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EX-32.1 - EXHIBIT 32.1 - COMMUNITY SHORES BANK CORPv359992_ex32-1.htm
EX-32.2 - EXHIBIT 32.2 - COMMUNITY SHORES BANK CORPv359992_ex32-2.htm
EX-31.2 - EXHIBIT 31.2 - COMMUNITY SHORES BANK CORPv359992_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - COMMUNITY SHORES BANK CORPv359992_ex31-1.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended   September 30, 2013

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ____________________________________ to ____________________________________

 

Commission File Number:   000-51166

 

Community Shores Bank Corporation
(Exact name of registration as specified in its charter)

 

Michigan 38-3423227
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)

 

1030 W. Norton Avenue, Muskegon, MI 49441
(Address of principal executive offices) (Zip Code)

 

(231) 780-1800
(Registrant’s telephone number, including area code)

 

 
(Former name, former address and former fiscal year, if changed since last report)

 

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.

x Yes ¨ No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

¨ Yes x No

 

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

 

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company x
    (Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨ Yes x No

 

At November 1, 2013, 1,468,800 shares of common stock were outstanding.

 

 
 

 

Community Shores Bank Corporation Index

 

    Page No.
PART I. Financial Information  
       
  Item 1. Financial Statements 1
       
  Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 41
       
  Item 3. Quantitative and Qualitative Disclosures about Market Risk 60
       
  Item 4. Controls and Procedures 60
       
PART II. Other Information  
       
  Item 1. Legal Proceedings 61
       
  Item 1A. Risk Factors 61
       
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 61
       
  Item 3. Defaults upon Senior Securities 62
       
  Item 4. Mine Safety Disclosures 62
       
  Item 5. Other Information 62
       
  Item 6. Exhibits 62
       
  Signatures 63

 

 
 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1.FINANCIAL STATEMENTS

 

COMMUNITY SHORES BANK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

 

   September 30,   December 31, 
   2013   2012 
   (unaudited)   (audited) 
ASSETS          
Cash and due from financial institutions  $3,245,012   $2,979,189 
Interest-bearing deposits in other financial institutions   6,895,413    17,317,926 
Total cash and cash equivalents   10,140,425    20,297,115 
Securities available for sale (at fair value)   33,500,614    41,460,396 
Loans held for sale   0    6,040,869 
Loans   128,547,253    125,830,250 
Less: Allowance for loan losses   2,870,036    3,382,977 
Net loans   125,677,217    122,447,273 
Federal Home Loan Bank stock (at cost)   450,800    450,800 
Premises and equipment, net   9,168,352    9,420,886 
Accrued interest receivable   485,441    592,043 
Foreclosed assets   2,686,237    2,806,781 
Other assets   855,210    715,200 
Total assets  $182,964,296   $204,231,363 
LIABILITIES AND SHAREHOLDERS’ EQUITY          
Deposits          
Non-interest-bearing  $31,700,054   $40,271,190 
Interest-bearing   131,868,405    143,905,303 
Total deposits   163,568,459    184,176,493 
Federal funds purchased and repurchase agreements   8,972,374    10,190,059 
Subordinated debentures   4,500,000    4,500,000 
Notes payable   1,280,000    5,000,000 
Accrued expenses and other liabilities   873,104    1,603,907 
Total liabilities   179,193,937    205,470,459 
Shareholders’ equity          
Preferred Stock, no par value: 1,000,000 shares authorized and none issued   0    0 
Common Stock, no par value: 9,000,000 shares authorized; 1,468,800 issued and outstanding   13,296,691    13,296,691 
Retained deficit   (9,312,447)   (14,816,593)
Accumulated other comprehensive (loss) income   (213,885)   280,806 
Total shareholders’ equity   3,770,359    (1,239,096)
Total liabilities and shareholders’ equity  $182,964,296   $204,231,363 

 

See accompanying notes to consolidated financial statements.

 

- 1 -
 

 

COMMUNITY SHORES BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

   Three Months   Three Months   Nine Months   Nine Months 
   Ended   Ended   Ended   Ended 
   September 30,   September 30,   September 30,   September 30, 
   2013   2012   2013   2012 
Interest and dividend income                    
Loans, including fees  $1,701,576   $1,946,158   $5,292,942   $6,199,527 
Securities   127,222    162,014    421,821    511,709 
Federal funds sold and other income   8,283    15,841    26,596    39,456 
Total interest income   1,837,081    2,124,013    5,741,359    6,750,692 
Interest expense                    
Deposits   226,945    333,829    757,995    1,094,497 
Repurchase agreements, federal funds purchased, and other debt   14,193    15,574    43,919    54,593 
Federal Home Loan Bank advances and notes payable   55,947    108,093    143,985    322,937 
Total interest expense   297,085    457,496    945,899    1,472,027 
Net Interest Income   1,539,996    1,666,517    4,795,460    5,278,665 
Provision for loan losses   0    0    0    75,035 
Net Interest Income After Provision for Loan Losses   1,539,996    1,666,517    4,795,460    5,203,630 
Non-interest income                    
Service charges on deposit accounts   152,341    166,975    463,644    505,783 
Mortgage loan referral fees   0    0    0    14,441 
Gain on sale of loans   39,602    105,455    166,766    208,387 
Gain on sale of securities   0    0    0    2,856 
Gain (loss) on sale of foreclosed assets   136,786    2,375    181,163    (40,058)
Gain on sale of premises and equipment   0    0    1,000    208,389 
Gain on the extinguishment of debt   0    0    5,262,653    0 
Other   162,479    144,153    479,204    395,606 
Total non-interest income   491,208    418,958    6,554,430    1,295,404 
Non-interest expense                    
Salaries and employee benefits   952,400    939,795    2,779,445    2,828,517 
Occupancy   168,241    163,266    484,510    484,751 
Furniture and equipment   96,796    101,243    294,995    305,228 
Advertising   11,427    14,198    35,538    41,550 
Data processing   156,105    142,929    456,844    425,390 
Professional services   63,357    70,695    268,169    218,803 
Foreclosed asset impairment   32,791    92,428    141,531    277,448 
FDIC insurance   107,123    178,529    331,191    540,770 
Other   318,616    380,445    948,521    1,117,095 
Total non-interest expense   1,906,856    2,083,528    5,740,744    6,239,552 
Income Before Federal Income Taxes   124,348    1,947    5,609,146    259,482 
Federal income tax expense   0    0    105,000    0 
Net Income  $124,348   $1,947   $5,504,146   $259,482 
Weighted average shares outstanding   1,468,800    1,468,800    1,468,800    1,468,800 
Diluted average shares outstanding   1,468,800    1,468,800    1,468,800    1,468,800 
Basic earnings per share  $0.08   $0.00   $3.75   $0.18 
Diluted earnings per share  $0.08   $0.00   $3.75   $0.18 

 

See accompanying notes to consolidated financial statements.

 

- 2 -
 

 

COMMUNITY SHORES BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)

 

   Three Months   Three Months   Nine Months   Nine Months 
   Ended   Ended   Ended   Ended 
   September 30, 2013   September 30, 2012   September 30, 2013   September 30, 2012 
                 
Net income  $124,348   $1,947   $5,504,146   $259,482 
                     
Other comprehensive income (loss):                    
Unrealized holding gains and (losses) on available for sale securities   50,370    38,745    (494,691)   14,214 
Less reclassification adjustments for gains later recognized in income   0    0    0    (2,856)
Net unrealized gain (loss)   50,370    38,745    (494,691)   11,358 
Tax effect   0    0    0    0 
Total other comprehensive income (loss)   50,370    38,745    (494,691)   11,358 
                     
Comprehensive income  $174,718   $40,692   $5,009,455   $270,840 

 

See accompanying notes to consolidated financial statements.

 

- 3 -
 

 

COMMUNITY SHORES BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

               Accumulated     
               Other   Total 
       Common   Retained   Comprehensive   Shareholders’ 
   Shares   Stock   Deficit   Income (Loss)   Equity 
                     
Balance at January 1, 2012   1,468,800   $13,296,691   $(15,084,431)  $367,358   $(1,420,382)
                          
Net income             259,482         259,482 
Other comprehensive income                  11,358    11,358 
                          
Balance at September 30, 2012   1,468,800   $13,296,691   $(14,824,949)  $378,716   $(1,149,542)
                          
Balance at January 1, 2013   1,468,800   $13,296,691   $(14,816,593)  $280,806   $(1,239,096)
                          
Net income             5,504,146         5,504,146 
Other comprehensive loss                  (494,691)   (494,691)
                          
Balance at September 30, 2013   1,468,800   $13,296,691   $(9,312,447)  $(213,885)  $3,770,359 

 

See accompanying notes to consolidated financial statements.

 

- 4 -
 

 

COMMUNITY SHORES BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

   Nine Months Ended   Nine Months Ended 
   September 30, 2013   September 30, 2012 
Cash flows from operating activities          
Net income  $5,504,146   $259,482 
Adjustments to reconcile net income to net cash          
from operating activities:          
Provision for loan losses   0    75,035 
Depreciation and amortization   308,010    301,960 
Net amortization of securities   287,298    229,564 
Net realized gain on sale of securities   0    (2,856)
Net realized gain on sale of loans   (166,766)   (208,387)
Net realized (gain) loss on sale of foreclosed assets   (181,163)   40,058 
Net realized gain on sale of premises and equipment   (1,000)   (208,389)
Net realized gain on the extinguishment of debt   (5,262,653)   0 
Foreclosed asset impairment   141,531    277,448 
Originations of loans for sale   (7,291,857)   (11,657,459)
Proceeds from loan sales   7,617,841    11,364,365 
Net change in:          
Accrued interest receivable and other assets   (33,408)   (363,947)
Accrued interest payable and other liabilities   31,850    272,295 
Net cash from operating activities   953,829    379,169 
Cash flows from investing activities          
Activity in available for sale securities:          
Sales   0    257,997 
Maturities, prepayments and calls   7,177,793    8,331,960 
Purchases   0    (12,441,742)
Loan originations and payments, net   2,051,555    21,481,939 
Additions to premises and equipment, net   (55,476)   (156,328)
Proceeds from the sale of premises and equipment   1,000    998,524 
Proceeds from the sale of foreclosed assets   760,328    1,137,080 
Net cash from investing activities   9,935,200    19,609,430 
Cash flows from financing activities          
Net change in deposits   (20,608,034)   (2,251,104)
Net change in federal funds purchased and          
repurchase agreements   (1,217,685)   778,463 
Other borrowing activity:          
Repayment of note payable   (500,000)   0 
Issuance of senior debt   1,280,000    0 
Net cash used in financing activities   (21,045,719)   (1,472,641)
Net change in cash and cash equivalents   (10,156,690)   18,515,958 
Beginning cash and cash equivalents   20,297,115    8,919,568 
Ending cash and cash equivalents  $10,140,425   $27,435,526 
Supplemental cash flow information:          
Cash paid during the period for interest  $864,706   $1,156,813 
Transfers from loans to foreclosed assets   614,485    1,243,347 
Transfers from loans held for sale to portfolio   5,881,651    0 
Foreclosed asset sales financed by the Company   14,333    72,068 

 

See accompanying notes to consolidated financial statements.

 

- 5 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS

 

BASIS OF PRESENTATION: The unaudited, consolidated financial statements as of and for the three and nine months ended September 30, 2013 include the consolidated results of operations of Community Shores Bank Corporation (“Company”) and its wholly-owned subsidiaries, Community Shores Financial Services (“CS Financial Services”), and Community Shores Bank (the “Bank”), and the Bank’s wholly-owned subsidiary, Community Shores Mortgage Company (the “Mortgage Company”) and the Mortgage Company’s wholly-owned subsidiary, Berryfield Development, LLC (“Berryfield”). Community Shores Capital Trust I (“the Trust”) is not consolidated and exists solely to issue capital securities. These consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Article 8 of Regulation S-X and do not include all disclosures required by generally accepted accounting principles for a complete presentation of the Company’s financial condition and results of operations. In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) which are necessary in order to make the financial statements not misleading and for a fair representation of the results of operations for such periods. The results for the three and nine month periods ended September 30, 2013 should not be considered as indicative of results for a full year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the period ended December 31, 2012. Some items in the prior year financial statements may be reclassified to conform to the current presentation.

 

LOAN POLICY: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and an allowance for loan losses. The loan portfolio consists of the following segments:

 

Commercial- Loans to businesses that are sole proprietorships, partnerships, limited liability companies and corporations. These loans are for commercial, industrial, or professional purposes. The risk characteristics of these loans vary based on the borrowers business and industry as repayment is typically dependent on cash flows generated from the underlying business.

 

Commercial Real Estate- Loans to individuals or businesses that are secured by improved and unimproved vacant land, farmland, commercial real property, multifamily residential properties, and all other conforming, nonresidential properties. Proceeds may be used for land acquisition, development or construction. These loans typically fall into two general categories: property that is owner occupied and income or investment property. Owner occupied commercial real estate loans typically involve the same risks as commercial and industrial loans however the underlying collateral is the real estate which is subject to changes in market value after the loan’s origination. Adverse economic events and changes in real estate market valuations generally describe the risks that accompany commercial real estate loans involving income or investment property. The ability of the borrower to repay tends to depend on the success of the underlying project or the ability of the borrower to sell or lease the property at certain anticipated values.

 

Consumer-Term loans or lines of credit for the purchase of consumer goods, vehicles or home improvement. The risk characteristics of the loans in this segment vary depending on the type of collateral but for the most part repayment is expected from an individual continuing to generate a cash flow that supports the calculated payment obligation. Secondary support could involve liquidation of collateral.

 

- 6 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS (Continued)

 

Residential- Loans to purchase or refinance single family residences. The risks associated with this segment are similar to the risks for consumer loans as far as individual payment obligations however the underlying collateral is the real estate. Real estate is subject to changes in market valuation and can be unstable for a variety of reasons.

 

For all loan segments, interest income is accrued on the unpaid principal using the interest method assigned to the loan product and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt. A loan is moved to non-accrual status when it is past due over 90 days unless the loan is well-secured and in the process of collection. If a loan is not past due but deemed to be impaired it may also be moved to non-accrual status. These rules apply to loans in all segments. However certain classes of loans in the consumer segment may simply get charged-off as opposed to moving to non-accrual status.

 

All interest accrued but not received for a loan placed on non-accrual is reversed against interest income at the time the loan is assigned non-accrual status. Payments received on such loans are applied to principal when there is doubt about recovering the full principal outstanding. Loans are eligible to return to accrual status after six months of timely payment and future payments are reasonably assured.

 

The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and from recoveries of previously charged-off loans and decreased by charge-offs.

 

The allowance for loan loss analysis is performed monthly. Management’s methodology consists of specific and general components. The general component covers non-impaired loans and is based on historical loss experience adjusted for current economic factors.

 

The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Bank over the most recent 12 quarters. The historical loss experience is recalculated at the end of each quarter. This actual loss experience is supplemented with current economic factors based on the risks present for each portfolio segment. These current economic factors are also revisited at the end of each quarter and include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; quality of loan review system; degree of oversight by the Board of Directors; national and local economic trends and conditions; industry conditions; competition and legal and regulatory requirements; and effects of changes in credit concentrations.

 

For the commercial and commercial real estate portfolio segments, the historical loss is tracked by original loan grade. The Bank utilizes a numeric grading system for commercial and commercial real estate loans. Grades are assigned to each commercial and commercial real estate loan by assessing information about the specific borrower’s situation and the estimated collateral values. The description of the loan grade criteria is included in Note 4. The most significant risks to the commercial and commercial real estate segments are the level of development and sales of real estate and the collateral values.  Locally and nationally, real estate development and sales activity is slowly picking up but has not yet returned to pre-recession levels. There are widespread pockets of value stabilization but in some cases real estate values can be erratic for properties such as golf courses and non-owner occupied office space. Even so, impaired loan charge-off activity directly related to falling collateral values has been less frequent. In 2012 and 2013, with charge-off activity lessening, the calculated historical loss factor assigned to general allocations was reduced.

 

- 7 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS (Continued)

 

Within the commercial and industrial and commercial real estate portfolios, there are classes of loans with like risk characteristics that are periodically segregated because management has determined that the historical losses or current factors are unique and ought to be considered separately from the entire segment.

 

For the consumer segment, historical loss experience is based on the actual loss history of the following four classes; general consumer loans, personal lines of credit, home equity lines of credit and credit cards. The level of delinquencies and charge-off experience directly impacts the general allocations to the consumer classes. Both delinquencies and charge-offs have gone down in the last year allowing a reduction of the general allocations in the allowance for loan losses.

 

The residential segment loss experience is not segregated by grades or classes. The level of delinquencies, charge-off experience, and direction of real estate values directly impacts the allocations to the residential real estate segment. Stabilizing real estate values have resulted in reduced specific allocations in the allowance for loan losses.

 

The specific component of the allowance for loan losses relates to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and are classified as impaired.

 

Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

 

Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

 

Any loan within a segment can be considered for individual impairment if it meets the above criteria. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral.

 

Allocations of the allowance may be made for specific loans and groups, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan balances are generally charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Statutorily, the Bank must charge-off any bad debt that reaches delinquency of 360 days. In the case of an impaired loan, management typically charges off any portion of the debt that is unsecured based on an internal analysis of future cash flows and or collateral.

 

- 8 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS (Continued)

 

Various regulatory agencies periodically review our allowance for loan losses. These agencies may require the Company to take additional provisions based on their judgments about information available to them at the time of their examination.

 

There was no material change in the allowance for loan loss methodology in the first three quarters of 2013.

 

RECENT DEVELOPMENTS: In February 2013, the FASB issued ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which is intended to improve the reporting of reclassifications out of accumulated other comprehensive income.  The ASU requires an entity to report, either on the face of the income statement or in the notes to the financial statements, the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in the income statement.  This ASU was adopted by the Company prospectively in the first quarter of 2013.

 

In 2012, the Company recorded consolidated net income for the first time since 2006. The trend of profitability continued in the first three quarters of 2013. A large portion of the earnings reported for 2013 is attributable to a $5.3 million gain on extinguishment of debt recorded late in the first quarter. Operating profits recorded in the second and third quarters have added to the Company’s consolidated earnings, which were $5.5 million through September 30, 2013. The return to core earning profitability stems mainly from stabilized credit quality and real estate valuations and the associated effect on the calculated reserve for loan losses. There has been no provision for loan losses made since the first quarter of 2012, and at September 30, 2013, there was approximately $46,000 of unallocated reserves stemming from decreases to the Bank’s 36-month historical loss calculation. The unallocated reserves are not specific to any particular portfolio segment.

 

In spite of the improved financial outcome for the last several quarters, the Company’s significant consolidated losses from 2007 through 2011 eroded capital and reduced regulatory capital ratios. As a result, the Bank was deemed undercapitalized according to regulatory capital standards beginning December 31, 2010. At that time, the Bank had a total risk-based capital ratio of 7.06%. Earnings recorded by the Bank along with a significant reduction in risk-weighted assets during 2012 improved the total risk-based capital ratio to 7.88% at December 31, 2012. At March 31, 2013, the Bank’s total risk-based capital ratio advanced to 8.04% as a result of the Bank’s first quarter earnings and a $25,000 capital contribution from the Company. At that time, the Bank was considered adequately capitalized according to regulatory capital standards. As a result of earnings recorded during 2013’s second and third quarters, the Bank’s total risk-based capital ratio rose to 8.46% at September 30, 2013.

 

From 2007 through 2011 when the Company recorded significant losses primarily as a result of deteriorating asset quality, the Bank endured additional regulatory scrutiny and entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the State of Michigan’s Department of Insurance and Financial Services (“DIFS”) previously the Office of Financial and Insurance Regulation (“OFIR”), its primary regulators, on September 2, 2010. The Bank agreed to the terms of the Consent Order without admitting or denying any charge of unsafe or unsound banking practices relating to capital, asset quality, or earnings. The Consent Order imposes no fines or penalties on the Bank. The Consent Order will remain in effect and enforceable until it is modified, terminated, suspended, or set aside by the FDIC and DIFS.

 

- 9 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS (Continued)

 

Under the Consent Order, the Bank was required, within 90 days of September 2, 2010, to have and maintain its level of Tier 1 capital, as a percentage of its total assets, at a minimum of 8.5%, and its level of qualifying total capital, as a percentage of risk-weighted assets, at a minimum of 11%. The Bank was not able to meet these requirements within the required 90-day period and remained out of compliance with the Consent Order as of September 30, 2013.

 

The lack of financial soundness of the Bank and the Company’s inability to serve as a source of strength for the Bank resulted in the board of directors entering into a Written Agreement with the Federal Reserve Bank of Chicago (the “FRB”), the Company’s primary regulator. The Written Agreement became effective on December 16, 2010, when it was executed by the FRB. The Written Agreement provides that: (i) the Company must take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to the Bank; (ii) the Company may not declare or pay any dividends or take dividends or any other payment representing a reduction in capital from the Bank or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior FRB approval; (iii) the Company may not incur, increase or guarantee any debt or purchase or redeem any shares of its stock without prior FRB approval; (iv) the Company must submit a written statement of its planned sources and uses of cash for debt service, operating expenses and other purposes to the FRB within 30 days of the Written Agreement; (v) the Company shall take all necessary actions to ensure that the Bank, the Company and all nonbank subsidiaries of both the Bank and the Company comply with sections 23A and 23B of the Federal Reserve Act and Regulation W of the Board of Governors (12 C.F.R. Part 223) in all transactions between affiliates; (vi) the Company may not appoint any new director or senior executive officer, or change the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, without prior regulatory approval; and finally (vii) within 30 days after the end of each calendar quarter following the date of the Written Agreement, the board of directors shall submit to the FRB written progress reports detailing the form and manner of all actions taken to secure compliance with the provisions of the Written Agreement as well as current copies of the parent company only financial statements. The Company has not yet been able to meet the obligation detailed in part (i) above; as the Company currently has limited resources with which to assist the Bank in achieving the capital level required by the Consent Order. The Company’s main liquidity resource is its cash account balance which, as of September 30, 2013, was approximately $656,000.

 

On January 3, 2011, the Company was not able to repay its $5 million term loan owed to Fifth Third Bank (“Fifth Third”); nor was the Company able to make the preceding ten quarterly interest payments. The term loan was in default for 25 months. At December 31, 2012, the total amount owed Fifth Third was $5,763,000. On March 20, 2013, the Company, with approval from the FRB, borrowed $1,280,000 from 1030 Norton LLC, a Michigan limited liability company owned by nine individuals; three directors of the Company-Gary F. Bogner, Robert L. Chandonnet and Bruce J. Essex, one former director and five local businessmen, and settled its debt with Fifth Third for $500,000. Settling the Fifth Third debt resulted in a gain of approximately $5.3 million in the first quarter of 2013. As a result of this transaction, the Company was able to achieve positive shareholders’ equity of approximately $4 million at March 31, 2013.

 

In addition to the payment to Fifth Third, the proceeds of the new senior debt will be used for interest carry, general operations and potential capital support for the Bank. The note bears interest at 8% per annum until paid in full. Interest is payable quarterly in arrears. The note matures on March 31, 2015 and is secured by all of the issued and outstanding shares of the Bank as evidenced by a pledge agreement between the Company and 1030 Norton LLC dated March 20, 2013. The reduced amount of borrowings is expected to decrease interest expense by approximately $200,000 annually. Refer to Note 11 for further discussion.

 

- 10 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BASIS OF PRESENTATION, LOAN POLICY AND RECENT DEVELOPMENTS (Continued)

 

On August 17, 2011, the Bank was issued a Supervisory Prompt Corrective Action Directive (the “Directive”) because of its undercapitalized capital category at December 31, 2010, its failure to submit a capital restoration plan that satisfies the requirements stipulated in the FDIC Rules and Regulations, and the continued deterioration of the Bank. The Directive stipulated that the Bank be restored to an “adequately capitalized” capital category within 60 days of the issuance of the Directive. During the 60 days, the board made efforts to secure funding and comply with the Directive but was not successful. Through several quarters of earnings and a $25,000 capital contribution from the Company, the Bank reached an adequately capitalized regulatory capital category at March 31, 2013—see Note 15 to the consolidated financial statements. Management formally communicated achievement of the capital level stipulated in the Directive to the FDIC through the submission of the quarterly Call Report and the required quarterly written communication to the regulatory agencies at the end of April. Recent feedback received by management indicated that formal public release of the Directive is anticipated to occur upon achievement of four consecutive quarters of adequate capitalization, which is expected to occur by way of submitting 2013’s fourth quarter Call Report to the FDIC on or about January 30, 2014, assuming that the capital ratios of the Bank remain stable for the remaining quarter of 2013.

 

Regardless of meeting the stipulations in the Directive, failure to comply with the provisions of the Consent Order or the Written Agreement may subject the Bank to further regulatory enforcement action.

 

As of December 31, 2012, the Company’s extended period of net losses, failure to repay its term loan at maturity (subsequently settled as noted above), timely compliance with the higher capital ratios of the Directive and the Consent Order, and the provisions of the Written Agreement raised substantial doubt about the Company’s ability to continue as a going concern and as a result of this doubt, our auditors added an explanatory paragraph to their opinion on the Company’s December 31, 2012 consolidated financial statements expressing such doubt. These financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

 

2.SECURITIES AVAILABLE FOR SALE

 

The following tables represent the securities held in the Company’s portfolio at September 30, 2013 and at December 31, 2012:

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
September 30, 2013  Cost   Gains   Losses   Value 
                 
US Treasury  $3,029,943   $22,166   $0   $3,052,109 
US Government and federal agency   16,867,009    119,983    (43,990)   16,943,002 
Municipals   1,565,075    33,077    0    1,598,152 
Mortgage-backed and collateralized mortgage obligations– residential   11,931,575    150,175    (174,399)   11,907,351 
   $33,393,602   $325,401   $(218,389)  $33,500,614 

 

- 11 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

2.SECURITIES AVAILABLE FOR SALE (Continued)

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
December 31, 2012  Cost   Gains   Losses   Value 
                 
US Treasury  $4,044,909   $49,623   $0   $4,094,532 
US Government and federal agency   20,013,843    250,523    (4,623)   20,259,743 
Municipals   2,260,272    73,469    0    2,333,741 
Mortgage-backed and collateralized                    
mortgage obligations– residential   14,539,668    264,090    (31,378)   14,772,380 
   $40,858,692   $637,705   $(36,001)  $41,460,396 

 

The amortized cost and fair value of the securities portfolio are shown by expected maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment fees. Below is the schedule of contractual maturities for securities held at September 30, 2013:

 

   Amortized   Fair 
   Cost   Value 
Due in one year or less  $5,024,323   $5,056,320 
Due from one to five years   16,085,877    16,175,309 
Due from five to ten years   351,827    361,634 
Due in more than ten years   0    0 
Mortgage-backed and collateralized mortgage obligations – residential   11,931,575    11,907,351 
   $33,393,602   $33,500,614 

 

Below is the table of securities with unrealized losses, aggregated by investment category and length of time such securities were in an unrealized loss position at September 30, 2013 and December 31, 2012:

 

   Less than 12 Months   12 Months or Longer   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
September 30, 2013  Value   Losses   Value   Losses   Value   Losses 
US Government and federal agency  $3,999,792   $(43,990)  $0   $0   $3,999,792   $(43,990)
Mortgage-backed and collateralized mortgage obligations - residential   5,702,888    (141,394)   1,058,476    (33,005)   6,761,364    (174,399)
   $9,702,680   $(185,384)  $1,058,476   $(33,005)  $10,761,156   $(218,389)

 

   Less than 12 Months   12 Months or Longer   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
December 31, 2012  Value   Losses   Value   Losses   Value   Losses 
US Government and federal agency  $3,050,187   $(4,623)  $0   $0   $3,050,187   $(4,623)
Mortgage-backed and collateralized mortgage obligations - residential   3,882,818    (21,580)   269,692    (9,798)   4,152,510    (31,378)
   $6,933,005   $(26,203)  $269,692   $(9,798)  $7,202,697   $(36,001)

 

- 12 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

2.SECURITIES AVAILABLE FOR SALE (Continued)

 

No securities were sold in the three or nine months ended September 30, 2013. One security was sold in the first quarter of 2012 and none in 2012’s second or third quarters. The sale decision was made by management because the security no longer complied with the Bank’s internal investment policy. Proceeds from the sale were $257,997 resulting in a realized gain of $2,856. In the first nine months of 2013, there were no transfers out of accumulated other comprehensive income for security sales.

 

Other-Than-Temporary-Impairment

 

Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

 

At September 30, 2013, all of the mortgage-backed securities and collateralized mortgage obligations held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. At September 30, 2013, 16 debt securities had unrealized losses with aggregate depreciation of 1.99% from the amortized cost basis; fourteen of the 16 securities had unrealized losses less than twelve months and two had unrealized losses longer than twelve months. Furthermore, five of the 16 securities are issued by government agencies and 11 are issued by a government-sponsored entity. It is likely that these debt securities will be retained given the fact that they are pledged to various public funds. The aggregate depreciation of 1.99% of amortized cost is not material however; there has been a marked decline in value since year-end 2012. The decrease was $495,000. Even so, the change appears to be market driven and attributable to changes in interest rates and not credit quality, and because the Company does not have the intent to sell these securities and it is not likely that it will be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at September 30, 2013.

 

- 13 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

3.LOANS

 

Outstanding loan balances by portfolio segment and class were as follows:

 

   September 30, 2013   December 31, 2012 
Commercial  $43,596,519   $39,915,144 
Commercial Real Estate:          
General   56,402,659    53,096,828 
Construction   2,094,988    3,464,366 
Consumer:          
Lines of credit   8,291,775    9,105,387 
Other   1,669,427    2,015,234 
Credit card   470,836    490,802 
Residential   16,078,808    17,798,131 
Net deferred loan fees   (57,759)   (55,642)
    128,547,253    125,830,250 
Less:  Allowance for loan losses   (2,870,036)   (3,382,977)
Loans, net  $125,677,217   $122,447,273 

 

- 14 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS

 

The following tables present the activity in the allowance for loan losses for the three month periods ended September 30, 2013 and 2012 by portfolio segment:

 

Three Months Ended September 30, 2013  Commercial   Commercial
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Beginning balance  $439,993   $1,920,587   $419,511   $157,406   $349,777   $3,287,274 
Charge-offs   (25,794)   0    (225,308)   (193,596)   0    (444,698)
Recoveries   19,656    0    7,804    0    0    27,460 
Provision for loan losses   (51,133)   (105,707)   209,672    250,712    (303,544)   0 
Ending balance  $382,722   $1,814,880   $411,679   $214,522   $46,233   $2,870,036 

 

Three Months Ended September 30, 2012  Commercial   Commercial
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Beginning balance  $1,356,903   $2,251,981   $442,467   $193,706   $76,240   $4,321,297 
Charge-offs   (656,201)   (2,299)   (79,767)   0    0    (738,267)
Recoveries   10,296    8,204    1,877    0    0    20,377 
Provision for loan losses   (98,273)   (100,367)   2,191    (39,529)   235,978    0 
Ending balance  $612,725   $2,157,519   $366,768   $154,177   $312,218   $3,603,407 

 

- 15 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

The following tables present the activity in the allowance for loan losses for the nine month periods ended September 30, 2013 and 2012 by portfolio segment:

 

Nine Months Ended September 30, 2013  Commercial   Commercial
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Beginning balance  $582,198   $2,266,302   $331,459   $203,018   $0   $3,382,977 
Charge-offs   (66,047)   (25,025)   (263,905)   (248,195)   0    (603,172)
Recoveries   75,856    0    14,375    0    0    90,231 
Provision for loan losses   (209,285)   (426,397)   329,750    259,699    46,233    0 
Ending balance  $382,722   $1,814,880   $411,679   $214,522   $46,233   $2,870,036 

 

Nine Months Ended September 30, 2012  Commercial   Commercial 
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Beginning balance  $1,309,632   $3,386,433   $410,001   $193,388   $0   $5,299,454 
Charge-offs   (869,270)   (859,504)   (111,248)   (11,392)   0    (1,851,414)
Recoveries   36,844    21,727    21,761    0    0    80,332 
Provision for loan losses   135,519    (391,137)   46,254    (27,819)   312,218    75,035 
Ending balance  $612,725   $2,157,519   $366,768   $154,177   $312,218   $3,603,407 

 

- 16 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

The remaining loan footnote tables on the following pages present loans at the recorded investment which includes unpaid principal, accrued interest receivable and net deferred, unearned fees. The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of September 30, 2013 and December 31, 2012:

 

September 30, 2013  Commercial   Commercial
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Ending allowance balance attributable to loans:                              
Individually evaluated for impairment  $31,938   $1,319,242   $147,892   $75,361   $0   $1,574,433 
Collectively evaluated for impairment   350,784    495,638    263,787    139,161    0    1,249,370 
Unallocated   0    0    0    0    46,233    46,233 
Total ending allowance balance  $382,722   $1,814,880   $411,679   $214,522   $46,233   $2,870,036 
                               
Loans:                              
Individually evaluated for impairment  $1,226,231   $6,911,363   $306,026   $861,509   $0   $9,305,129 
Collectively evaluated for impairment   42,469,937    51,680,583    10,164,702    15,260,815    0    119,576,037 
Total ending loans balance  $43,696,168   $58,591,946   $10,470,728   $16,122,324   $0   $128,881,166 

 

December 31, 2012  Commercial   Commercial
Real Estate
   Consumer   Residential   Unallocated   Total 
Allowance for loan losses:                              
Ending allowance balance attributable to loans:                              
Individually evaluated for impairment  $104,727   $1,489,569   $89,050   $127,030   $0   $1,810,376 
Collectively evaluated for impairment   477,471    776,733    242,409    75,988    0    1,572,601 
Unallocated   0    0    0    0    0    0 
Total ending allowance balance  $582,198   $2,266,302   $331,459   $203,018   $0   $3,382,977 
                               
Loans:                              
Individually evaluated for impairment  $3,288,294   $7,322,850   $321,820   $782,732   $0   $11,715,696 
Collectively evaluated for impairment   36,739,269    49,391,498    11,329,495    17,063,417    0    114,523,679 
Total ending loans balance  $40,027,563   $56,714,348   $11,651,315   $17,846,149   $0   $126,239,375 

 

- 17 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

The following tables present loans individually evaluated for impairment by class of loans as of September 30, 2013 and December 31, 2012. For purposes of this disclosure, the unpaid principal balance is not reduced for partial charge-offs.

 

   As of September 30, 2013   For the periods ended September 30, 2013 
               Three Months   Three Months   Three Months   Nine Months   Nine Months   Nine Months 
       Unpaid       Average   Interest   Cash Basis   Average   Interest   Cash Basis 
   Recorded   Principal   Related   Recorded   Income   Interest   Recorded   Income   Interest 
   Investment   Balance   Allowance   Investment   Recognized   Recognized   Investment   Recognized   Recognized 
With no related allowance recorded:                                             
Commercial  $1,122,429   $1,258,174   $0   $1,104,010   $7,911   $5,315   $1,406,983   $28,936   $26,460 
Commercial Real Estate:                                             
General   2,472,673    2,504,385    0    2,343,382    26,440    26,440    2,369,993    78,459    78,459 
Construction   0    0    0    0    0    0    0    0    0 
Consumer:                                             
Lines of credit   9,800    157,584    0    7,159    0    0    60,136    0    0 
Other   58,369    73,870    0    42,295    0    0    26,438    0    0 
Credit card   0    0    0    0    0    0    0    0    0 
Residential   461,646    687,718    0    292,817    563    563    191,531    1,671    1,671 
Subtotal  $4,124,917   $4,681,731   $0   $3,789,663   $34,914   $32,318   $4,055,081   $109,066   $106,590 
                                              
With an allowance recorded:                                             
Commercial  $103,802   $103,343   $31,938   $133,788   $1,493   $1,493   $326,595   $13,895   $13,540 
Commercial Real Estate:                                             
General   4,438,690    4,438,407    1,319,242    4,513,623    30,960    30,960    4,517,192    92,370    92,370 
Construction   0    0    0    0    0    0    0    0    0 
Consumer:                                             
Lines of credit   197,628    196,715    127,124    286,416    2,953    2,296    183,031    6,696    5,141 
Other   40,229    40,071    20,768    62,352    476    474    92,557    1,411    1,411 
Credit card   0    0    0    0    0    0    299    0    0 
Residential   399,863    408,113    75,361    560,146    4,879    3,677    513,278    14,479    10,988 
Subtotal  $5,180,212   $5,186,649   $1,574,433   $5,556,325   $40,761   $38,900   $5,632,952   $128,851   $123,450 
Total  $9,305,129   $9,868,380   $1,574,433   $9,345,988   $75,675   $71,218   $9,688,033   $237,917   $230,040 

 

- 18 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

   As of December 31, 2012   For the periods ended September 30, 2012 
               Three Months   Three Months   Three Months   Nine Months   Nine Months   Nine Months 
       Unpaid       Average   Interest   Cash Basis   Average   Interest   Cash Basis 
   Recorded   Principal   Related   Recorded   Income   Interest   Recorded   Income   Interest 
   Investment   Balance   Allowance   Investment   Recognized   Recognized   Investment   Recognized   Recognized 
With no related allowance recorded:                                             
Commercial  $2,147,075   $2,295,401   $0   $2,374,733   $13,665   $13,665   $2,496,173   $40,811   $40,696 
Commercial Real Estate:                                             
General   2,662,984    2,739,027    0    3,328,040    27,030    18,288    2,665,005    39,906    31,214 
Construction   0    0    0    61,223    0    0    223,032    0    0 
Consumer:                                             
Lines of credit   55,659    55,524    0    41,072    1,966    995    47,143    8,752    4,814 
Other   26,221    26,221    0    15,557    71    0    18,796    106    0 
Credit card   0    0    0    0    0    0    0    0    0 
Residential   208,178    240,491    0    358,875    0    0    285,696    0    0 
Subtotal  $5,100,117   $5,356,664   $0   $6,179,500   $42,732   $32,948   $5,735,845   $89,575   $76,724 
With an allowance recorded:                                             
Commercial  $1,141,219   $1,139,885   $104,727   $1,186,175   $9,981   $9,276   $1,595,863   $30,009   $26,306 
Commercial Real Estate:                                             
General   4,659,866    4,675,981    1,489,569    2,922,193    33,091    32,866    3,448,840    111,506    80,952 
Construction   0    0    0    1,960,467    0    0    1,988,734    0    0 
Consumer:                                             
Lines of credit   135,111    134,976    40,180    162,470    1,054    871    187,926    2,777    2,594 
Other   104,829    104,664    48,870    119,951    611    484    113,378    1,572    1,447 
Credit card   0    0    0    3,248    0    0    1,317    0    0 
Residential   574,554    594,307    127,030    440,504    3,313    3,129    500,164    9,658    9,253 
Subtotal  $6,615,579   $6,649,813   $1,810,376   $6,795,008   $48,050   $46,626   $7,836,222   $155,522   $120,552 
Total  $11,715,696   $12,006,477   $1,810,376   $12,974,508   $90,782   $79,574   $13,572,067   $245,097   $197,276 

 

Non-performing loans and impaired loans are defined differently. Some loans may be included in both categories, whereas other loans may only be included in one category. However, non-accrual loans and loans past due 90 days still on accrual are all individually classified impaired loans.

 

- 19 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

The following tables present the aging of the recorded investment in past due and non accrual loans by class of loans as of September 30, 2013:

 

           Greater Than 90   Total Accruing       Total Recorded 
   30-59 Days Past   60-89 Days  Past   Days Past   Past Due   Current   Investment of 
Accruing Loans  Due   Due   Due   Loans   Accruing Loans   Accruing Loans 
Commercial  $0   $0   $0   $0   $43,613,174   $43,613,174 
Commercial Real Estate:                              
General   0    0    0    0    53,811,236    53,811,236 
Construction   0    0    0    0    2,101,163    2,101,163 
Consumer:                              
Lines of credit   97,593    0    0    97,593    8,154,142    8,251,735 
Other   0    4,949    0    4,949    1,662,599    1,667,548 
Credit card   506    0    0    506    470,330    470,836 
Residential   0    0    0    0    15,737,314    15,737,314 
Total  $98,099   $4,949   $0   $103,048   $125,549,958   $125,653,006 

 

           Greater Than 90   Total   Current   Total Non Accrual 
   30-59 Days Past   60-89 Days Past   Days Past   Non Accrual   Non Accrual   Recorded 
Non Accrual Loans  Due   Due   Due   Past Due Loans   Loans   Investment 
Commercial  $0   $0   $40,316   $40,316   $42,678   $82,994 
Commercial Real Estate:                              
General   204,541    0    0    204,541    2,475,006    2,679,547 
Construction   0    0    0    0    0    0 
Consumer:                              
Lines of credit   9,800    0    44,528    54,328    16,811    71,139 
Other   0    2,141    0    2,141    7,329    9,470 
Credit card   0    0    0    0    0    0 
Residential   0    0    285,528    285,528    99,482    385,010 
Total  $214,341   $2,141   $370,372   $586,854   $2,641,306   $3,228,160 

 

- 20 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

The following tables present the aging of the recorded investment in past due and non accrual loans by class of loans as of December 31, 2012:

 

           Greater Than 90   Total Accruing       Total Recorded 
   30-59 Days Past   60-89 Days Past   Days Past   Past Due   Current   Investment of 
Accruing Loans  Due   Due   Due   Loans   Accruing Loans   Accruing Loans 
Commercial  $1,956   $0   $0   $1,956   $39,465,435   $39,467,391 
Commercial Real Estate:                              
General   97,605    0    0    97,605    50,193,607    50,291,212 
Construction   0    0    0    0    3,479,043    3,479,043 
Consumer:                              
Lines of credit   26,037    44,866    0    70,903    8,963,308    9,034,211 
Other   3,707    0    0    3,707    2,015,334    2,019,041 
Credit card   2,010    0    0    2,010    488,792    490,802 
Residential   0    85,242    0    85,242    17,456,776    17,542,018 
Total  $131,315   $130,108   $0   $261,423   $122,062,295   $122,323,718 

 

           Greater Than 90   Total   Current   Total Non Accrual 
   30-59 Days Past   60-89 Days Past   Days Past   Non Accrual   Non Accrual   Recorded 
Non Accrual Loans  Due   Due   Due   Past Due Loans   Loans   Investment 
Commercial  $8,958   $20,469   $320,592   $350,019   $210,153   $560,172 
Commercial Real Estate:                              
General   8,414    280,399    406,792    695,605    2,248,488    2,944,093 
Construction   0    0    0    0    0    0 
Consumer:                              
Lines of credit   0    21,583    0    21,583    79,628    101,211 
Other   0    0    6,050    6,050    0    6,050 
Credit card   0    0    0    0    0    0 
Residential   0    0    195,649    195,649    108,482    304,131 
Total  $17,372   $322,451   $929,083   $1,268,906   $2,646,751   $3,915,657 

 

- 21 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

Troubled Debt Restructurings:

 

The Company has allocated $1,537,738 of specific reserves on $8,361,469 of unpaid principal balance of loans to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2013 and $1,699,851 on $10,441,218 of unpaid principal balance of loans as of December 31, 2012. At September 30, 2013, the Company had an additional $181,503 in performing loans outstanding to one of those customers. As of December 31, 2012, there was $184,364 committed to one customer.

 

During the three and nine month periods ending September 30, 2013 and 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a stated rate of interest lower than the current market rate for new debt with similar risk; interest only payments on an amortizing note; a reduced payment amount which does not fully cover the interest; financing concessions; or a permanent reduction of the recorded investment in the loan.

 

In the nine month period ended September 30, 2013, one modification involved a stated interest rate below the current market rate for a period of 7 years, while another modification for 2.5 years involved interest-only payments on an amortizing note. One A-B note modification involved a permanent reduction of the recorded investment in the loan.

 

In the nine month period ended September 30, 2012, modifications involving a stated interest rate of the loan below the current market rate were for periods ranging from 11 months to 5 years. Modifications involving a reduced payment amount were for periods ranging from 5 months to 4 years. Two modifications involved a permanent reduction of the recorded investment in the loan.

 

In the three month period ended September 30, 2013, there were no loans modified as troubled debt restructurings and no charge-offs as part of a troubled debt restructuring.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ended September 30, 2013:

 

      Pre-Modification   Post-Modification 
      Outstanding Recorded   Outstanding Recorded 
Nine Months Ended September 30, 2013  Number of Loans  Investment   Investment 
Troubled Debt Restructurings:             
Commercial  1  $143,136   $133,425 
Consumer:             
Lines of credit  2   137,893    137,893 
Total  3  $281,029   $271,318 

 

In the nine month period ended September 30, 2013, there were $9,711 of charge-offs as part of a troubled debt restructuring arrangement and an additional $38,913 of specific reserves were established on these troubled debt restructurings.

 

- 22 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

In the three month period ended September 30, 2012, there were no loans modified as troubled debt restructurings and no charge-offs as part of a troubled debt restructuring.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ending September 30, 2012:

 

      Pre-Modification   Post-Modification 
      Outstanding Recorded   Outstanding Recorded 
Nine Months Ended September 30, 2012  Number of Loans  Investment   Investment 
Troubled Debt Restructurings:             
Commercial  1  $11,880   $11,880 
Commercial Real Estate:             
General  5   3,446,269    2,808,146 
Consumer:             
Lines of credit  2   126,860    126,860 
Residential  1   62,085    62,085 
Total  9  $3,647,094   $3,008,971 

 

In the nine month period ended September 30, 2012, there were $638,000 of charge-offs as part of a troubled debt restructuring arrangement and an additional $50,000 of specific reserves were established on these troubled debt restructurings.

 

Generally, a modified loan is considered to be in payment default when the borrower is not performing according to the renegotiated terms.

 

For the three and nine month periods ended September 30, 2013 and 2012, there were no troubled debt restructurings that experienced a payment default within 12 months following the modification.

 

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed utilizing the Company’s internal underwriting policy.

 

- 23 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

Credit Quality Indicators:

 

The Bank utilizes a numeric grading system for commercial and commercial real estate loans to indicate the strength of the credit. At origination, grades are assigned to each commercial and commercial real estate loan by assessing information about the specific borrower’s situation including cash flow analysis and the estimated collateral values. The loan grade is reassessed at each renewal or amendment but any credit may receive a review based on lender identification of changes in the situation or behavior of the borrower. All commercial and commercial real estate loans exceeding $500,000 are formally reviewed at least annually. Once a loan is graded a 5M or greater number, and is over $100,000, the loan grade will be reanalyzed once a quarter to assess the borrower’s compliance with the Bank’s documented action plan. In addition to these methods for assigning loan grades, changes may occur through the external loan review or regulatory exam process. The loan grades are as follows:

 

1.Exceptional. Loans with an exceptional credit rating.
2.Quality. Loans with excellent sources of repayment that conform, in all respects, to Bank policy and regulatory requirements. These are loans for which little repayment risk has been identified.
3.Above Average. Loans with above average sources of repayment and minimal identified credit or collateral exceptions and minimal repayment risk.
4.Average. Loans with average sources of repayment that materially conform to Bank policy and regulatory requirements. Repayment risk is considered average.
5.Acceptable. Loans with acceptable sources of repayment and risk.

5M. Monitor. Loans considered to be below average quality. The loans are often fundamentally sound but require more frequent management review because of an adverse financial event. Risk of non payment is elevated.

6.Special Mention. Loans that have potential weaknesses and deserve close attention. If uncorrected, further deterioration is likely. Risk of non payment is above average.
7.Substandard. Loans that are inadequately protected by the borrower’s capacity to pay or the collateral pledged. Risk of non payment is high.
8.Doubtful. Loans in this grade have identified weaknesses that make full repayment highly questionable and improbable.

 

When a loan is downgraded to a nine, it is considered a loss and is charged-off.

 

- 24 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4.ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (Continued)

 

As of September 30, 2013 and December 31, 2012, and based on the most recent analysis performed, the recorded investment by risk category and class of loans is as follows:

 

       Commercial Real Estate   Commercial Real Estate 
   Commercial   General   Construction 
   September 30,   December 31,   September 30,   December 31,   September 30,   December 31, 
   2013   2012   2013   2012   2013   2012 
1  $0   $0   $0   $0   $0   $0 
2   261,437    298,200    0    0    0    0 
3   7,791,976    2,004,476    4,697,215    4,141,391    0    0 
4   13,313,325    14,017,221    17,931,763    12,911,811    467,651    384,848 
5   15,217,224    16,373,423    21,066,423    22,177,734    236,099    1,695,990 
5M   4,275,905    3,318,016    3,817,196    3,675,131    1,397,413    1,398,205 
6   1,705,945    2,180,119    6,298,783    7,365,970    0    0 
7   1,072,584    1,369,803    519,913    287,682    0    0 
8   57,772    466,305    2,159,490    2,675,586    0    0 
Total  $43,696,168   $40,027,563   $56,490,783   $53,235,305   $2,101,163   $3,479,043 

 

The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential and consumer loan classes, the Company evaluates credit quality based on the aging status of the loan, which was previously presented and by payment activity. The following tables present the recorded investment in residential and consumer loans based on payment activity as of September 30, 2013 and December 31, 2012:

 

   Residential 
   September 30,   December 31, 
   2013   2012 
Performing  $15,260,815   $17,063,417 
Impaired   861,509    782,732 
Total  $16,122,324   $17,846,149 

 

   Consumer – Lines of credit   Consumer – Other   Consumer – Credit card 
   September 30,   December 31,   September 30,   December 31,   September 30,   December 31, 
   2013   2012   2013   2012   2013   2012 
Performing  $8,115,446   $8,944,652   $1,578,420   $1,894,041   $470,836   $490,802 
Impaired   207,428    190,770    98,598    131,050    0    0 
Total  $8,322,874   $9,135,422   $1,677,018   $2,025,091   $470,836   $490,802 

 

- 25 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

5.FORECLOSED ASSETS

 

Foreclosed asset activity:

 

   September 30,   September 30, 
   2013   2012 
Beginning of year  $2,806,781   $3,276,838 
Additions   614,485    1,243,347 
Reductions from sales   (593,498)   (1,249,206)
Direct write-downs   (141,531)   (277,448)
End of period  $2,686,237   $2,993,531 
           
Expenses related to foreclosed assets include:          
Operating expenses, net of rental income  $189,268   $199,278 

 

6.PREMISES AND EQUIPMENT

 

Period end premises and equipment were as follows:

 

   September 30,   December 31, 
   2013   2012 
Land & land improvements  $4,700,464   $4,700,464 
Buildings & building improvements   6,148,829    6,132,163 
Furniture, fixtures and equipment   3,839,270    3,800,460 
    14,688,563    14,633,087 
Less:  accumulated depreciation   5,520,211    5,212,201 
   $9,168,352   $9,420,886 

 

During the second quarter of 2012, the Company sold land with a carrying value of $790,135 resulting in a gain on sale of $208,389.

 

- 26 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

7.DEPOSITS

 

The components of the outstanding deposit balances at September 30, 2013 and December 31, 2012 were as follows:

 

   September 30,   December 31, 
   2013   2012 
Non-interest-bearing DDA  $31,700,054   $40,271,190 
Interest-bearing DDA   25,738,324    22,865,704 
Money market   21,524,818    18,602,302 
Savings   8,157,419    9,018,387 
Time, under $100,000   66,976,766    83,416,175 
Time, over $100,000   9,471,078    10,002,735 
Total Deposits  $163,568,459   $184,176,493 

 

There were no brokered deposits at September 30, 2013 and December 31, 2012. Since the Bank was not categorized as “well capitalized” at September 30, 2013 and is under a Consent Order, a regulatory waiver is required to accept, renew or rollover brokered deposits. The Bank has not issued brokered deposits since January of 2010.

 

8.SHORT-TERM BORROWINGS

 

The Company’s short-term borrowings consist of repurchase agreements and less frequently borrowings from the FRB Discount Window. There have been no borrowings from the FRB Discount Window since January 2010. The September 30, 2013 and December 31, 2012 short-term borrowing information was as follows:

 

   Repurchase 
   Agreements 
     
Outstanding at September 30, 2013  $8,972,374 
Average interest rate at period end   0.56%
Average balance during period   9,996,881 
Average interest rate during period   0.59%
Maximum month end balance during period   10,878,256 
      
Outstanding at December 31, 2012  $10,190,059 
Average interest rate at year-end   0.59%
Average balance during year   9,241,260 
Average interest rate during year   0.75%
Maximum month end balance during year   12,037,087 

 

- 27 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

9.FEDERAL HOME LOAN BANK BORROWINGS

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Indianapolis. Based on its current FHLB stock holdings and collateral, the Bank has the capacity to borrow $2,839,659. Each borrowing requires a direct pledge of securities and or loans. To support potential borrowings with the FHLB, the Bank had residential loans with a fair market value of $3,549,574 pledged at September 30, 2013. The Bank had no outstanding borrowings with the FHLB at either September 30, 2013 or December 31, 2012.

 

10.SUBORDINATED DEBENTURES

 

The Trust, as defined in Note 1, sold 4,500 Cumulative Preferred Securities (“trust preferred securities”) at $1,000 per security in a December 2004 offering. The proceeds from the sale of the trust preferred securities were used by the Trust to purchase an equivalent amount of subordinated debentures from the Company. The trust preferred securities and subordinated debentures carry a floating rate of 2.05% over the 3-month LIBOR and was 2.30% at September 30, 2013 and 2.36% at December 31, 2012. The stated maturity is December 30, 2034. The trust preferred securities are redeemable at par value on any interest payment date and are, in effect, guaranteed by the Company. Interest on the subordinated debentures is payable quarterly on March 30th, June 30th, September 30th and December 30th. The Company is not considered the primary beneficiary of the Trust (under the variable interest entity rules), therefore the Trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability, and the interest expense is recorded on the Company’s consolidated statement of income.

 

The terms of the subordinated debentures, the trust preferred securities and the agreements under which they were issued, give the Company the right, from time to time, to defer payment of interest for up to 20 consecutive quarters, unless certain specified events of default have occurred and are continuing. The deferral of interest payments on the subordinated debentures results in the deferral of distributions on the trust preferred securities. In May 2010, the Company exercised its option to defer regularly scheduled quarterly interest payments beginning with the quarterly interest payment that was scheduled to be paid on June 30, 2010. The Company’s deferral of interest does not constitute an event of default.

 

During the deferral period, interest will continue to accrue on the subordinated debentures. Also, the deferred interest will accrue interest. At the expiration of the deferral period, all accrued and unpaid interest will become immediately due and payable.

 

The indenture under which the subordinated debentures were issued prohibits certain actions by the Company during the deferral period. Among other things, during the deferral period and subject to certain exceptions, the Company is prohibited from declaring or paying any dividends or distributions on, or redeeming, purchasing, acquiring or making any liquidation payment with respect to, any shares of its capital stock. Although the Company has not determined the duration of the deferral period, as of December 16, 2010, under the FRB Written Agreement, the Company is prohibited from making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior FRB approval. At September 30, 2013, the accrued interest payable on the subordinated debentures was $414,429.

 

- 28 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

11.NOTES PAYABLE

 

On January 3, 2011, the Company’s $5,000,000 term loan with Fifth Third Bank (“Fifth Third”) matured. The Company did not have the resources to pay the amount due. The loan was in default at year-end 2012. In addition to the outstanding principal due, there was accrued interest of $763,000 at December 31, 2012. The outstanding principal had an interest rate of 6.00% per annum; 275 basis points above Fifth Third’s prime rate.

 

On March 20, 2013, the Company, with approval from the FRB, borrowed $1,280,000 from 1030 Norton LLC, a Michigan limited liability company owned by nine individuals; three directors of the Company-Gary F. Bogner, Robert L. Chandonnet and Bruce J. Essex, one former director and five local businessmen, and settled its debt in full with Fifth Third for $500,000. In addition to the payment to Fifth Third, the proceeds of the new senior debt will be used for interest carry, general operations and potential capital support for the Bank. The note bears interest at a fixed rate of 8.00% per annum until paid in full. Interest is payable quarterly, in arrears. The note matures on March 31, 2015. The note is secured by a pledge of all of the issued and outstanding shares of the Bank as evidenced by a pledge agreement between the Company and 1030 Norton LLC. The accrued interest at September 30, 2013 was approximately $26,000. The entire interest balance due was paid on October 1, 2013.

 

Settling the Fifth Third debt resulted in a gain of approximately $5.3 million in the first quarter of 2013. As a result of this transaction, the Company was able to achieve positive shareholders’ equity of approximately $4 million at March 31, 2013.

 

12.COMMITMENTS AND OFF-BALANCE SHEET RISK

 

Some financial instruments are used to meet financing needs and to reduce exposure to interest rate changes. These financial instruments include commitments to extend credit and standby letters of credit. These involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the financial statements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment, and generally have fixed expiration dates. Standby letters of credit are conditional commitments to guarantee a customer’s performance to another party. Exposure to credit loss, if the customer does not perform, is represented by the contractual amount for commitments to extend credit and standby letters of credit. Collateral or other security is normally obtained for these financial instruments prior to their use and many of the commitments are expected to expire without being used.

 

A summary of the notional and contractual amounts of outstanding financing instruments with off-balance-sheet risk as of September 30, 2013 and December 31, 2012 follows:

 

   September 30, 2013   December 31, 2012 
         
Unused lines of credit and letters of credit  $25,064,561   $22,817,615 
Commitments to make loans   453,935    253,000 

 

Commitments to make loans generally terminate one year or less from the date of commitment and may require a fee. Since many of the above commitments on lines of credit and letters of credit expire without being used, the above amounts related to those categories do not necessarily represent future cash disbursements.

 

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COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS

 

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The Company used the following methods and significant assumptions to estimate fair value:

 

Securities: The fair values of securities are obtained from a third party who utilizes quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing (Level 2 inputs), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.

 

Impaired Loans: The method used to determine the valuation of impaired loans depends on the anticipated source of repayment. Collateral dependent impaired loans with specific allocations of the allowance for loan losses are measured using the fair value of the collateral which is generally based on recent real estate appraisals or internal evaluations. Management may add discounts to third party appraisals. The appraisals are generally obtained annually and are performed by qualified licensed appraisers approved by the Board of Directors. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. The comparable sales approach evaluates the sales price of similar properties in the same market area. This approach is inherently subjective due to the wide range of comparable sale dates. The income approach considers net operating income generated by the property and the investor’s required return. This approach utilizes various inputs including lease rates and cap rates which are subject to judgment. Such adjustments can be significant and result in a Level 3 classification of the inputs for determining fair value.

 

- 30 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

Non-real estate collateral may be valued using appraisals, independent valuation tools, net book value per the borrower’s financial statements, or aging reports.  To determine the fair value, these values are adjusted or discounted based on several factors, including but not limited to: the Bank’s historical losses within that particular asset category;  knowledge of the collateral, including age and condition; and  changes in market conditions from the time of the valuation,  resulting in a Level 3 fair value classification.  Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

 

Foreclosed Assets: Commercial and residential real estate properties classified as foreclosed assets are measured at fair value, less costs to sell at the time of foreclosure, establishing a new cost basis. Subsequently, foreclosed assets continue to be measured at the lower of cost or fair value. Fair values are generally based on recent real estate appraisals or internal evaluations. Management may add discounts to third party appraisals. The appraisals are generally obtained annually and are performed by qualified licensed appraisers approved by the Board of Directors. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. The comparable sales approach evaluates the sales price of similar properties in the same market area. This approach is inherently subjective due to the wide range of comparable sale dates. The income approach considers net operating income generated by the property and the investor’s required return. This approach utilizes various inputs including lease rates and cap rates which are subject to judgment. Adjustments of the carrying amount utilizing this process result in a Level 3 classification.

 

- 31 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

Assets measured at fair value on a recurring basis are summarized below as of the periods ended September 30, 2013 and December 31, 2012:

 

       Fair Value Measurements Using 
       Quoted Prices   Significant     
       in Active   Other   Significant 
       Markets for   Observable   Unobservable 
       Identical Assets   Inputs   Inputs 
September 30, 2013  Total   (Level 1)   (Level 2)   (Level 3) 
Available for sale securities:                    
US Treasury  $3,052,109   $3,052,109   $0   $0 
US Government and federal agency   16,943,002    0    16,943,002    0 
Municipals   1,598,152    0    1,598,152    0 
Mortgage-backed and collateralized mortgage obligations– residential   11,907,351    0    11,907,351    0 
Total  $33,500,614   $3,052,109   $30,448,505   $0 
                     
December 31, 2012                    
Available for sale securities:                    
US Treasury  $4,094,532   $4,094,532   $0   $0 
US Government and federal agency   20,259,743    0    20,259,743    0 
Municipals   2,333,741    0    2,333,741    0 
Mortgage-backed and collateralized mortgage obligations– residential   14,772,380    0    14,772,380    0 
Total  $41,460,396   $4,094,532   $37,365,864   $0 

 

There were no transfers between levels during the first nine months of 2013 or 2012.

 

- 32 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

Assets measured at fair value on a non-recurring basis are summarized below as of the periods ended September 30, 2013 and December 31, 2012. Impaired loans and foreclosed assets are included if the fair value of such assets was revised during the quarterly period then ended.

 

       Significant 
       Unobservable Inputs 
   Total   (Level 3) 
September 30, 2013          
Impaired loans:          
Consumer:          
Other  $52,612   $52,612 
Residential   61,722    61,722 
Total  $114,334   $114,334 
Foreclosed assets:          
Commercial Real Estate:          
General  $267,390   $267,390 
Residential   55,794    55,794 
Total  $323,184   $323,184 
           
December 31, 2012          
Impaired loans:          
Commercial  $84,755   $84,755 
Commercial Real Estate:          
General   786,282    786,282 
Residential   140,269    140,269 
Total  $1,011,306   $1,011,306 
Foreclosed assets:          
Commercial Real Estate:          
General  $141,596   $141,596 
Construction   380,142    380,142 
Total  $521,738   $521,738 

 

The following describes the impairment charges recognized during the period:

 

At September 30, 2013, impaired loans carried at fair value had a recorded investment of $114,334 with no valuation allowance, resulting in additional provision of $15,818. At December 31, 2012, impaired loans carried at fair value had a recorded investment of $2,394,211 and a valuation allowance of $1,382,905, resulting in additional provision of $13,000.

 

Foreclosed assets carried at fair value at September 30, 2013 were $323,184 compared to $521,738 at December 31, 2012. During 2013, four properties included in this total were written down by $40,240. During 2012, three properties included in this total were written down by $128,139.

 

- 33 -
 

 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

As of September 30, 2013, there were no individually material Level 3 financial assets, by class, measured on a non-recurring basis.

 

The following table presents information as of December 31, 2012 about significant unobservable inputs related to the Bank’s individually material1 Level 3 financial assets, by class, measured on a non-recurring basis:

 

       Valuation  Significant Unobservable  Range   Weighted 
   Fair Value   Technique (s)  Inputs  of Inputs   Average 
December 31, 2012                     
                      
Impaired loans:          Adjustments for differences between          
Commercial Real Estate:       Sales comparison approach  the comparable sales   0%   0%
General  $698,475   Income approach  Capitalization rate   10.0%   10.0%
Total  $698,475                 
Foreclosed assets:                     
Commercial Real Estate:          Adjustments for differences between          
Construction  $269,100   Sales comparison approach  the comparable sales   (45.0) - 0%    (4.5)%
Total  $269,100                 

 

 
1For purposes of this disclosure, only material Level 3 assets are disclosed. These assets are included in the total non-recurring Level 3 financial assets reported in the preceding tables.

 

- 34 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

The carrying amounts and estimated fair values of financial instruments not previously presented above are as follows:

 

       Fair Value Measurements 
       at September 30, 2013 Using 
   Carrying                 
   Amount   Level 1   Level 2   Level 3   Total 
   (in thousands) 
Financial assets                         
Cash and cash equivalents  $10,140   $10,140   $0   $0   $10,140 
Loans held for sale   0    0    0    0    0 
Loans, net (including impaired)   125,677    0    0    125,272    125,272 
FHLB stock   451    N/A    N/A    N/A    N/A 
Accrued interest receivable   485    15    136    334    485 
                          
Financial liabilities                         
Deposits   163,568    80,770    76,847    0    157,617 
Federal funds purchased and repurchase agreements   8,972    0    8,972    0    8,972 
Subordinated debentures   4,500    0    0    1,125    1,125 
Notes payable   1,280    0    0    1,280    1,280 
Accrued interest payable   475    3    31    130    164 

 

       Fair Value Measurements 
       at December 31, 2012 Using 
   Carrying                 
   Amount   Level 1   Level 2   Level 3   Total 
   (in thousands) 
Financial assets                         
Cash and cash equivalents  $20,297   $20,297   $0   $0   $20,297 
Loans held for sale   6,041    0    6,183    0    6,183 
Loans, net (including impaired)   122,447    0    0    116,004    116,004 
FHLB stock   451     N/A      N/A      N/A      N/A  
Accrued interest receivable   592    12    163    417    592 
                          
Financial liabilities                         
Deposits   184,176    88,959    94,185    0    183,144 
Federal funds purchased and repurchase agreements   10,190    0    10,190    0    10,190 
Subordinated debentures   4,500    0    0    1,125    1,125 
Notes payable   5,000    0    0    500    500 
Accrued interest payable   1,156    4    64    81    149 

 

- 35 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

The methods and assumptions, not previously presented above, used to estimate fair values are described as follows:

 

(a) Cash and cash equivalents

 

The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

 

(b) FHLB stock

 

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

 

(c) Loans

 

Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

 

The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

 

(d) Deposits

 

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

 

(e) Federal funds purchased and repurchase agreements

 

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

 

(f) Subordinated debentures and Notes payable

 

The fair values of the Company’s subordinated debentures and notes payable are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements and consideration of the Company’s liquidity, resulting in a Level 3 classification.

 

(g) Accrued interest receivable/payable

 

The carrying amounts of accrued interest approximate fair value resulting in a Level 1, 2 or 3 classification, depending on the associated asset or liability.

 

- 36 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

13.FAIR VALUE MEASUREMENTS (Continued)

 

(h) Off-balance sheet instruments

 

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

 

14. INCOME TAXES

 

Accounting guidance related to income taxes requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors which may impact future operating results. Significant weight is given to evidence that can be objectively verified.  The previous losses dating back to 2007 significantly restricted our ability under the accounting rules to rely on projections of future taxable income to support the recovery of our deferred tax assets. Consequently, we determined it necessary to carry a valuation allowance against our entire net deferred tax asset.

 

Although the Company recognized a profit in 2012 and the first three quarters of 2013, there must be a consistent trend of profitability in order to support the realization of our deferred tax assets. The valuation allowance against our deferred tax assets may be reversed to income in future periods to the extent that the related deferred income tax assets are realized or the valuation allowance is otherwise no longer required.  We will continue to monitor our deferred tax assets quarterly for changes affecting their realizability.

 

As a result of the large gain on the extinguishment of debt, the Company recorded income tax expense from operations in the amount of $105,000. This amount represents projected taxable earnings subject to alternative minimum taxation which may fluctuate throughout the year with changes in operating results. Additionally, the gain on the extinguishment of debt may result in a reduction of net operating loss carry-forward tax attributes by an estimated $5.3 million.  Even so, the Company’s estimated net operating loss carry-forward remaining would be over $6 million.

 

15.REGULATORY MATTERS

 

Banks are subject to regulatory capital requirements administered by the federal banking agencies. Since the Company is a one bank holding company with consolidated assets less than $500 million, regulatory minimum capital ratios are applied only to the Bank. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet various capital requirements can initiate regulatory action.

 

- 37 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

15.REGULATORY MATTERS (Continued)

 

Prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If a bank is not well capitalized, regulatory approval is required to accept brokered deposits. Subject to limited exceptions, a bank may not make a capital distribution if, after making the distribution, it would be undercapitalized. If a bank is undercapitalized, it is subject to being closely monitored by its principal federal regulator, its asset growth and expansion are restricted, acquisitions, new activities, new branches, payment of dividends or management fees are prohibited and plans for capital restoration are required. In addition, further specific types of restrictions may be imposed on the Bank at the discretion of the federal regulator. The Bank was in the undercapitalized category at December 31, 2012. At March 31, 2013, through earnings and a $25,000 capital contribution from the Company, the Bank achieved a total risk-based capital ratio of 8.04%; four basis points above the required level to be in the adequately capitalized regulatory category. At September 30, 2013, the total risk-based capital ratio of the Bank had risen to 8.46% and the Bank continues to be adequately capitalized.

 

Actual capital amounts and ratios for the Bank and required capital amounts and ratios for the Bank to be adequately capitalized and to be at the level mandated by the Consent Order at September 30, 2013 and December 31, 2012 were:

 

           Minimum Required   Minimum Required 
           For Capital   Under 
   Actual   Adequacy Purposes   Consent Order 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
                         
September 30, 2013                              
Total Capital (Tier 1 and                              
Tier 2) to risk-weighted assets of the Bank  $11,305,260    8.46%  $10,688,585    8.00%  $14,696,805    11.00%
Tier 1 (Core) Capital to risk-weighted assets of the Bank   9,620,354    7.20    5,344,293    4.00    N/A    N/A 
Tier 1 (Core) Capital to average assets of the Bank   9,620,354    5.06    7,602,012    4.00    16,154,276    8.50 

 

           Minimum Required   Minimum Required 
           For Capital   Under 
   Actual   Adequacy Purposes   Consent Order 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
                         
December 31, 2012                              
Total Capital (Tier 1 and Tier 2) to risk-weighted assets of the Bank  $10,760,348    7.88%  $10,928,836    8.00%  $15,027,149    11.00%
Tier 1 (Core) Capital to risk-weighted assets of the Bank   9,032,034    6.61    5,464,418    4.00    N/A    N/A 
Tier 1 (Core) Capital to average assets of the Bank   9,032,034    4.53    7,976,194    4.00    16,949,413    8.50 

 

- 38 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

15.REGULATORY MATTERS (Continued)

 

Federal Reserve guidelines limit the amount of allowance for loan losses that can be included in Tier 2 capital. In general only 1.25% of net risk-weighted assets are allowed to be included. At September 30, 2013, only $1,684,905 was counted as Tier 2 capital and $1,185,131 was disallowed. At December 31, 2012, $1,728,314 was counted as Tier 2 capital and $1,654,663 was disallowed.

 

The Bank’s Consent Order with the FDIC and the DIFS, its primary banking regulators, became effective on September 2, 2010. The Bank agreed to the terms of the Consent Order without admitting or denying any charge of unsafe or unsound banking practices relating to capital, asset quality, or earnings. The Consent Order imposes no fines or penalties on the Bank. The Consent Order will remain in effect and enforceable until it is modified, terminated, suspended, or set aside by the FDIC and DIFS.

 

The Consent Order required the Bank to implement a written profit plan, a written contingency funding plan, a written plan to reduce the Bank's reliance on brokered deposits, a comprehensive strategic plan; and to develop an analysis and assessment of the Bank's management needs. Under the Consent Order, the Bank is required to maintain higher capital levels than requested under prompt corrective action and the Bank may not declare or pay any dividend without the prior written consent of the regulators.

 

Prior to the issuance of the Consent Order, the Bank's Board of Directors and management had already commenced initiatives and strategies to address a number of the requirements of the Consent Order. The Bank continues to work in cooperation with its regulators. Our ability to fully comply with all of the requirements of the Consent Order, including maintaining specified capital levels, is not entirely within our control, and is not assured. Our ability to comply with the requirements of the Consent Order may be affected by many factors, including the availability of capital and other funds, the extent of repayment of loans by borrowers, declines in the value of collateral including real estate, the Bank's ability to realize on collateral and actions by bank regulators. Failure to comply with provisions of the Consent Order may result in further regulatory action that could have a material adverse effect on us and our shareholders, as well as the Bank.

 

There were several directives related to loans contained in the Consent Order. All action plans were submitted to the FDIC as required. As of September 11, 2013, action plan submission is no longer required; however management continues to update plans as needed and works diligently to mitigate and reduce associated credit risk.

 

Under the Consent Order, the Bank was required, within 90 days of September 2, 2010, to have and maintain its level of tier one capital, as a percentage of its total assets, at a minimum of 8.5%, and its level of qualifying total capital, as a percentage of risk-weighted assets, at a minimum of 11%. The Bank was not in compliance with this requirement at September 30, 2013 or either December 31, 2010, 2011 or 2012. Management continues to explore options to raise the capital required for full compliance. At September 30, 2013, a capital contribution of $6,534,000 would have been needed to meet the capital ratios specified in the Consent Order.

 

Under the Consent Order the Bank is restricted from declaring or paying dividends without prior written authorization of the FDIC. The Bank is in full compliance with this restriction.

 

- 39 -
 

 

COMMUNITY SHORES BANK CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

15.REGULATORY MATTERS (Continued)

 

As required by the Consent Order, the Bank adopted a detailed liquidity plan on November 17, 2010 which provided for intended liquidity sources to meet the Bank’s assessed liquidity needs over the time horizons of 6, 12 and 18 months. The liquidity plan was meant to address the stipulation in the Consent Order that prohibited the Bank from accepting brokered deposits. To meet this restriction, the Bank’s liquidity plan entailed replacing maturing brokered deposits with a combination of local deposits and internet based time deposits. Since the beginning of 2010, the Bank has successfully used this strategy. There were no brokered deposits outstanding at September 30, 2013. The Bank has been able to maintain sufficient liquidity for its required payments despite the restriction on issuing brokered deposits.

 

On August 17, 2011, the Bank was issued a Supervisory Prompt Corrective Action Directive (the “Directive”) because of its undercapitalized capital category at December 31, 2010, its failure to submit a capital restoration plan that satisfies the requirements stipulated in the FDIC Rules and Regulations, and the continued deterioration of the Bank. The Directive stipulated that the Bank be restored to an “adequately capitalized” capital category within 60 days of the issuance of the Directive. During the 60 days, the board made efforts to secure funding and comply with the Directive but was not successful. Through several quarters of earnings and a $25,000 capital contribution from the Company, the Bank reached an adequately capitalized regulatory capital category at March 31, 2013. Management formally communicated achievement of the capital level stipulated in the Directive to the FDIC through the submission of the quarterly Call Report and the required quarterly written communication, at the end of April. Recent feedback received by management indicated that formal public release of the Directive is anticipated to occur upon achievement of four consecutive quarters of adequate capitalization which is expected to occur by way of submitting 2013’s fourth quarter Call Report to the FDIC on or about January 30, 2014, assuming that the capital ratios of the Bank remain stable for the remaining quarter of 2013.

 

- 40 -
 

 

COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The discussion below details the financial results of the Company and its wholly owned subsidiaries, the Bank and Community Shores Financial Services, and the Bank’s subsidiary, the Mortgage Company, and Berryfield, the Mortgage Company’s subsidiary, through September 30, 2013 and is separated into two parts which are labeled Financial Condition and Results of Operations. The part labeled Financial Condition compares the financial condition at September 30, 2013 to that at December 31, 2012. The part labeled Results of Operations discusses the three and nine month periods ending September 30, 2013 as compared to the same periods of 2012. Both parts should be read in conjunction with the interim consolidated financial statements and footnotes included in Item 1 of Part I of this Form 10-Q.

 

This discussion and analysis of financial condition and results of operations, and other sections of the Form 10-Q contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about the Company, the Bank, the Mortgage Company, Berryfield and CS Financial Services. Words such as “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “intends”, “is likely”, “plans”, “projects”, variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are intended to be covered by the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. The Company undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

 

Future factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation or actions by bank regulators; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economy; the ability of the Company to borrow money or raise additional capital to maintain or increase its or the Bank’s capital position or when desired to support future growth; failure to comply with provisions of the Consent Order, Written Agreement or Directive may result in further regulatory action that could have a material adverse effect on us and our shareholders, as well as the Bank; and other factors, including risk factors, referred to from time to time in filings made by the Company with the Securities and Exchange Commission. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement. These risks and uncertainties should be considered when evaluating forward-looking statements. Undue reliance should not be placed on such statements.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The overall economic environment remains challenging particularly from an interest rate standpoint, but other economic indicators appear to be stabilizing, both nationally and locally. Unemployment in both Muskegon and Ottawa counties is stable but nonetheless remains at an elevated level. At August 31, 2013, unemployment was 8.5% for Muskegon County and 6.5% for Ottawa County. Additionally, property values, although low, are holding. Stable property values are likely to lead to more real estate sales and construction activity. However, in spite of the improvements in the economic climate, the effects of the extended downturn had an adverse effect on the financial health of the Bank. Poor earnings stemming primarily from deteriorating asset quality eroded the Bank’s capital and corresponding regulatory capital ratios subjecting it to additional regulatory scrutiny.

 

On September 2, 2010, the Bank entered into a Consent Order with the FDIC and the State of Michigan’s DIFS, its primary regulators. The Bank agreed to the terms of the Consent Order without admitting or denying any charge of unsafe or unsound banking practices relating to capital, asset quality, or earnings. The Consent Order imposes no fines or penalties on the Bank. The Consent Order will remain in effect and enforceable until it is modified, terminated, suspended, or set aside by the FDIC and DIFS. Under the Consent Order, the Bank was required, within 90 days of September 2, 2010, to have and maintain its level of Tier 1 capital, as a percentage of its total assets, at a minimum of 8.5%, and its level of qualifying total capital, as a percentage of risk-weighted assets, at a minimum of 11%. The Bank was not able to meet these requirements within the required 90-day period and remained out of compliance with the Consent Order as of September 30, 2013.

 

The lack of financial soundness of the Bank and the Company’s inability to serve as a source of strength for the Bank resulted in the board of directors entering into a Written Agreement with the Federal Reserve Bank of Chicago (the “FRB”), the Company’s primary regulator. The Written Agreement became effective on December 16, 2010, when it was executed by the FRB. The Written Agreement provides that: (i) the Company must take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to the Bank; (ii) the Company may not declare or pay any dividends or take dividends or any other payment representing a reduction in capital from the Bank or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior FRB approval; (iii) the Company may not incur, increase or guarantee any debt or purchase or redeem any shares of its stock without prior FRB approval; (iv) the Company must submit a written statement of its planned sources and uses of cash for debt service, operating expenses and other purposes to the FRB within 30 days of the Written Agreement; (v) the Company shall take all necessary actions to ensure that the Bank, the Company and all nonbank subsidiaries of both the Bank and the Company comply with sections 23A and 23B of the Federal Reserve Act and Regulation W of the Board of Governors (12 C.F.R. Part 223) in all transactions between affiliates; (vi) the Company may not appoint any new director or senior executive officer, or change the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, without prior regulatory approval; and finally (vii) within 30 days after the end of each calendar quarter following the date of the Written Agreement, the board of directors shall submit to the FRB written progress reports detailing the form and manner of all actions taken to secure compliance with the provisions of the Written Agreement as well as current copies of the parent company only financial statements. The Company has not yet been able to meet the obligation detailed in part (i) above; as the Company currently has limited resources with which to assist the Bank in achieving the capital level required by the Consent Order. For additional information regarding the capital levels see Note 15 to the Consolidated Financial Statements. The Company’s main liquidity resource is its cash account balance which, as of September 30, 2013, was approximately $656,000 compared to $8,000 at year-end 2012. The increase in cash resulted from the issuance of senior debt during the first quarter of 2013.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

On January 3, 2011, the Company was not able to repay its $5 million term loan owed to Fifth Third Bank; nor was the Company able to make the preceding ten quarterly interest payments. The term loan was in default for 25 months. At December 31, 2012, the total amount owed Fifth Third was $5,763,000. On March 20, 2013, the Company, with approval from the FRB, borrowed $1,280,000 from 1030 Norton LLC, a Michigan limited liability company owned by nine individuals; three directors of the Company-Gary F. Bogner, Robert L. Chandonnet and Bruce J. Essex, one former director and five local businessmen, and settled its debt with Fifth Third for $500,000. In addition to the payment to Fifth Third, the proceeds of the new senior debt will be used for interest carry, general operations and potential capital support for the Bank. The note bears interest at 8.00% per annum until paid in full. Interest is payable quarterly in arrears. The note matures on March 31, 2015. The note is secured by all of the issued and outstanding shares of the Bank as evidenced by a pledge agreement between the Company and 1030 Norton LLC dated March 20, 2013. The reduced amount of borrowings is expected to decrease interest expense by approximately $200,000 annually.

 

Settling the Fifth Third debt resulted in a gain of approximately $5.3 million in the first quarter of 2013. As a result of this transaction, the Company was able to achieve positive shareholders’ equity of approximately $4 million at March 31, 2013.

 

On August 17, 2011, the Bank was issued a Supervisory Prompt Corrective Action Directive (the “Directive”) because of its undercapitalized capital category at December 31, 2010, its failure to submit a capital restoration plan that satisfies the requirements stipulated in the FDIC Rules and Regulations, and the continued deterioration of the Bank. The Directive stipulated that the Bank be restored to an “adequately capitalized” capital category within 60 days of the issuance of the Directive. During the 60 days, the board made efforts to secure funding and comply with the Directive but was not successful. Through several quarters of earnings and a $25,000 capital contribution from the Company, the Bank reached an adequately capitalized regulatory capital category at March 31, 2013. Management formally communicated achievement of the capital level stipulated in the Directive to the FDIC through the submission of the quarterly Call Report and the required quarterly written communication, at the end of April. Recent feedback received by management indicated that formal public release of the Directive is anticipated to occur upon achievement of four consecutive quarters of adequate capitalization which is expected to occur by way of submitting 2013’s fourth quarter Call Report to the FDIC on or about January 30, 2014, assuming that the capital ratios of the Bank remain stable for the remaining quarter of 2013.

 

Regardless of meeting the stipulations in the Directive, failure to comply with the provisions of the Consent Order or the Written Agreement may subject the Bank to further regulatory enforcement action.

 

As of December 31, 2012, the Company’s extended period of net losses, failure to repay its term loan at maturity (subsequently settled as noted above), timely compliance with the higher capital ratios of the Directive and the Consent Order, and the provisions of the Written Agreement raised substantial doubt about the Company’s ability to continue as a going concern and as a result of this doubt, our auditors added an explanatory paragraph to their opinion on the Company’s December 31, 2012 consolidated financial statements expressing such doubt. These financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 CRITICAL ACCOUNTING POLICIES AND ESTIMATES: The “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as disclosures found elsewhere in Form 10-Q are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The allowance for loan losses, income taxes and foreclosed assets are deemed critical due to the required level of management judgment and the use of estimates that are particularly susceptible to significant change in the near term.

 

Allowance for loan losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans and loan groupings, assessments of the impact of current and anticipated economic conditions on the portfolio and historical loss experience. See the Financial Condition section of Management’s Discussion and Analysis and Notes 1 and 4 to the Company’s consolidated financial statements for additional information.

 

Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and anticipated economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Company’s assets reported on the balance sheet as well as its net income. Management has discussed the development of this critical accounting estimate with the Board of Directors and the Audit Committee.

 

Income Taxes. Income taxes are accounted for under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

 

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

 

Net deferred tax assets are recorded to the extent it is believed that they will more likely than not be realized. In making such a determination, all available positive and negative evidence is considered, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. In the event it is determined that deferred income tax assets are in excess of their realizable amount, an adjustment to the valuation allowance would be made which would increase the provision for income taxes.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

In determining the possible realization of deferred tax assets, future taxable income from operations exclusive of reversing temporary differences and tax planning strategies that, if necessary, would be implemented to accelerate taxable income into periods in which net operating losses might otherwise expire is considered.

 

Interest and penalties related to unrecognized tax benefits are recognized within the federal income tax expense (benefit) line in the accompanying consolidated statements of income. Accrued interest and penalties are included within the related tax liability line in the consolidated balance sheets.

 

Foreclosed Assets. Foreclosed assets are acquired through loan foreclosure or other proceedings and are initially recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. During the time that foreclosed assets are waiting to be sold, there will be occasions that the Bank will need to re-evaluate the individual market values of each asset. If there is evidence that the fair value has declined since the last evaluation, the Bank will incur an impairment charge in order to properly reflect the estimated fair value of the asset at the end of the reporting period. On a quarterly basis, the Bank’s Credit Department analyzes foreclosed asset values to determine the level at which they should be held on our books.

 

FINANCIAL CONDITION

 

Total assets were $183.0 million at September 30, 2013 compared to $204.2 million at December 31, 2012. The $21.2 million decrease in assets stemmed mainly from the seasonal fluctuation in the deposit balances of several of the Bank’s large public fund customers, the maturity of securities and a reduction in the outstanding senior debt of the Company.

 

Cash and cash equivalents decreased by $10.2 million in the first three quarters of 2013 and were $10.1 million at September 30, 2013. Cash and cash equivalents were $20.3 million at year-end 2012. The Bank’s FRB balance decreased $10.5 million since year-end 2012 and was $6.8 million on September 30, 2013. The decrease in balance is driven largely by the seasonal deposit activities of several of the Bank’s public fund customers and a reduction in time deposits. The FRB balance at September 30, 2013 was near management’s desired range of $7 to $10 million. The range indicated is enough to cover the typical liquidity needs of the Bank’s operations as well as provide a surplus for unexpected events.

 

The balance held at the FRB on December 31, 2012 was purposely elevated because management had implemented its contingency funding plan to be prepared for customer deposit withdrawals after the conclusion of the FDIC Transaction Account Guarantee Program (“TAG”) on December 31, 2012. In the months following the TAG sunset, the Bank was able to reduce its additional FRB liquidity as there was very little deposit loss and the additional liquidity negatively impacted the earnings of the Company.

 

The Bank’s security portfolio was $33.5 million at September 30, 2013 and $41.5 million at December 31, 2012. Investment activity in the first nine months of the year consisted of maturities, prepayments and calls totaling $7.2 million and market value adjustments of $(495,000). There were no sales or purchases of portfolio securities in the first nine months of 2013.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The securities portfolio is a key source of liquidity for the Bank. Given the Bank’s weakened condition, off-balance-sheet borrowing facilities are significantly limited, forcing the Bank to resort to on-balance-sheet sources. Consequently, it remains critical to maintain the unencumbered portion of the Bank’s security portfolio at a level equal to or perhaps above its general internal policy, depending on assessed liquidity needs. The level of unpledged securities is regularly monitored and needs are formally assessed on a monthly basis. Maintaining an adequate level of pledgeable assets is one of the driving forces behind investment activity. Prior to the Consent Order, the Bank strived to have between 10% and 20% of its investment portfolio unpledged. At September 30, 2013, 16% of the investment portfolio was unencumbered. This outcome is down from the 35% unpledged position that existed on December 31, 2012 when the portfolio was intentionally inflated to allow for additional customer pledging needs after the conclusion of the FDIC Transaction Account Guarantee Program.

 

The Bank believes that customer needs related to the conclusion of TAG have been addressed and has chosen not to replace any of the securities that matured in the first nine months of 2013.

 

At September 30, 2013, securities with a market value of $28.1 million were pledged to public fund customers, FRB Automated Clearing House (“ACH”) debit activity and customer repurchase agreements. On October 18, 2013, the FRB formally communicated the removal of pledging required for ACH debit activity. Both loans and securities were pledged. Management anticipates release of the securities will increase the percent of unencumbered securities by nearly 4%.

 

Investment portfolio quality has received much scrutiny over the past several years. Recently, as a result of signs that global central banks may wind down monetary stimulus, the U.S. 10-year Treasury yield rose drastically having a significant impact on the market value of the Bank’s investment portfolio. The investment portfolio’s net unrealized gain was reduced by $495,000 since year-end 2012 decreasing the unrealized gains on the entire portfolio to $107,000 at September 30, 2013. Included in this total are 16 securities with an amortized cost of $11.0 million having an unrealized loss of $218,000. Two of the 16 had an unrealized loss longer than 12 months.

 

Although there has been a significant change in the market value of the portfolio overall, none of the unrealized losses are expected to impact earnings. At September 30, 2013, the Bank conducted its standard review for other-than-temporary impairment (“OTTI”). The unrealized losses referenced above were not determined to be other-than-temporary given the fact that they are all fully guaranteed by the U.S. government and the Bank does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. The portfolio will continue to be reviewed for impairment in accordance with the Bank’s investment policy.

 

To reduce exposure to future loss (both realized and unrealized) the Bank intends to adhere to the diversification principles outlined in the investment policy and limit issuer concentrations. Besides fully guaranteed U.S. government and federal agency securities, there were no holdings of securities of any one issuer in an amount greater than 10% of the Bank’s common stock and surplus at September 30, 2013.

 

Loans held for sale activity during the first nine months of 2013 included $7.3 million of loan originations, $5.9 million of loans transferred to the held for investment portfolio and $7.6 million of loan sales. The associated gain on the loan sales was $167,000. The loans that were transferred to the held for investment portfolio consisted of Small Business Administration (“SBA”) and United States Department of Agriculture (“USDA”) loans. The transfer was based on management’s re-evaluation of the Bank’s intent to sell these loans in the short-term.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Total loans (held for investment) were $128.5 million at September 30, 2013 and $125.8 million at December 31, 2012. The $2.7 million increase since year-end 2012 was brought about mainly by the $5.9 million transferred from the held for sale portfolio offset by net customer repayments and transfers to foreclosed assets.

 

Details of the activity since year-end 2012 was an increase of $3.7 million to the commercial loan portfolio; an increase of $1.9 million to the commercial real estate portfolio and a decrease of $2.9 million to the consumer and residential portfolios. With the increase in commercial loans outstanding, the concentration changed slightly. At September 30, 2013, the concentration of commercial and commercial real estate loans was 79%; up from a level of 77% at year-end 2012. The wholesale focus of the Bank has remained since opening in 1999. Unfortunately, the sustained economic weakness both nationally and locally from 2008 through 2011 affected many borrowers but particularly the borrowers in these two segments. During that time, the credit deterioration of customers in those segments, primarily commercial real estate, increased the overall risk profile of the Bank. As a result, the Bank incurred significant expenses to address the assessed risk which negatively impacted the Bank’s earnings and capital.

 

Management believes that the economy in the local market has stabilized substantially over the past several quarters. Loan credit quality has improved. Even so, the Bank remains diligent about monitoring its loan portfolio and will continue its efforts to develop and educate lenders and credit staff, and to invest time into the design and overall strengthening of the Company’s credit risk assessment processes.

 

Simply put, credit risk is the risk of borrower nonpayment typically on loans although it can be applicable to the investment portfolio as well. In both cases, avoiding portfolio concentrations in any one type of credit or in a specific industry helps to decrease risk; however, the risk of nonpayment for any reason exists with respect to all loans and investments. The Bank recognizes that credit losses will be experienced and will vary with, among other things, general economic conditions; the creditworthiness of the borrower over the term of the debt; and in the case of a collateralized loan, the quality of the collateral.

 

The Bank has developed a detailed process to estimate credit risk. The process is discussed at length in Note 1 to the Company’s financial statements. At each period end, the balance in the allowance for loan losses is based on management’s estimation of probable incurred credit losses. The estimation is the result of loan portfolio analysis completed utilizing a detailed methodology prescribed in the Bank’s credit procedures. Management reviews and analyzes the loan portfolio on a regular basis for the purpose of estimating probable incurred credit losses.

 

The analysis of the allowance for loan losses is comprised of two portions: general credit allocations and specific credit allocations. General credit allocations are made to various categories of loans based on loan ratings, delinquency trends, historical loss experience as well as current economic conditions. The specific credit allocation includes a detailed review of a borrower and its entire relationship resulting in an allocation being made to the allowance for that particular borrower. A loan becomes specifically identified when, based on current information and events related to that particular borrower, it is probable that the Company will be unable to collect the scheduled payments of principal and interest according to the contractual terms of the loan agreement.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The allowance for loan losses is adjusted accordingly to maintain an adequate level based on the conclusion of the general and specific analysis. There are occasions when a specifically identified loan requires no allocated allowance for loan losses. To have no allocated allowance for loan loss, a specifically identified loan must be well secured and have a collateral analysis that supports a loan loss reserve allocation of zero.

 

At September 30, 2013, the allowance for loan losses totaled $2.9 million. At year-end 2012, the allowance for loan losses was $3.4 million. The reduction in the allowance is the result of net charge-offs of $513,000 recorded in the first nine months of 2013. The ratio of allowance to gross loans outstanding decreased to a level of 2.23% at September 30, 2013 compared to 2.69% at year-end 2012. Twenty percent of the loan charge-offs occurring in the first three quarters of 2013 held specific allocations at year-end 2012.

 

The allocation at each period end was as follows:

 

   September 30, 2013   December 31, 2012 
       Percent of       Percent of 
       Loans in Each       Loans in Each 
Balance at End of Period      Category to       Category to 
Applicable to:  Amount   Total Loans   Amount   Total Loans 
Commercial  $382,722    33.9%  $582,198    31.7%
Commercial Real Estate   1,814,880    45.5    2,266,302    45.0 
Consumer   411,679    8.1    331,459    9.2 
Residential   214,522    12.5    203,018    14.1 
Unallocated   46,233    N/A    0    N/A 
Total  $2,870,036    100%  $3,382,977    100%

 

The general component of the allowance for loan losses as a percentage of non-specifically identified loans was 1.04% at September 30, 2013, a decrease of 33 basis points from year-end 2012. At year-end 2012, the general component of the allowance for loan losses was 1.37% of total non-specifically identified loans. There are $46,000 of unallocated reserves in the allowance for loan losses stemming mostly from decreases to the Bank’s 36-month historical loss calculation. If the unallocated reserves were added to the general component of the allowance for loan losses, the ratio would be 1.08%. Management believes that the trend of the general component of the allowance for loan losses and the increase in the unallocated reserves is in line with stabilization and strengthening of the local economy, local unemployment and the overall improvement in the credit quality of the loan portfolio.

 

At September 30, 2013, the allowance contained $1,574,000 in specific allocations for impaired loans whereas at December 31, 2012 there was $1,810,000 specifically allocated. There was $9.3 million of recorded investment on impaired loans at September 30, 2013, compared to $11.7 million at year-end 2012. At September 30, 2013, the recorded investment on impaired loans requiring no reserves was $4.1 million, a decrease of $1.0 million since year-end 2012. In the first quarter of 2013, there was a $1.4 million relationship that was removed from TDR status. The specific allocation associated with the loan was $34,000 at year-end 2012. Furthermore, $614,000 of impaired loans were moved to foreclosed assets in the first nine months of 2013. There were specific allocations on these loans of $58,000 at year-end 2012.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

At September 30, 2013, 44% of specifically identified loans required no reserves; the same percentage at year-end 2012. In many cases, management approves further charge-offs after the time of initial impairment. The charge-offs reduce principal to the current value of assigned collateral or expected repayment, therefore no specific reserve is required on these loans.

 

Recorded investment on specifically identified loans requiring reserves was $5.2 million at September 30, 2013 compared to $6.6 million at year-end 2012.

 

Another factor considered in the assessment of the adequacy of the allowance is the quality of the loan portfolio from a past due standpoint. From year-end 2012 to September 30, 2013, the recorded investment in accruing past due and non-accrual loans decreased by $846,000. This was evidenced by a $158,000 decrease in the recorded investment in past due loans and a $688,000 decrease in the recorded investment in non-accrual loans in the first nine months of 2013.

 

The recorded investment of accruing loans past due 30-59 days was $98,000 at September 30, 2013; a decrease of $33,000 since December 31, 2012. There were two loans and one credit card balance past due 30-59 days at September 30, 2013.

 

There was a $5,000 recorded investment in accruing loans past due 60-89 days at September 30, 2013. At year-end 2012, the balance of these loans was $130,000.

 

There were no accruing loans with a recorded investment past due 90 days and greater at either September 30, 2013 or year-end 2012.

 

The Bank’s delinquency has been reduced compared to prior periods and compares favorably to typical industry averages. The credit review process will continue to be stringent; however, it is possible that past dues could fluctuate in future periods.

 

The recorded investment of non-accrual loans totaled $3.2 million at September 30, 2013 which is a reduction since year-end 2012 when the recorded investment of non-accrual loans totaled $3.9 million. The majority of the non-accrual loans are secured by developed real estate, only 1% of the total is secured by undeveloped real estate. At September 30, 2013, there were specific allocations of $1.2 million in the allowance for any estimated collateral deficiency on non-accrual loans.

 

Loan charge-off activity in the third quarter stemmed mainly from two customers. Overall net charge-offs for the third quarter of 2013 were $417,000 and were $513,000 for the first nine months of 2013. The corresponding ratio of net charge-offs to average loans for the third quarter of 2013 was 1.30% while the ratio of net charge-offs to average loans was 0.52% for the first nine months of 2013. Management does not think the recent charge-offs are indicative of changes in the local economy but rather unfortunate circumstances particular to each relationship.

 

The net charge-offs for the third quarter of 2012 were $718,000 and $1.8 million for the first three quarters of 2012. The resulting ratio of net charge-offs to average loans for the third quarter of 2012 was 2.15% and 1.68% for the first nine months of the same year.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

In the first quarter of 2012, a large commercial real estate credit was restructured in a modification that is commonly referred to as an A-B note structure. In these types of modifications, a detailed analysis of the borrower’s financial condition is performed and the total debt is separated into two notes. The first note (“note A”) is underwritten to be supported by current cash flows and collateral and the second note (“note B”) is made for the remaining debt. Note B is immediately charged-off after closing with any recoveries occurring only after note A is completely repaid. Sixty-six percent of the charge-offs recorded in the first quarter of 2012 was the note B of a commercial real estate restructuring. Aside from that single transaction, normal recurring charge offs would have been less than 1% of total loans during the first three months of 2012.

 

Another risk identified by the Company is interest rate risk. The Company attempts to mitigate interest rate risk in its loan portfolio in many ways. In addition to product diversification, the Company also seeks to mitigate interest rate risk by balancing the rate sensitivity of the portfolio and avoiding extension risk1.

 

The loan maturities and rate sensitivity of the loan portfolio at September 30, 2013 are set forth below:

 

   Within   Three to   One to   After     
   Three Months   Twelve Months   Five Years   Five Years   Total 
Commercial  $3,974,684   $17,252,348   $16,235,243   $6,076,485   $43,538,760 
Commercial Real Estate:                         
General   2,742,903    8,528,077    38,290,520    6,841,159    56,402,659 
Construction   1,442,164    8,910    643,914    0    2,094,988 
Consumer:                         
Lines of credit   779,237    769,944    2,392,032    4,350,562    8,291,775 
Other   49,020    161,388    921,450    537,569    1,669,427 
Credit card   53,348    165,085    252,403    0    470,836 
Residential   144,480    535,757    0    15,398,571    16,078,808 
   $9,185,836   $27,421,509   $58,735,562   $33,204,346   $128,547,253 
Loans at fixed rates  $4,738,124   $15,086,633   $44,335,922   $23,888,946   $88,049,625 
Loans at variable rates   4,447,712    12,334,876    14,399,640    9,315,400    40,497,628 
   $9,185,836   $27,421,509   $58,735,562   $33,204,346   $128,547,253 

 

At September 30, 2013, there were 68% of the loan balances carrying a fixed rate and 32% a floating rate. This concentration of fixed rate loans is down from a level of 75% at September 30, 2012. Prior to 2008, the Bank’s mix of fixed and floating rate loans had been relatively evenly divided. During the economic downturn the loan portfolio mix became more heavily weighted with fixed rate loans. The movement in the third quarter of 2013 towards a balanced portfolio is management’s preference. However, a majority of the composition change is not controllable. Shifts can occur as a result of the types of loans that have been repaid and changes in customer preference at the time of renewal. Restoring the loan portfolio to a balanced position between fixed and floating loans will be important since future rate movements are likely to trend upward.

 

 

1Extension risk, as related to loans, exists when booking fixed rate loans with long final contractual maturities. When a customer is contractually allowed longer to return its borrowed principal and rates rise, the Bank is delayed from taking advantage of the opportunity to reinvest the returning principal at the higher market rate.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The maturity distribution of the loan portfolio has lengthened over the last several years but still remains at a level that is within the parameters determined to be acceptable by management. Contributing to the change in distribution is the increase in the mortgage loan portfolio. Typically management strives to retain only 10-15% of residential mortgages originated because of the longer contractual terms generally associated with mortgage products. For 2013, the percent retained is averaging 19% due to a variety of conditions related to rates, regulations and investor preferences.

 

At September 30, 2013, approximately 26% of the entire loan portfolio had a contractual maturity longer than five years. To control extension risk, management tries to ensure that loans with a longer contractual maturity are either floating rate or have a repricing or balloon date that is much shorter than the amortization period. A majority of the loans in the greater than five year contractual maturity are residential mortgage loans. Statistically, loans of this type do not normally remain on the books until maturity as a result of customer repricing opportunities or changes in circumstance. Additionally, the mortgage staff remains focused on originating loans saleable into the secondary market, thus minimizing the number that is booked into the held for investment portfolio.

 

Foreclosed assets were $2.7 million at September 30, 2013 which was a decrease of $121,000 since December 31, 2012. These assets consist of relinquished properties through the collection process which were previously customer collateral supporting various loans. At September 30, 2013 there were 25 real estate holdings and at December 31, 2012 there were 24 real estate holdings. Foreclosed asset activity in the first nine months of 2013 consisted of twelve lot and eight property sales and nine additional properties acquired through the foreclosure process.

 

Deposit balances were $163.6 million at September 30, 2013 down from $184.2 million at December 31, 2012. The net decrease of $20.6 million stemmed from non-interest bearing balances declining $8.6 million and interest bearing balances decreasing $12.0 million in the first nine months of 2013.

 

Non-interest bearing balances were $31.7 million on September 30, 2013 and $40.3 million on December 31, 2012. The four largest public fund customers have decreased their balances by $5.1 million since year-end 2012. The level of deposits at September 30, 2013 is in line with the seasonality of these customers. One non-interest bearing customer wired $2.2 million to another financial institution in January to diversify their deposits after the conclusion of TAG.

 

Total interest bearing deposits are made up of interest bearing demand deposits, money market and savings accounts and time deposits. Total interest bearing deposits were $131.9 million on September 30, 2013 down from $143.9 million on December 31, 2012. The $12.0 million decrease in the first three quarters of the year was the result of interest bearing demand deposits and money market accounts together rising $5.8 million and the time deposit portfolio declining $17.0 million. Savings accounts declined $861,000 in the first nine months of 2013. The time deposit portfolio was deliberately contracted in an effort to reduce excess liquidity at the FRB.

 

Repurchase agreement balances were $9.0 million at September 30, 2013 and $10.2 million at December 31, 2012; a decrease of $1.2 million. The decrease between the two period ends was primarily the result of one customer decreasing its balance since year-end 2012.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

A repurchase agreement is treated like a short-term borrowing of the Bank. To secure the short-term borrowing (repurchase agreement), balances held by customers are collateralized by high quality government securities held in a sub-account within the Bank’s security portfolio. Some customers with investable dollars exceeding the FDIC limits are utilizing this account type because they are seeking higher interest rates while mitigating their risk.

 

The Company had a $5.0 million term loan with Fifth Third secured by the common stock of the Bank that was in default at year-end 2012. In addition to the outstanding principal due, there was accrued interest of $763,000 at December 31, 2012. On March 20, 2013, the Company, with approval from the FRB, borrowed $1,280,000 from a group of investors and settled its debt in full with Fifth Third for $500,000. At closing, Fifth Third released its secured interest in the common stock of the Bank. The new senior debt bears interest at a fixed rate of 8.00% per annum and is payable quarterly, in arrears. The new note matures on March 31, 2015 and is secured by a pledge of 100% of the common stock of the Bank owned by the Company. The extinguishment of debt resulted in a gain of $5.3 million.

 

Shareholders’ equity was $3.8 million on September 30, 2013compared to $(1.2) million on December 31, 2012. The net increase of $5.0 million was made up of net income recorded in the first three quarters of 2013, largely attributable to settlement of our term loan with Fifth Third, and partially offset by decreases in accumulated other comprehensive income (security market value adjustments). The book value per share was $2.57 at September 30, 2013.

 

The Bank’s capital ratios have risen since year-end 2012. At September 30, 2013, the Bank’s total risk-based capital ratio was 8.46% and its tier one to average assets ratio was 5.06%. The Bank’s total risk-based capital ratio at December 31, 2012 was 7.88%. Its tier one to average assets ratio was 4.53% at year-end 2012. The total risk-based capital ratio improved because of the Bank’s earnings recorded in the first three quarters of 2013 along with a capital contribution of $25,000 from the Company. Achieving a total risk-based capital ratio above 8.00% qualifies the Bank to be considered adequately capitalized according to prompt corrective action regulation administered by federal banking agencies. The Bank was considered under-capitalized at year-end 2012.

 

Under the Consent Order, the Bank is required to have and maintain its level of tier one capital, as a percentage of its total assets, at a minimum of 8.5%, and its level of qualifying total capital, as a percentage of risk-weighted assets, at a minimum of 11%. The Consent Order capital requirements were effective beginning with the December 31, 2010 capital reporting period. The Bank was not in compliance with required capital ratios at the December 2010 capital reporting period and remains out of compliance at September 30, 2013. In order to attain the level of capital required by the Consent Order, the Bank would have needed additional capital of $6,534,000 on September 30, 2013 based on its asset mix and size. This is less than the amount that would have been needed on December 31, 2012 which was $7,917,000.

 

The Directive, issued by the FDIC to the Bank on August 17, 2011, stipulated that the Bank be restored to an “adequately capitalized” capital category by October 17, 2011. Although the board made efforts to secure funding and comply with the Directive, they were not successful. As such, the Bank was not in compliance with the Directive by the required date. The Bank reached an adequately capitalized regulatory capital category at March 31, 2013. Management formally communicated achievement of the capital level stipulated in the Directive to the FDIC through the submission of the quarterly Call Report and the required quarterly written communication, at the end of April. Recent feedback received by management indicated that formal public release of the Directive is anticipated to occur upon achievement of four consecutive quarters of adequate capitalization, which is expected to occur by way of submitting 2013’s fourth quarter

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Call Report to the FDIC on or about January 30, 2014, assuming that the capital ratios of the Bank remain stable for the remaining quarter of 2013.

 

RESULTS OF OPERATIONS

 

Net income recorded for the first nine months of 2013 was $5.5 million. Net income recorded for the similar period in 2012 was $259,000. The improvement of $5.2 million between the first three quarters of 2013 and the first three quarters of 2012 stemmed mainly from a $5.3 million gain on debt extinguishment. The corresponding basic and diluted earnings per share for the first nine months of 2013 was $3.75. The basic and diluted earnings per share for the first nine months of 2012 was $0.18.

 

The net income for the third quarter of 2013 was $124,000, which was $122,000 more than net income of $2,000 recorded for the third quarter of 2012. The corresponding basic and diluted earnings per share for the third quarter of 2013 was $0.08. The basic and diluted earnings per share for the third quarter of 2012 was $0.00.

 

For the first nine months of 2013, the annualized return on the Company’s average total assets was 3.74% compared to 0.16% for the first nine months of 2012. For the third quarter of 2013, the annualized return on the Company’s average total assets was 0.26%. The Company’s earnings for the third quarter of 2012 were just above breakeven so the annualized return on average assets was 0.00%.

 

The Company’s average shareholders’ equity became positive in the first quarter of 2013 after recording the $5.3 million debt extinguishment gain on March 20, 2013. For the first nine months of 2013, the annualized return on shareholders’ equity was 296.6%. The Company’s average shareholders’ equity for the third three month period of 2013 was 13.57%. The ratio was not meaningful for the comparable periods in 2012 because shareholders’ equity was negative.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

A significant component of the Company’s revenue is its net interest income. The Company’s net interest income and net interest margin were both lower for the first nine months of 2013 compared to the similar period in 2012. The following table sets forth certain information relating to the Company’s consolidated average interest earning assets and interest bearing liabilities and reflects the average yield on assets and average cost of liabilities for the periods indicated. Such yields and costs are derived by dividing annualized income or expenses by the average daily balance of assets or liabilities, respectively, for the periods presented.

 

   Nine Months ended September 30, 
   2013   2012 
   Average       Average   Average       Average 
   Balance   Interest   Rate   Balance   Interest   Rate 
Assets                        
Federal funds sold and interest- bearing deposits with banks  $14,785,764   $26,596    0.24%  $21,683,580   $39,456    0.24%
Securities   37,751,706    421,821    1.49    36,153,180    511,709    1.89 
Loans (including held for sale and non accrual)   130,419,135    5,292,942    5.41    140,298,678    6,199,527    5.89 
    182,956,605    5,741,359    4.18    198,135,438    6,750,692    4.54 
Other assets   13,081,968              12,855,802           
   $196,038,573             $210,991,240           
Liabilities and Shareholders’ Equity                              
Interest-bearing deposits  $141,193,801   $757,995    0.72%  $153,248,982   $1,094,497    0.95%
Repurchase agreements   9,996,881    43,919    0.59    9,606,429    54,593    0.76 
Subordinated debentures and notes payable   5,414,286    143,985    3.55    9,500,000    322,937    4.53 
    156,604,968    945,899    0.81    172,355,411    1,472,027    1.14 
Non-interest-bearing deposits   34,499,333              38,559,716           
Other liabilities   2,460,712              1,349,193           
Shareholders’ Equity   2,473,560              (1,273,080)          
   $196,038,573             $210,991,240           
Net interest income       $4,795,460             $5,278,665      
Net interest spread on earning assets             3.37%             3.40%
Net interest margin on earning assets             3.49              3.55 
Average interest-earning assets to average interest-bearing liabilities             116.83              114.96 

 

The net interest spread on average earning assets decreased 3 basis points to 3.37% in the past twelve months. The net interest margin decreased by 6 basis points from 3.55% for the first nine months of 2012 to 3.49% for the first nine months of 2013. Net interest income for the first three quarters of 2013 was $4.8 million compared to $5.3 million for the same three quarters in 2012. During the twelve month period from September 30, 2012 to September 30, 2013, average earning assets decreased by $15.2 million; 65% of the decrease occurred in the loan portfolio which is the highest yielding earning asset. In addition to fewer earning assets, there was a decrease in the overall yield on those assets.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The average rate earned on interest earning assets was 4.18% for the nine month period ending September 30, 2013 compared to 4.54% for the same period in 2012. In addition to the average loan portfolio shrinking by $9.9 million over the last twelve months, the yield declined 48 basis points in that period. Management attributes this to improved economic conditions. As the economy improves, businesses become healthier which strengthens their financial condition and allows them more banking options; including using excess liquidity to repay loans or requesting lower borrowing rates. Since the Bank’s internal prime lending rate is 175 basis points above the Wall Street Journal Prime Lending Rate, there is substantial competitive pressure to revisit pricing on those customers that have recovered and are experiencing an improved financial condition. The Bank carefully considers every request and when the request does not adequately reflect borrower risk according to the Bank’s lending standards, the rate will not be lowered fully to match competition. Sometimes this results in businesses pursuing financing at other financial institutions.

 

Also contributing to the decreased yield on average earning assets is the marked decrease in the yield earned on the investment portfolio. Throughout the last year, as securities were called or matured, they were either not replaced or replaced with securities that bear lower rates reflective of the current environment.

 

A portion of the decrease to the overall yield on interest earning assets was offset by rate reductions on the funding side. Management spends a significant amount of time managing the continued improvement in the cost of funds, especially in light of the restrictions placed by the Consent Order. Interest expense incurred on rate-bearing liabilities decreased by $526,000 and the average rate paid improved by 33 basis points when comparing the first three quarters of 2013 to that of the similar period in 2012.

 

The yield paid on interest bearing deposits declined 23 basis points primarily due to a 20 basis point reduction in the average rate paid on the time deposit portfolio over the last twelve months. The time deposit portfolio makes up roughly 61% of interest bearing deposits so changes to rates paid on this portfolio have a substantial impact on the blended rate paid on interest bearing deposits. There are limited opportunities to further improve this portfolio since the rate environment has remained low for such an extended period of time. Changing the mix of interest bearing deposits to be less heavily weighted towards time deposits will be beneficial to earnings and is an ongoing goal of management.

 

The Bank’s customer repurchase agreement balance remained essentially the same in both nine month periods; however, the average rate paid declined by 17 basis points. Rates have remained substantially the same, however, the product has tiered pricing which means that the mix of customer balances was different when comparing the nine month periods of 2012 and 2013, resulting in a lower overall yield.

 

Finally, the Company’s average rate paid on notes payable and subordinated debentures decreased by 98 basis points between the first three quarters of 2013 and the first three quarters of 2012. Decreases to the average rate on subordinated debentures and notes payable is directly related to the settlement with Fifth Third that occurred late in the first quarter of 2013. As a result, there was a reduction in interest bearing liabilities of $4.1 million. Although the new senior debt bears interest at a rate 2% higher than the former Fifth Third note payable, the increase in the average rate paid is offset by a much smaller balance outstanding. The Company’s subordinated debt carried an average rate of 2.34% in the first nine months of 2013 which is roughly 21 basis points lower than an average rate of 2.55% paid for the same period in 2012.

 

- 55 -
 

 

COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The quarter-to-quarter comparison of consolidated average interest earning assets and interest bearing liabilities and average yield on assets and average cost of liabilities for the third quarter ended September 30, 2013 and 2012 is in the table below.

 

   Three Months ended September 30, 
   2013   2012 
   Average       Average   Average       Average 
   Balance   Interest   Rate   Balance   Interest   Rate 
Assets                              
Federal funds sold and interest- bearing deposits with banks  $13,570,152   $8,283    0.24%  $25,987,402   $15,841    0.24%
Securities   35,038,321    127,222    1.45    36,423,425    162,014    1.78 
Loans (including held for sale and non accrual)   128,391,263    1,701,576    5.30    133,689,544    1,946,158    5.82 
    176,999,736    1,837,081    4.15    196,100,371    2,124,013    4.33 
Other assets   13,070,572              13,244,006           
   $190,070,308             $209,344,377           
Liabilities and Shareholders’ Equity                              
Interest-bearing deposits  $136,331,382   $226,945    0.67%  $148,153,284   $333,829    0.90%
Repurchase agreements   9,905,021    14,193    0.57    8,432,594    15,574    0.74 
Subordinated debentures and notes payable   5,780,000    55,947    3.87    9,500,000    108,093    4.55 
    152,016,403    297,085    0.78    166,085,878    457,496    1.10 
Non-interest-bearing deposits   33,450,338              42,840,183           
Other liabilities   948,697              1,493,868           
Shareholders’ Equity   3,654,870              (1,075,552)          
   $190,070,308             $209,344,377           
Net interest income       $1,539,996             $1,666,517      
Net interest spread on earning assets             3.37%             3.23%
Net interest margin on earning assets             3.48              3.40 
Average interest-earning assets to average interest-bearing liabilities             116.43              118.07 

 

Although net interest income was $127,000 less between the third quarter of 2013 and the similar period in 2012, the net interest spread on average earning assets improved by 14 basis points and was 3.37% compared to a spread of 3.23% for the third quarter of 2012. The net interest margin for the third quarter of 2013 was 3.48% or 8 basis points higher than the 3.40% shown for the third quarter of 2012. The improvement was achieved because the decline in yield on earning assets was more than offset by the reduction in yield paid on interest-bearing liabilities.

 

The average rate earned on interest earning assets was 4.15% for the three month period ending September 30, 2013, compared to 4.33% for the same period in 2012. The two biggest earning asset categories, securities and loans, each had a decline in yield when comparing the third quarter of 2013 to the similar period of 2012. A decline in the interest-bearing balances held at other banks positively impacted the overall average rate earned on earning assets. Due to the low rate earned, reductions to the concentration of this category help dilute rate declines in other categories. The concentration of this earning asset category was 8% for the third quarter of 2013 and 13% for the third quarter of 2012.

 

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COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The decline in the yield on the securities portfolio was 33 basis points when comparing the outcome for the third quarter of 2013 to the third quarter of 2012. The result is directly related to rate differences between maturing securities and replacement securities, the same situation that was described earlier.

 

Additionally, the average rate earned on the loan portfolio, the Company’s largest earning asset category, was 5.30% for the third quarter of 2013. The average rate earned on the loan portfolio was 5.82% for the third quarter of 2012. The difference between the two periods was 52 basis points. A portion of the yield decrease was due to lower rates given to existing customers at the time of renewal. The healthier business climate allows some customers to qualify for lower rates and the Bank is challenged to remain on par with competition or risk losing the borrowing relationship.

 

Decreases to the overall yield on interest earning assets were more than offset by rate reductions on the funding side. Since the third quarter of 2012, the cost of funds improved 32 basis points. The main contributing factor was a 23 basis point improvement in the rate paid on interest bearing deposits when comparing the third quarter of 2013 to that of the similar period of 2012; the entire improvement was linked to a 23 basis point reduction in the average rate paid on the time deposit portfolio between the two periods.

 

Additionally, there were improvements in the average rate paid on repurchase agreements, subordinated debentures and notes payable between the third quarter of 2013 and the third quarter of 2012. The average rate paid on repurchase agreements was 17 basis points less. The average rate paid on subordinated debentures and notes payable was 3.87% for the third quarter of 2013; a 68 basis point decrease stemming from the new blended rate of the Company’s debt.

 

While the Company experienced improvements to its cost of funds that were able to offset the decline in the yield on average earning assets in the third quarter of 2013, management believes it is unlikely that this trend will continue. If the trend does not continue, the Company’s net interest income and net interest margin will likely be negatively impacted.

 

In general, the rate environment remains at historically low levels and management is continually challenged to improve its mix of assets and its net interest income, thus asset liability management remains an important tool for assessing interest rate sensitivity; it also provides a tool for monitoring liquidity. Liquidity management involves the ability to meet the cash flow requirements of the Company’s customers. These customers may be either borrowers with credit needs or depositors wanting to withdraw funds. Management of interest rate sensitivity attempts to avoid widely varying net interest margins and achieve consistent net interest income through periods of changing interest rates.

 

The Company uses a sophisticated computer program to perform analysis of interest rate risk, assist with asset liability management, and model and measure interest rate sensitivity. Interest rate sensitivity varies with different types of earning assets and interest-bearing liabilities. Overnight investments, of which rates change daily, and loans tied to the prime rate, differ considerably from long term investment securities and fixed rate loans. Interest bearing checking and money market accounts are more interest sensitive than long term time deposits and fixed rate FHLB advances. Comparison of the repricing intervals of interest earning assets to interest bearing liabilities is a measure of interest sensitivity gap. Balancing this gap is a continual challenge in a highly competitive and changing rate environment.

 

- 57 -
 

 

COMMUNITY SHORES BANK CORPORATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Details of the repricing gap at September 30, 2013 were:

 

   Interest Rate Sensitivity Period 
   Within   Three to   One to   After     
   Three   Twelve   Five   Five     
   Months   Months   Years   Years   Total 
Earning assets                         
Interest-bearing deposits in other financial institutions  $6,895,413   $0   $0   $0   $6,895,413 
Securities (including FHLB stock)   3,914,015    6,008,926    21,852,670    2,175,803    33,951,414 
Loans held for sale   0    0    0    0    0 
Loans   52,271,942