maturity), other types of preferred stock and the allowance for loan losses. The portion of the allowance for loan losses includable in Tier 2 capital is limited to 1.25 percent of risk-weighted assets.

The Board and OCC also require an additional measure of capital adequacy, the Tier 1 leverage ratio, which is evaluated in conjunction with risk-based capital ratios. The Tier 1 leverage ratio is computed by dividing period-end Tier 1 capital by adjusted quarterly average assets. The Board and OCC established a minimum ratio of 3 percent applicable only to the strongest banking organizations having, among other things, excellent asset quality, high liquidity, good earnings and no undue interest rate risk exposure. Other institutions are expected to maintain a minimum ratio of 4 percent.

The Federal Deposit Insurance Corporation Improvement Act of 1991 contains prompt corrective action provisions that established five capital categories for all FDIC-insured institutions ranging from “well capitalized” to “critically undercapitalized.” Classification within a category is based primarily on the three capital adequacy measures.

 

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Noncompliance with minimum capital requirements may result in regulatory corrective actions that could have a material effect on the Bank’s financial statements.

As of December 31, 2011 and 2010, the most recent notification from the FDIC categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. Management is not aware of any conditions or events since December 31, 2011 that have changed the capital category of the Bank.

At December 31, 2011 and 2010, the Bank had noncontrolling interests in preferred stock of subsidiaries of $260.7 million and $250.0 million, respectively. For the years ended December 31, 2011 and 2010, dividends declared and paid on the preferred stock were $19.8 million and $18.4 million, respectively. The preferred stock qualifies as Tier 1 capital for the Bank under U.S. banking regulatory guidelines.

On November 22, 2011 the Board issued a final rule requiring top-tier U.S. bank holding companies with total consolidated assets of $50 billion or more, which includes BFC, to submit annual capital plans for review beginning January 9, 2012. In addition, the OCC had similar expectations of the Bank. The BHB and BFC capital plans submitted in January 2012 included, as required, a schedule of anticipated capital actions, including external dividend payments by subsidiaries, which must be approved by the Board and the OCC. On March 13, 2012 the Board informed BFC that it had completed its 2012 Capital Plan Review, and it did not object to the proposed capital distributions through March 31, 2013 submitted to the Board pursuant to the Capital Plan Review.

The following table summarizes the Bank’s risk-based capital ratios and Tier 1 leverage ratio for the past two years as well as the minimum amounts and ratios as per capital adequacy guidelines and FDIC prompt corrective action provisions. Ratios as of December 31, 2010 have not been recast to reflect the historical financial results of The Harris Bank N.A.

 

                               To Be Well Capitalized  
                  For Capital     Under Prompt Corrective  
     Actual     Adequacy Purposes     Action Provisions  
     Capital      Capital     Capital      Capital     Capital      Capital  
     Amount      Ratio     Amount      Ratio     Amount      Ratio  
     (In thousands)  

As of December 31, 2011

               

Tier 1 Common to Risk-Weighted Assets (1)

   $ 8,573,206         13.93          

Tier 1 Capital to Risk-Weighted Assets

   $ 8,828,959         14.34   ³ $2,462,750       ³ 4.00   ³ $3,694,125       ³ 6.00

Total Capital to Risk-Weighted Assets

   $ 10,291,543         16.72   ³ $4,924,183       ³ 8.00   ³ $6,155,229       ³ 10.00

Tier 1 Capital to Quarterly Average Assets

   $ 8,828,959         9.91   ³ $3,563,657       ³ 4.00   ³ $4,454,571       ³ 5.00

As of December 31, 2010

               

Tier 1 Common to Risk-Weighted Assets (1)

   $ 4,177,320         15.10          

Tier 1 Capital to Risk-Weighted Assets

   $ 4,422,319         15.98   ³ $1,106,963       ³ 4.00   ³ $1,660,445       ³ 6.00

Total Capital to Risk-Weighted Assets

   $ 4,945,364         17.87   ³ $2,213,929       ³ 8.00   ³ $2,767,411       ³ 10.00

Tier 1 Capital to Quarterly Average Assets

   $ 4,422,319         9.64   ³ $1,834,987       ³ 4.00   ³ $2,293,734       ³ 5.00

 

(1) There is no published regulatory minimun for the Tier 1 common ratio.

 

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20.    Investments in Subsidiaries and Statutory Restrictions

BMO Harris Bank N.A.’s investment in the combined net assets of its wholly-owned subsidiaries was $1.0 billion and $983 million at December 31, 2011 and 2010, respectively.

Provisions of Federal banking laws place restrictions upon the amount of dividends that can be paid to BFC by its bank subsidiaries. The National Bank Act requires all national banks 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 net 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, Harris Preferred Capital Corporation, as an indirect subsidiary of the Bank, became subject to the provisions relating to dividend approval and the Bank must receive prior approval from the OCC before Harris Preferred Capital Corporation declares dividends on the Preferred Shares. Prior approval from the OCC was received for the 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 may be declared by the board of Harris Preferred Capital Corporation in the fourth quarter ending December 31, 2011, was not required to obtain permission from the OCC for such a declaration. 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 Harris Preferred Capital Corporation 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. There were no cash dividends paid to BFC by the Bank in 2011 and there were no cash dividends paid to Bankcorp by the Bank in 2010.

The Bank is required by the Federal Reserve Act to maintain reserves against certain of their deposits. Reserves are held either in the form of vault cash or balances maintained with the Federal Reserve Bank. Required reserves are essentially a function of daily average deposit balances and statutory reserve ratios prescribed by type of deposit. During 2011 and 2010, daily average reserve balances of $518.7 million and $312.1 million, respectively, were required for the Bank. At December 31, 2011 and 2010, balances on deposit at the Federal Reserve Bank totaled $16.8 billion and $14.1 billion, respectively. Interest income recognized in the year ended December 31, 2011, 2010 and 2009 was $41.6 million, $25.8 million and $15.8 million, respectively.

21.    Contingent Liabilities and Litigation

The Bank and certain of its subsidiaries are party to legal proceedings, including regulatory investigations, in the ordinary course of their businesses. Reserves are established for legal claims when management determines that it is probable that a loss will be incurred and the amount of such loss can be reasonably estimated. No material reserves have been recorded related to legal proceedings or regulatory investigations as of December 31, 2011 or 2010. While there is inherent difficulty in predicting the outcome of these proceedings, management believes that current legal reserves are adequate and does not expect the outcome of any of these proceedings, individually or in the aggregate, to have a material adverse effect on the Bank’s consolidated financial position or results of operations. However, in the event of unexpected future developments, it is possible that the ultimate resolution of these matters may differ from management’s current assessment.

22.    Accumulated Other Comprehensive Loss

The following table summarizes the components of accumulated other comprehensive loss shown in stockholder’s equity, net of tax:

 

     Unrealized            Unrealized     Accumulated  
     Gain on      Pension and     Loss on Cash Flow     Other  
     Securities      Postretirement     Hedge     Comprehensive  
     Available-For-Sale      Adjustments     Activity     Loss  
     (In thousands)  

Balance at December 31, 2011

   $ 103,319       $ (137,482   $ (64,145   $ (98,308
  

 

 

    

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

   $ 41,484       $ (85,184   $ (92,659   $ (136,359
  

 

 

    

 

 

   

 

 

   

 

 

 

Balance at December 31, 2009

   $ 61,079       $ (74,729   $ (83,402   $ (97,052
  

 

 

    

 

 

   

 

 

   

 

 

 

 

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23.     Foreign Activities (by Domicile of Customer)

Income and expenses identifiable with foreign and domestic operations are summarized in the table below:

 

     Foreign      Domestic     Consolidated  
     (In thousands)  

2011

       

Total operating income

   $ 14,000       $ 3,040,671      $ 3,054,671   

Total expenses

     7,554         2,586,842        2,594,396   
  

 

 

    

 

 

   

 

 

 

Income before taxes

   $ 6,446       $ 453,829      $ 460,275   

Applicable income tax expense

     2,514         101,279        103,793   
  

 

 

    

 

 

   

 

 

 

Net income

   $ 3,932       $ 352,550      $ 356,482   
  

 

 

    

 

 

   

 

 

 

Identifiable assets at year-end

   $ 3,331,656       $ 93,926,900      $ 97,258,556   
  

 

 

    

 

 

   

 

 

 

2010

       

Total operating income

   $ 20,350       $ 1,784,816      $ 1,805,166   

Total expenses

     13,491         1,814,917        1,828,408   
  

 

 

    

 

 

   

 

 

 

Income (loss) before taxes

   $ 6,859       $ (30,101   $ (23,242

Applicable income tax expense (benefit)

     2,726         (49,864     (47,138
  

 

 

    

 

 

   

 

 

 

Net income

   $ 4,133       $ 19,763      $ 23,896   
  

 

 

    

 

 

   

 

 

 

Identifiable assets at year-end

   $ 1,468,249       $ 49,105,387      $ 50,573,636   
  

 

 

    

 

 

   

 

 

 

2009

       

Total operating income

   $ 34,679       $ 1,847,768      $ 1,882,447   

Total expenses

     34,355         2,072,664        2,107,019   
  

 

 

    

 

 

   

 

 

 

Income (loss) before taxes

   $ 324       $ (224,896   $ (224,572

Applicable income tax expense (benefit)

     129         (121,889     (121,760
  

 

 

    

 

 

   

 

 

 

Net income (loss)

   $ 195       $ (103,007   $ (102,812
  

 

 

    

 

 

   

 

 

 

Determination of rates for foreign funds generated or used is based on the actual external costs of specific interest-bearing sources or uses of funds for the periods. Internal allocations for certain unidentifiable income and expenses were distributed to foreign operations based on the percentage of identifiable foreign income to total income. As of December 31, 2011 and 2010, identifiable foreign assets accounted for 3.4 percent and 2.9 percent respectively, of total consolidated assets. Assets and liabilities denominated in foreign currencies have been translated into United States dollars at respective year-end rates of exchange. Monthly translation gains or losses are computed at rates prevailing at month-end. There were no material translation gains or losses during the three years presented.

24.     Interest in Variable Interest Entities

Variable interest entities include entities whose equity is considered insufficient to finance its activities or for which the equity holders do not have a controlling financial interest. A variable interest is one that changes with changes in the fair value of the VIE’s net assets. The Bank is required to consolidate a VIE if the investment held in the entity and/or the relationships with it results in the Bank being the primary beneficiary. The primary beneficiary is the party that has a controlling financial interest in the VIE where control is defined as both 1) the power to direct the activities that most significantly impact the VIE’s economic performance and 2) the obligation to absorb losses and/or the right to receive benefits from the VIE that could potentially be significant to the VIE. The Bank determines whether it is the primary beneficiary of a VIE based on qualitative and quantitative assessments performed on an ongoing basis.

 

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The Bank is committed to community reinvestment and is required under federal law to take affirmative steps to help meet the credit needs of the local communities it serves. For this purpose, the Bank holds variable interests in variable interest entities. The Bank regularly invests in or lends to entities that: own residential facilities that provide housing for low-to-moderate income families (affordable housing projects); own commercial properties that are involved in historical preservations (rehabilitation projects); or provide funds for qualified low income community investments. These projects are generally located within the geographic markets served by the Bank. The Bank’s involvement in these entities is limited to providing funding in the form of subordinated debt or equity interests. The Bank does not have the power to direct the activities of the entities that significantly affects their economic performance. At December 31, 2011, the aggregate carrying value of investments in the form of subordinated debt amounted to $21.2 million represented an involvement in 26 entities. At December 31, 2010, the aggregate carrying value of investments in the form of subordinated debt amounted to $12.9 million represented an involvement in 15 entities.

Generally, the economic benefit from the equity investments consists of the income tax benefits obtained from the Bank’s allocated operating losses from the partnership that are tax deductible, allocated income tax credits for projects that qualify under the Internal Revenue Code and in some cases, participation in the proceeds from the eventual disposition of the property. The Bank uses the equity method of accounting to account for these investments in entities where equity is held. To the extent a project qualifies for income tax credits, the project must continue to qualify as an affordable housing project for fifteen years, a rehabilitation project for five years, or a qualified low income community investment for seven years in order to avoid recapture of the income tax credit. These requirements generally define the time the Bank will be involved in a project.

The Bank’s maximum exposure to loss as a result of its involvement with these entities is generally limited to the carrying value of these investments plus any unfunded commitments on projects that are not completed. At December 31, 2011, the aggregate carrying value of the subordinated debt and equity investments amounted to approximately $129.1 million and the amount of unfunded commitments outstanding was $53.3 million. At December 31, 2010, the aggregate carrying value of the subordinated debt and equity investments amounted to approximately $56.6 million and the amount of unfunded commitments outstanding was $30.3 million.

The Bank enters into debt modifications (some qualifying under GAAP as troubled debt restructurings) where the borrowers emerge as VIEs in relation to the Bank. The Bank may hold equity investments in the VIEs along with modified debt due from the VIEs. The Bank does not have the ability to direct the activities that most significantly affect the VIEs’ economic performance and is not required to consolidate them. In addition, the Bank interests in the VIEs are not considered significant variable interests as defined by GAAP at December 31, 2011 and December 31, 2010.

25.     Related Party Transactions

During 2011, 2010 and 2009, the Bank engaged in various transactions with BMO and its subsidiaries. These transactions included the payment and receipt of service fees and occupancy expenses; purchasing and selling Federal funds; repurchase and reverse repurchase agreements; short and long-term borrowings; interest rate and foreign exchange rate contracts. The purpose of these transactions was to facilitate a more efficient use of combined resources and to better serve customers. Fees for these services were determined in accordance with applicable banking regulations. During 2011, 2010 and 2009, the Bank received from BMO approximately $39.0 million, $34.8 million, and $27.4 million respectively, primarily for data processing, other operations support and corporate support provided by the Bank. Excluding interest expense payments disclosed below, the Bank made payments for services to BMO of approximately $122.4 million, $88.3 million, and $85.2 million, in 2011, 2010, and 2009, respectively. During 2011, 2010 and 2009, the Bank received from BFC approximately $66.8 million $69.8 million, and $66.5 million, respectively, primarily for data processing, other operations support and corporate support provided by the Bank. Excluding interest expense payments disclosed below, the Bank made payments for services to BFC of approximately $8.3 million, $8.6 million, and $7.0 million in 2011, 2010 and 2009, respectively.

During 2010, the Bank sold $272 million of nonperforming loans to psps. During 2009, the Bank sold $503 million of nonperforming loans to psps Holdings, LLC (“psps”). psps was formed in December 2008 to hold and manage nonperforming loans. Loans were sold at fair value. For nonperforming loans sold, credit losses were

 

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recorded at the Bank prior to closing, as required, to reflect any credit deterioration. Credit-related write-downs were reflected in the provision for credit losses and/or as write-downs against the allowance for loan losses. For these loans, the carrying value after any required write-downs was considered by management to represent estimated fair value. No gain or loss was recognized in the Consolidated Statements of Operations on sale of loans from the Bank to psps. No loans were sold to psps in 2011.

At December 31, 2011, derivative contracts with BMO represent $713.0 million and $627.6 million of unrealized gains and unrealized losses, respectively. At December 31, 2010, derivative contracts with BMO represent $350.8 million and $422.6 million of unrealized gains and unrealized losses, respectively. At December 31, 2009, derivative contracts with BMO represented $350.4 million and $485.4 million of unrealized gains and unrealized losses, respectively.

In June 2007 the Bank amended the leaseback agreement for the building located at 111 West Monroe Street, Chicago, Illinois. The Bank received from BMO Chicago Branch a payment of $6.1 million as compensation for the extension of the original lease termination dates and a payment of $5.8 million as compensation for the vacancy anticipated on the original lease. The payments were deferred and are amortized on a straight-line basis over the remaining term of the lease. Deferred revenue of $0.7 million was recognized in each of 2011, 2010 and 2009.

The Bank and BMO combined their U.S. FX activities. Under this arrangement, the Bank and BMO share FX net profit in accordance with a specific formula set forth in the agreement. This agreement expires on September 30, 2012 but may be extended at that time. Either party may terminate the arrangement at its option. FX revenues are reported net of expenses. During 2011, 2010 and 2009 foreign exchange revenues were $3.0 million, $4.9 million, and $11.5 million, respectively, under this agreement.

The Bank has loans outstanding to certain executive officers and directors of BHB. These loans totaled $1.9 million and $1.3 million at December 31, 2011 and 2010, respectively. The Bank also has loans outstanding to certain executive officers and directors of BFC. These loans totaled $66.4 million and zero at December 31, 2011 and 2010, respectively. The total unfunded commitments outstanding relating to the loans to certain executive officers and directors of BHB and BFC were $34.4 million and $0.3 million at December 31, 2011 and 2010, respectively.

During 2011 and 2010 the Bank held demand deposits on behalf of BMO and its subsidiaries. At December 31, 2011 and 2010, the Bank had $506.6 million and $239.1 million of such deposits, respectively. The Bank also held a foreign demand deposit with another BMO affiliate of $2.6 billion as of December 31, 2011 and $2.7 billion as of December 31, 2010.

The Bank enters into purchases of securities, primarily U.S. Treasury and Federal agency securities, under agreements to resell identical securities with BFC and its subsidiaries. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the Consolidated Statements of Condition. Securities purchased under agreement to resell between the Bank and BFC and its subsidiaries totaled $1.7 billion and $1.2 billion at December 31, 2011 and 2010, respectively.

The Bank enters into sales of securities, primarily U.S. Treasury and Federal agency securities under agreements to repurchase identical securities. The amounts received under these agreements, between the Bank and BFC and its subsidiaries, represent short-term borrowings and are reflected as liabilities in the Consolidated Statements of Condition. Securities sold under agreement to repurchase between the Bank and BFC and its subsidiaries totaled $410.3 million and $433.9 million at December 31, 2011 and 2010, respectively.

 

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The following tables summarize the Bank’s related party transactions for long-term notes (senior and subordinated) and certificates of deposit:

 

    Interest Expense
Year Ended
December 31
    Loan Balance
December 31
           
    2011     2010     2011     2010    

Rate

  Reprice  
    (In thousands)            

Long-term notes — senior/unsecured

           

Floating rate senior note to BMO subsidiary due June 13, 2011

  $ 1,421      $ 3,594      $      $ 746,500      14bps + 90 day LIBOR     Quarterly   

Floating rate senior note to BMO subsidiary due September 29, 2011

    7,184        9,990               550,000      14bps + 90 day LIBOR     Quarterly   

Floating rate senior note to BMO subsidiary due September 29, 2011

    653        908               50,000      145bps + 90 day LIBOR     Quarterly   

Floating rate senior note to BMO branch due August 14, 2012

    4,998        5,301        1,100,000        1,100,000      14bps + 90 day LIBOR     Quarterly   
 

 

 

   

 

 

   

 

 

   

 

 

     

Total long-term notes — senior/unsecured

  $ 14,256      $ 19,793      $ 1,100,000      $ 2,446,500       
 

 

 

   

 

 

   

 

 

   

 

 

     

Long-term notes — subordinated

           

Floating rate subordinated note to BFC due December 23, 2012

  $      $ 48      $      $      50bps + 90 day LIBOR     Quarterly   

Floating rate subordinated note to BFC due May 30, 2013

           57                    50bps + 90 day LIBOR     Quarterly   

Floating rate subordinated note to BFC due November 26, 2013

           41                    50bps + 90 day LIBOR     Quarterly   

Floating rate subordinated note to BFC due February 26, 2014

           12                    50bps + 90 day LIBOR     Quarterly   

Floating rate subordinated note to BFC due May 31, 2014

    657        702        100,000        100,000      35bps + 90 day LIBOR     Quarterly   

Floating rate subordinated note to BFC due May 31, 2016

    683        728        100,000        100,000      38bps + 90 day LIBOR     Quarterly   
 

 

 

   

 

 

   

 

 

   

 

 

     

Total long-term notes — subordinated

  $ 1,340      $ 1,588      $ 200,000      $ 200,000       
 

 

 

   

 

 

   

 

 

   

 

 

     

Total long-term notes

  $ 15,596      $ 21,381      $ 1,300,000      $ 2,646,500       
 

 

 

   

 

 

   

 

 

   

 

 

     
                       
    Interest Expense
Year Ended
December 31
    Certificate of Deposit
Balance December 31
           
    2011     2010     2011     2010            
    (In thousands)            

Certificates of deposit

     

Certificate of deposit to BMO subsidiary due on January 26, 2011(1)

  $      $      $      $ 250      0.14%     Fixed   

Certificate of deposit to BMO subsidiary due on February 7, 2011

    1        3               1,300      0.18%     Fixed   

Certificate of deposit to BMO subsidiary due on July 29, 2011

    6,720        12,201               950,000      93bps + 90 day LIBOR     Quarterly   

Certificate of deposit to BMO subsidiary due on January 4, 2012(1)

    2        4        3,750        3,194      0.12%     Fixed   
 

 

 

   

 

 

   

 

 

   

 

 

     

Total certificates of deposit

  $ 6,723      $ 12,208      $ 3,750      $ 954,494       
 

 

 

   

 

 

   

 

 

   

 

 

     

 

(1) Includes interest expense less than $1 thousand

In 2009, the Bank’s interest expense on long-term notes and certificates of deposit was $35.6 million and $35.9 million, respectively.

 

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26.     Restructuring Charge

During 2011, the Bank recorded restructuring costs relating to the M&I acquisition of $24.4 million in the Consolidated Statement of Operations, and a corresponding liability for restructuring costs, measured initially at its fair value. The costs related primarily to severance and other employee-related charges, premises-related charges, and contract termination charges.

The following table summarizes the activity related to the Bank’s accrual for restructuring during 2011. The Bank expects substantially all of the accrual as of December 31, 2011 to be paid out within one year.

 

     Severance and
retention related
charges
    Premises related
charges
    Contract
termination and
other related
charges
    Total  

Balance at December 31, 2010

   $      $      $      $   

Restructuring accruals during the year

     22,035        1,050        1,356        24,441   

Paid during the year

     (5,397     (59     (1,356     (6,812
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

   $ 16,638      $ 991      $      $ 17,629   
  

 

 

   

 

 

   

 

 

   

 

 

 

27.     Visa Indemnification Charge

BHB was a member of Visa U.S.A. Inc. (“Visa U.S.A.”) and in 2007 received shares of restricted stock in Visa, Inc. (“Visa”) as a result of its participation in the global restructuring of Visa U.S.A., Visa Canada Association, and Visa International Service Association in preparation for an initial public offering by Visa. BHB and other Visa U.S.A. member banks are obligated to share in potential losses resulting from certain indemnified litigation involving Visa that has been settled.

A member bank such as BHB is also required to recognize the contingent obligation to indemnify Visa under Visa’s bylaws (as those bylaws were modified at the time of the Visa restructuring on October 3, 2007) for potential losses arising from the other indemnified litigation that has not yet settled at its estimated fair value. BHB is not a direct party to this litigation and does not have access to any specific, non-public information concerning the matters that are the subject of the indemnification obligations. While the estimation of any potential losses is highly judgmental, as of December 31, 2007, BHB recorded a liability and corresponding charge of $34 million (pretax) for the remaining litigation.

The initial public offering (IPO) of Visa shares occurred on March 25, 2008 followed by a mandatory partial redemption of BHB’s restricted stock in Visa that took place in two parts: exchange for cash and funding of the covered litigation escrow account. During the first quarter of 2008, BHB received $37.8 million in cash in conjunction with the mandatory partial redemption which was recognized as an equity security gain in the Consolidated Statements of Operations since there was no basis in the stock. In addition, Visa funded the U.S. litigation escrow account with IPO proceeds. BHB’s share of the U.S. litigation escrow account funding was $17 million which was recognized as a reversal to the litigation reserve and as a decrease to non-interest expense.

On October 27, 2008, Visa announced the settlement of the litigation involving Discover Financial Services. As a result, BHB recorded an additional reserve for this matter of $7 million (pretax) during the third quarter of 2008 as an increase to non-interest expense.

On July 5, 2011, as part of BMO’s acquisition of M&I, BHB assumed an additional $3.8 million in Visa litigation reserve.

In December 2011, March 2011, October 2010, June 2010, July 2009 and December 2008, BHB recorded decreases to noninterest expense of $8.9 million, $2.2 million, $4.7 million, $2.8 million, $3.0 million and $6.3 million, respectively, as a reduction in the Visa litigation reserve to reflect Visa’s use of a portion of BHB’s restricted Visa stock to fund the escrow account available to settle certain litigation matters. Visa’s funding of amounts required beyond the current escrow, if any, will be obtained via additional mandatory redemptions of restricted shares. As of December 31, 2011 and 2010, the recorded reserve relating to the Visa litigation matter included in the Consolidated Statements of Condition was $0 and $7.2 million respectively.

 

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28.     Other Assets

Other securities are recorded in Other Assets on the Bank’s Consolidated Statements of Condition and primarily include Federal Reserve stock, FHLB stock and Community Reinvestment Act (“CRA”) investments. Other securities totaled $801.8 million at December 31, 2011 and $336.1 million at December 31, 2010.

Federal Reserve stock totaled $308.4 million and $106.9 million at December 31, 2011 and 2010, respectively, and FHLB stock totaled $364.1 million and $172.5 million at December 31, 2011 and 2010, respectively. The Bank is required to own these securities as a member of both the Federal Reserve System and the FHLB, and in amounts as required by these financial institutions. These securities are “restricted” in that they can only be sold back to the respective institutions or another member institution at par. Therefore, their fair value is considered to be equal to amortized cost unless there is an identified event that may have a significant adverse effect on their fair value. No other-than-temporary impairment was recorded for Federal Reserve stock or FHLB stock during 2011, 2010 or 2009.

The FHLB of Chicago announced in October 2007 that it was under a consensual cease and desist order with its regulator, which among other things, restricts various future activities of the FHLB of Chicago. Such restrictions may limit or prevent the FHLB of Chicago from paying dividends or redeeming stock without prior approval. In December 2011, the FHLB of Chicago received approval from its regulator to repurchase excess stock held by its members beginning in the first quarter of 2012. Additionally, the FHLB of Chicago declared and paid a dividend in the first quarter of 2012. Based on evaluations of this investment as of December 31, 2011 and 2010, the Bank believes the cost of the investment will be recovered.

Securities received in satisfaction of debt are recorded at fair value. Fair value is determined using exchange traded prices where available. Otherwise, fair value is determined using other methods such as third party valuations or analysis of discounted cash flows. Securities that are not designated trading or available-for-sale are recorded in other assets.

CRA investments and other nonmarketable securities are subject to ongoing impairment reviews. See Note 3 to the Consolidated Financial Statements for additional information on the impairment review applied to all investments, including nonmarketable securities. During 2011, the Bank recorded other-than-temporary impairment of $0.6 million on eight CRA investments. During 2010, the Bank recorded other-than-temporary impairment of $0.2 million on four CRA investments. During 2009, the Bank recorded other-than-temporary impairment of $1.3 million on 27 CRA investments. Losses related to declines in the estimated fair value of the investments and were recorded in the Consolidated Statements of Operations to other-than-temporary impairment in 2011, 2010 and 2009.

The acquisition of AMCORE from the FDIC includes a loss share agreement with the FDIC. The loss share agreement provides for reimbursement from the FDIC for 80% of losses incurred on covered assets, including loans and OREO, subsequent to acquisition date. At acquisition, acquired loans and OREO of $1.5 billion and $23.0 million, respectively, were subject to the loss share agreement. An indemnification asset estimated at a fair value of $427.5 million was recorded at acquisition based on the present value of expected cash flows to be received from the FDIC for loss reimbursements covered by the agreement. The indemnification asset is included in Other Assets. Subsequent to acquisition date but prior to December 31, 2010, the FDIC indemnification asset was increased by approximately $8.1 million due to an increase in the expected cash flows to be received from the FDIC from those initially expected and was reduced by $75.2 million for losses reimbursed by the FDIC. During the year ended December 31, 2011, the indemnification asset was decreased by approximately $28.3 million due to a decrease in the expected cash flows to be received from the FDIC and was reduced by $101.1 million for losses reimbursed by the FDIC. The balance was $230.5 million and $359.9 million at December 31, 2011 and 2010, respectively.

At December 31, 2011, OREO totaled $277.4 million which was net of the valuation allowance of $13.9 million, of which $28.5 million was covered by the FDIC loss share agreement. At December 31, 2010, OREO totaled $38.1 million which was net of the valuation allowance of $3.7 million, of which $21.7 million was covered by the FDIC loss share agreement.

 

 

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Property held for sale is recorded in other assets at the lower of cost or fair value less estimated selling costs. The carrying value of property held for sale was $3.8 million and $4.6 million at December 31, 2011 and 2010, respectively. All changes in the valuation allowance were recorded directly to noninterest expense during the years ended December 31, 2011 and 2010.

29. Subsequent Events

The consolidated financial statements have been prepared by management from the books and records of the Bank. The statements reflect all adjustments and disclosures which, in the opinion of management, are necessary for a fair presentation of the results for the periods presented. Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements through March 23, 2012, the date the consolidated financial statements were available to be issued.

 

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