Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended September 30, 2014

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 001-34955

 

 

ANCHOR BANCORP WISCONSIN INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware		39-1726871
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)
25 West Main Street Madison, Wisconsin		53703
(Address of principal executive office)		(Zip Code)

(608) 252-8700

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.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.    Yes  x    No  ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class: Common stock — $0.01 Par Value

Number of shares outstanding as of October 31, 2014: 9,245,300

 

 

 

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ANCHOR BANCORP WISCONSIN INC.

INDEX—FORM 10-Q

 

		Page #
Part I—Financial Information
Item 1 Financial Statements
Unaudited Consolidated Balance Sheets as of September 30, 2014 and Audited as of December 31, 2013			2
Unaudited Consolidated Statements of Operations and Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2013			3
Unaudited Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the Nine Months Ended September 30, 2014 and Audited for the Nine Months Ended December 31, 2013			5
Unaudited Consolidated Statements of Cash Flows for Nine Months Ended September 30, 2014 and 2013			6
Notes to Unaudited Consolidated Financial Statements			8
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations
Executive Overview			54
Results of Operations			58
Financial Condition			68
Risk Management			69
Credit Risk Management			70
Liquidity Risk Management			78
Market Risk Management			80
Compliance, Strategic and/or Reputational Risk Management			82
Regulatory Developments			83
Critical Accounting Estimates and Judgments			85
Forward Looking Statements			88
Item 3 Quantitative and Qualitative Disclosures About Market Risk			89
Item 4 Controls and Procedures			89
Part II—Other Information
Item 1 Legal Proceedings			90
Item 1A Risk Factors			90
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds			91
Item 3 Defaults Upon Senior Securities			91
Item 4 Mine Safety Disclosures			91
Item 5 Other Information			91
Item 6 Exhibits			91
Signatures			92

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Balance Sheets

 

		September 30,				December 31,
		2014				2013
		(Unaudited)
		(In thousands, except share data)
Assets
Cash and due from banks		$	28,806			$	44,139
Interest-earning deposits			145,218				99,257
Cash and cash equivalents			174,024				143,396
Investment securities available for sale (AFS)			291,867				277,872
Loans held for sale			4,937				3,085
Loans held for investment			1,556,283				1,609,506
Less: Allowance for loan losses			(47,037	)			(65,182	)
Loans held for investment, net			1,509,246				1,544,324
Other real estate owned (OREO), net			46,725				63,460
Premises and equipment, net			26,057				24,800
Federal Home Loan Bank stock—at cost			11,940				11,940
Mortgage servicing rights, net			20,479				22,294
Accrued interest receivable			7,467				8,216
Other assets			13,778				13,087
Total assets		$	2,106,520			$	2,112,474
Liabilities and Stockholders’ Equity
Deposits
Non-interest bearing		$	274,945			$	259,926
Interest bearing			1,583,862				1,615,367
Total deposits			1,858,807				1,875,293
Other borrowed funds			13,060				12,877
Accrued interest payable			396				415
Accrued taxes, insurance and employee related expenses			6,533				7,302
Other liabilities			13,015				14,389
Total liabilities			1,891,811				1,910,276
Commitments and contingent liabilities (Note 13)
Preferred stock: par value $0.01, authorized 100,000 shares, none outstanding at September 30, 2014 or December 31, 2013			—				—
Common stock: par value $0.01, authorized 11,900,000, issued and outstanding shares were 9,245,300 at September 30, 2014 and 9,050,000 at December 31, 2013			92				91
Additional paid-in capital			188,697				188,370
Retained earnings			29,858				20,359
Accumulated other comprehensive loss related to AFS securities			(3,893	)			(6,378	)
Accumulated other comprehensive loss related to other than temporary impairment (OTTI) securities—non-credit factors			(45	)			(244	)
Total accumulated other comprehensive loss			(3,938	)			(6,622	)
Deferred compensation obligation			—				—
Total stockholders’ equity			214,709				202,198
Total liabilities and stockholders’ equity		$	2,106,520			$	2,112,474

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Income

(Unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
						(In thousands, except per share data)
Interest income
Loans		$	17,044			$	19,231			$	52,241			$	60,185
Investment securities and Federal Home Loan Bank stock			1,465				1,506				4,527				4,219
Interest-earning deposits			103				122				262				347
Total interest income			18,612				20,859				57,030				64,751
Interest expense
Deposits			994				1,374				3,115				4,588
Other borrowed funds			60				3,673				180				16,114
Total interest expense			1,054				5,047				3,295				20,702
Net interest income			17,558				15,812				53,735				44,049
Provision for loan losses			(1,304	)			—				(1,304	)			950
Net interest income after provision for loan losses			18,862				15,812				55,039				43,099
Non-interest income
Net impairment losses recognized in earnings			(30	)			—				(64	)			(83	)
Loan servicing income, net of amortization			705				646				2,219				756
Service charges on deposits			2,626				2,667				7,415				7,616
Investment and insurance commissions			1,015				893				3,002				2,908
Net gain on sale of loans			837				1,565				2,127				7,388
Net gain (loss) on sale of investment securities			482				—				783				(200	)
Net gain on sale of OREO			987				1,217				2,188				3,479
Extinguishment of debt			—				134,514				—				134,514
Other income			1,393				1,177				3,887				2,656
Total non-interest income			8,015				142,679				21,557				159,034

 

(Continued)

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Statements of Operations and Comprehensive Income

(Unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
						(In thousands, except per share data)
Non-interest expense
Compensation and benefits		$	10,872			$	10,727			$	32,773			$	31,999
Occupancy			1,685				2,703				5,537				7,000
Furniture and equipment			758				902				2,315				2,514
Federal deposit insurance premiums			701				1,276				2,449				3,962
Data processing			1,340				1,264				4,026				4,546
Communications			611				497				1,647				1,445
Marketing			962				848				2,494				1,750
OREO expense, net			2,999				3,214				6,451				19,762
Investor loss reimbursement			136				223				50				3,404
Mortgage servicing rights impairment (recovery)			(53	)			(466	)			42				(3,914	)
Provision for unfunded commitments			(2,401	)			974				(1,621	)			3,133
Loan processing and servicing expense			577				795				1,853				2,989
Legal services			502				1,047				1,457				3,418
Other professional fees			404				878				1,162				2,032
Insurance			259				1,773				775				2,567
Debt prepayment penalty			—				16,149				—				16,149
Reorganization costs			—				1,866				—				1,866
Other expense			2,563				562				5,677				3,653
Total non-interest expense			21,915				45,232				67,087				108,275
Income before income taxes			4,962				113,259				9,509				93,858
Income tax expense			—				9				10				9
Net income			4,962				113,250				9,499				93,849
Preferred stock dividends in arrears			—				(837	)			—				(4,200	)
Preferred stock discount accretion			—				(4,304	)			—				(8,010	)
Retirement of preferred shares			—				104,000				—				104,000
Net income available to common equity		$	4,962			$	212,109			$	9,499			$	185,639
Net income		$	4,962			$	113,250			$	9,499			$	93,849
Reclassification adjustment for realized net (gains) losses recognized in Statements of Operations—Net gain (loss) on sale and call of investment securities			(482	)			—				(783	)			200
Reclassification adjustments recognized in Statements of Operations—Net impairment losses recognized in earnings:
Net change in unrealized credit related other-than-temporary impairment			(18	)			(90	)			(97	)			(248	)
Realized credit losses			48				90				161				331
Change in net unrealized gains (losses) on available-for-sale securities			(1,636	)			(1,444	)			3,403				(7,093	)
Total other comprehensive income (loss)			(2,088	)			(1,444	)			2,684				(6,810	)
Comprehensive income		$	2,874			$	111,806			$	12,183			$	87,039
Income per common share:
Basic		$	0.55			$	10.24			$	1.05			$	8.81
Diluted			0.55				10.24				1.05				8.81
Dividends declared per common share			—				—				—				—

See accompanying Notes to Unaudited Consolidated Financial Statements

 

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Stockholders’ Equity (Deficit)

 

																										Accu-
																										mulated
																										Other
																										Compre-
										Additional				Retained								Deferred				hensive
		Preferred				Common				Paid-in				Earnings				Treasury				Compensation				Income
		Stock				Stock				Capital				(Deficit)				Stock				Obligation				(Loss)				Total
		(In thousands)
Balance at March 31, 2013 (Audited)		$	103,833			$	2,536			$	110,034			$	(189,097	)		$	(89,848	)		$	(901	)		$	3,579			$	(59,864	)
Net income			—				—				—				111,623				—				—				—				111,623
Other comprehensive income, net of tax			—				—				—				—				—				—				(10,201	)			(10,201	)
Recapitalization transaction fees			—				—				(14,360	)			—				—				—				—				(14,360	)
Cancellation of common stock			—				(2,536	)			(88,213	)			—				89,848				901				—				—
Issuance of common stock			—				88				174,912				—				—				—				—				175,000
Preferred stock exchanged for common stock			(110,000	)			3				5,997				104,000				—				—				—				—
Accretion of preferred stock discount			6,167				—				—				(6,167	)			—				—				—				—
Balance at December 31, 2013 (Audited)		$	—			$	91			$	188,370			$	20,359			$	—			$	—			$	(6,622	)		$	202,198
Net income			—				—				—				9,499				—				—				—				9,499
Other comprehensive income, net of tax			—				—				—				—				—				—				2,684				2,684
Issuance of restricted common stock			—				1				(1	)			—				—				—				—				—
Stock compensation expense			—				—				328				—				—				—				—				328
Balance at September 30, 2014 (Unaudited)		$	—			$	92			$	188,697			$	29,858			$	—			$	—			$	(3,938	)		$	214,709

See accompanying Notes to Unaudited Consolidated Financial Statements

 

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

		Nine Months Ended September 30,
		2014				2013
		(In thousands)
Operating Activities
Net income		$	9,499			$	93,849
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization and accretion of investment securities premium, net			1,091				1,067
Net (gain) loss on sale of investment securities			(783	)			200
Net impairment losses on investment securities			64				83
Origination of loans held for sale			(100,883	)			(360,979	)
Proceeds from sale of loans held for sale			101,158				395,279
Net gain on sale of loans			(2,127	)			(7,388	)
Provision for loan losses			(1,304	)			950
Valuation adjustments for OREO			4,627				13,575
Provision for unfunded loan commitments			(1,621	)			3,133
Gain on sale of OREO			(2,188	)			(3,479	)
Depreciation and amortization			1,880				1,903
Loss on disposal of premises and equipment, net			83				79
Mortgage servicing rights impairment (recovery)			42				(3,914	)
Impairment of real estate held for development and sale			—				212
Extinguishment of debt			—				(134,514	)
Decrease in accrued interest receivable			749				1,541
Decrease in other assets			1,082				7,987
Increase (decrease) in accrued interest payable			(19	)			11,236
Decrease in accrued taxes, insurance and employee related expenses			(769	)			(257	)
Increase (decrease) in other liabilities			247				(6,521	)
Stock based compensation			328				—
Net cash provided by operating activities			11,156				14,042
Investing Activities
Proceeds from sale of investment securities			12,169				6,420
Purchase of investment securities			(63,584	)			(88,162	)
Principal collected on investment securities			39,732				42,702
Decrease in loans held for investment			27,298				128,717
Purchases of premises and equipment			(3,220	)			(1,005	)
Proceeds from sale of OREO			23,408				40,480
Capitalized improvements of OREO			(28	)			(607	)
Net cash provided by investing activities			35,775				128,545

 

(Continued)

 

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ANCHOR BANCORP WISCONSIN INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

		Nine Months Ended September 30,
		2014				2013
		(In thousands)
Financing Activities
Decrease in deposits		$	(73,976	)		$	(169,729	)
Increase in advance payments by borrowers for taxes and insurance			57,490				57,824
Proceeds from borrowed funds			79,565				720,739
Repayment of borrowed funds			(79,382	)			(950,793	)
Issuance of common stock			—				175,000
Recapitalization transaction fees			—				(14,380	)
Net cash used in financing activities			(16,303	)			(181,339	)
Net increase (decrease) in cash and cash equivalents			30,628				(38,752	)
Cash and cash equivalents at beginning of period			143,396				191,280
Cash and cash equivalents at end of period		$	174,024			$	152,528
Supplemental disclosures of cash flow information:
Cash paid (received) or credited to accounts:
Interest on deposits and borrowings		$	3,314			$	17,111
Income tax payments (receipts)			15				(1,728	)
Non-cash transactions:
Transfer of loans to OREO			9,084				25,866

See accompanying Notes to Unaudited Consolidated Financial Statements

 

 

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ANCHOR BANCORP WISCONSIN INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The unaudited consolidated financial statements include the accounts and results of operations of Anchor BanCorp Wisconsin Inc. (the “Corporation” or the “Company”) and its wholly-owned subsidiaries, AnchorBank, fsb (the “Bank”) and Investment Directions, Inc. (“IDI”). The Bank has one subsidiary at September 30, 2014: ADPC Corporation. Significant inter-company balances and transactions have been eliminated.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (including normal recurring accruals) necessary for a fair presentation of the unaudited interim consolidated financial statements have been included.

In preparing the unaudited consolidated financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, the net carrying value of mortgage servicing rights and deferred tax assets, reserves for unfunded commitments and repurchased loans, and the fair value of investment securities, interest rate lock commitments, forward contracts to sell mortgage loans, and loans held for sale. The results of operations and other data for the three and nine month periods ended September 30, 2014 are not necessarily indicative of results that may be expected for the year ending December 31, 2014. We have evaluated all subsequent events through the date of this filing. The interim unaudited consolidated financial statements presented herein should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Corporation’s Annual Report on Form 10-K/T for the transition period ended December 31, 2013.

Change in Fiscal Year End. On December 18, 2013, the Board approved the change of our fiscal year end from March 31 to December 31, beginning with December 31, 2013. References to any previous fiscal years mean the fiscal years ended on March 31. As a result of the change in fiscal year end, the consolidated financial statements include the Company’s financial results for the nine month period from January 1, 2013 to September 30, 2013 of which January 1, 2013 to March 31, 2013 results were previously included in the fiscal year ended March 31, 2013 results.

Reclassifications. Certain prior period amounts are reclassified to conform to the current period presentations with no impact on net income or total stockholders’ equity when applicable.

Note 2 – Significant Transactions, Significant Risks and Uncertainties

Initial Public Offering

In October 2014, the Company completed its initial public offering (the “IPO”) in which the Company issued and sold 250,000 shares of common stock at a public offering price of $26.00 per share. The Company originally filed the registration statement on Form S-1 on December 20, 2013. The Company also granted the underwriters a 30-day option to purchase up to 55,794 additional shares of common stock to cover any over-allotments which the underwriters exercised and closed on October 30, 2014. The Company received net proceeds of $6.1 million after deducting underwriting discounts and commissions of $422,500. Other offering expenses of approximately $1.8 million will be recorded against the proceeds received from the IPO. Certain selling stockholders offered an additional 121,959 shares of common stock in the IPO. The Company did not receive any proceeds from the sale of the shares sold by the selling stockholders. The Company’s shares are now listed on the NASDAQ Global Select Market under the symbol “ABCW.”

 

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Bankruptcy Proceedings and Emergence from Chapter 11

Background

Headquartered in Madison, Wisconsin, the Company is a savings and loan holding company that operates primarily through AnchorBank, its wholly owned banking subsidiary. The Bank is a $2.11 billion bank and Wisconsin’s largest thrift and offers personal and business banking services to more than 110,000 households and businesses.

As a result of the economic downturn that began in 2008, the Company experienced significant operating losses beginning in fiscal 2009, significant levels of criticized assets, depleted levels of capital and difficulty in raising additional capital necessary to stabilize the Bank as required by our banking regulators. As a result, in 2009 both the Company and the Bank became subject to Orders to Cease and Desist issued by the Office of Thrift Supervision. Also, the Company owed $183.5 million under a credit facility, which we were unable to repay, and issued $110.0 million of Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the “TARP Preferred Stock”) to the United States Department of the Treasury (the “Treasury”) as part of the Troubled Asset Relief Program (“TARP”) in 2009. In order to facilitate our restructuring and the recapitalization of the Bank, on August 12, 2013 (the “Petition Date”), the Company filed a voluntary petition for relief (the “Chapter 11 Case”) under the provisions of Chapter 11 of title 11 of the United States Code, 11 U.S.C. §§ 101, et seq., in the United States Bankruptcy Court for the Western District of Wisconsin (the “Bankruptcy Court”) to implement a “pre-packaged” plan of reorganization (the “Plan of Reorganization”).

Plan of Reorganization

Pursuant to the Plan of Reorganization, the following transactions (collectively, the “Recapitalization”) were consummated on September 27, 2013 (the “Effective Date”):

 

•

we entered into stock purchase agreements (the “Investor SPAs”) on August 12, 2013 with certain institutional investors, other private investors and directors and officers of the Company (the “Investors”), pursuant to which we issued and sold our common stock to (i) certain Investors such that each such Investor owns up to 9.9% (the “9.9% Investors”) of the common stock for an aggregate purchase price of $87.8 million, (ii) certain other Investors such that each such Investor owns up to 4.9% of our common stock (the “4.9% Investors”) for an aggregate purchase price of $83.7 million, and (iii) certain directors and officers of the Company for an aggregate purchase price of $3.5 million (collectively, the “Private Placements”). We received gross proceeds of $175.0 million, implying a purchase price of $20 per share after giving effect to the reverse stock split, as a result of the Private Placements and incurred transaction costs of $14.4 million;

 

•

we (i) exchanged the TARP Preferred Stock for 60.0 million shares (adjusted to 300,000 common shares as a result of the reverse stock split) of common stock (the “Treasury Issuance”) and (ii) cancelled a warrant (the “TARP Warrant”) to purchase up to 7,399,103 shares of our pre-recapitalization common stock, par value $0.10 per share (the “Legacy Common Stock”) in its entirety (collectively, the “TARP Exchange”);

 

•

we satisfied all of our obligations under the Amended and Restated Credit Agreement, dated as of June 9, 2008 (the “Credit Agreement”), among us, the lenders from time to time a party thereto (the “Lenders”), and the U.S. Bank National Association (“U.S. Bank”), as administrative agent (the “Administrative Agent”) for the Lenders with a cash payment to the Lenders of $49.0 million (plus expense reimbursement as contemplated by the Credit Agreement) and recognized a gain on extinguishment of debt of $134.5 million;

 

•

we converted from a Wisconsin corporation to a Delaware corporation and filed a certificate of incorporation with the Secretary of State of the State of Delaware (the “Amended Charter”), to, among other things, declassify our board of directors (the “Board”), increase the number of authorized shares of our common stock and preferred stock and adopt certain restrictions on acquisitions and dispositions of our securities; and

 

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•

all shares of issued and outstanding legacy Common Stock were cancelled.

Following the effectiveness of the Plan of Reorganization, the Treasury sold to certain institutional investors (the “Secondary Investors”) all of the shares of common stock delivered to the Treasury in connection with the Treasury Issuance (the “Secondary Treasury Sales”). In connection with the Secondary Treasury Sales, we entered into secondary sale purchaser agreements (the “Secondary SPAs”) with the Secondary Investors pursuant to which we made certain representations and warranties to the Secondary Investors and provided rights to the Secondary Investors similar to the rights provided under the Investor SPAs. As a result of the Secondary Treasury Sales, the Treasury ceased to be our stockholder.

Emergence Accounting

Upon emergence, we determined we did not meet the requirements to apply fresh start reporting under applicable accounting standards because we did not meet the solvency criteria of Accounting Standards Codification (ASC) 852-10-45-19. The reorganization value immediately before the date of confirmation was greater than the total of all post-petition liabilities and allowed claims and, therefore, indicative of not meeting the test to require fresh start accounting under ASC 852. As of the date of confirmation, we estimated our enterprise value (or reorganization value) to be approximately $2.2 billion. The Company utilized the equity value using the income and market approach to approximate fair value. Accordingly, our consolidated financial statements do not include fresh start reporting, whereby the Company would have to revalue all of its assets and liabilities. At the time of filing for the Chapter 11 Case, we identified liabilities subject to compromise of $188.3 million, which included the outstanding Credit Agreement of approximately $116.3 million, interest and fees due under the Credit Agreement of $67.2 million and $4.8 million in other liabilities.

Regulatory Agreements

The Bank’s primary regulator is the Office of the Comptroller of the Currency (“OCC”). The Federal Reserve is the primary regulator of the Corporation. On June 26, 2009, the Corporation and the Bank each consented to the issuance of an Order to Cease and Desist (the “Corporation Order” and the “Bank Order,” respectively). On August 31, 2010, a Prompt and Corrective Action Directive (“PCA Directive”) was issued for the Bank.

The Corporation Order required the Corporation to notify, and in certain cases to obtain the permission of, the Federal Reserve prior to making dividends or capital distributions, incurring debt, making changes to or entering into contracts with directors or executive officers.

The Bank Order required the Bank to notify, or in certain cases obtain the permission of, the OCC prior to increases above a certain threshold in total assets, entering into brokered deposits, making changes to or entering into contracts with directors or executives officers, entering into certain transactions with affiliates or entering into third-party contracts outside the normal course of business and to meet and maintain both a core capital ratio and a total risk-based capital ratio.

On April 2, 2014, the Bank was notified that the Bank Order and the PCA Directive were terminated. On July 31, 2014, the Corporation was notified that the Corporation Order was terminated.

Purchase Agreement to Sell Bank Headquarters

In February 2014, the Bank entered into a purchase agreement with an unrelated third party to sell the Bank’s main office building located at 25 West Main Street, Madison, Wisconsin, the adjacent surface parking lot immediately behind the main office building at 115 South Carroll Street and the 261-stall parking ramp located at 126 South Carroll Street. The sale is expected to close during the fourth quarter of 2014 and the Bank will lease a portion of the space after the sale. We expect to record a gain on the sale of the office building for the quarterly period ending December 31, 2014.

 

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Note 3 – Recent Accounting Pronouncements

Accounting Standards Update (ASU) 2014-14, “Classification of Certain Government-Guaranteed Mortgage Loans Upon Foreclosure” – a consensus of the FASB Emerging Issues Task Force. The ASU requires creditors to reclassify mortgage loans as an other receivable that is separate from loans and to measure the receivable at the amount expected to be received under the government guarantee if the mortgage loan meets certain conditions upon foreclosure. For public business entities, the amendments in the ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. Early adoption, including adoption in an interim period, is permitted if the entity already has adopted ASU 2014-04. This ASU currently has no impact on the Company as the Bank does not own or service any government-guaranteed mortgage loans.

ASU 2014-12, “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved After the Requisite Service Period.” The ASU clarifies that entities should treat performance targets that can be met after the requisite service period of a share-based payment award as performance conditions that affect vesting. Therefore, an entity would not record compensation expense (measured as of the grant date without taking into account the effect of the performance target) related to an award for which transfer to the employee is contingent on the entity’s satisfaction of a performance target until it becomes probable that the performance target will be met. The ASU does not contain any new disclosure requirements and is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. This ASU currently has no impact on the Company.

ASU 2014-11, “Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures” makes limited amendments to the guidance in ASC 860 on accounting for certain repurchase agreements (“repos”). The ASU (1) requires entities to account for repurchase-to-maturity transactions as secured borrowings (rather than as sales with forward repurchase agreements), (2) eliminates accounting guidance on linking repurchase financing transactions, and (3) expands disclosure requirements related to certain transfers of financial assets that are accounted for as sales and certain transfers (specifically, repos, securities lending transactions and repurchase-to-maturity transactions) accounted for as secured borrowings. In addition, the ASU provides examples of repurchase and securities lending arrangements that illustrate whether a transferor has maintained effective control over the transferred financial assets. The accounting changes in the ASU are effective for public business entities for the first interim or annual period beginning after December 15, 2014. Early adoption is prohibited. This ASU will have no effect on the Company.

ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40)—Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” These amendments are intended to clarify when a creditor should be considered to have received physical possession of residential real estate property when collateralizing a consumer mortgage loan such that the loan should be derecognized and the real estate recognized. Further, this amendment clarifies that an in-substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either: (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure, or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. ASU 2014-04 is effective for public companies for annual periods and interim periods within those annual periods beginning after December 15, 2014. The Corporation has not yet evaluated the effect this ASU will have on its consolidated financial statements.

ASC Topic 740 “Income Taxes.” New authoritative accounting guidance under ASC Topic 740, “Income Taxes” amended prior guidance to include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such

 

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purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The authoritative guidance is effective for reporting periods after January 1, 2014. The Company is in compliance with these requirements and adoption did not have an impact on the consolidated financial statements.

Note 4 – Investment Securities

The amortized cost and fair value of investment securities are as follows:

 

		Amortized				Gross Unrealized								Fair
		Cost				Gains				Losses				Value
		(In thousands)
September 30, 2014
Available for sale:
U.S. government sponsored and federal agency obligations		$	3,274			$	17			$	—			$	3,291
Corporate stock and bonds			1				3				—				4
Non-agency CMOs (1)			5,706				38				(83	)			5,661
Government sponsored agency mortgage-backed securities (1)			104,261				171				(634	)			103,798
GNMA mortgage-backed securities (1)			182,563				481				(3,931	)			179,113
		$	295,805			$	710			$	(4,648	)		$	291,867
December 31, 2013
Available for sale:
U.S. government sponsored and federal agency obligations		$	3,359			$	17			$	—			$	3,376
Corporate stock and bonds			88				267				—				355
Non-agency CMOs (1)			6,452				9				(253	)			6,208
Government sponsored agency mortgage-backed securities (1)			50,721				160				(723	)			50,158
GNMA mortgage-backed securities (1)			223,874				1,056				(7,155	)			217,775
		$	284,494			$	1,509			$	(8,131	)		$	277,872

 

(1)	CMOs (collateralized mortgage obligations), government sponsored agencies and GNMA (Ginnie Mae) mortgage-backed securities are primarily collateralized by residential mortgages.

Independent pricing services are used to value all investment securities. One pricing service is used to value all securities except the non-agency CMOs. A specialized pricing service is used for valuation of the non-agency CMO portfolio.

To estimate the fair value of non-agency CMOs, the pricing service valuation model discounted estimated expected cash flows after credit losses at rates ranging from 4.0% to 6.5%. The rates utilized are based on the risk free rate equivalent to the remaining average life of the security, plus a spread for normal liquidity and a spread to reflect the uncertainty of the cash flow estimates. The pricing service benchmarks its fair value results to other pricing services and monitors the market for actual trades. The cash flow model includes these inputs in its derivation of the discount rates used to estimate fair value. There are no payments in kind allowed on these non-agency CMOs.

 

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The table below presents the fair value and gross unrealized losses of securities in a loss position, aggregated by investment category and length of time that individual holdings have been in a continuous unrealized loss position.

 

		Unrealized Loss Position
		Less than 12 months								12 months or More								Total
						Unrealized								Unrealized								Unrealized
		Fair Value				Loss				Fair Value				Loss				Fair Value				Loss
		(In thousands)
September 30, 2014
Non-agency CMOs		$	—			$	—			$	2,859			$	(83	)		$	2,859			$	(83	)
Government sponsored agency mortgage-backed securities (1)			49,065				(357	)			8,495				(277	)			57,560				(634	)
GNMA mortgage-backed securities			41,652				(278	)			101,378				(3,653	)			143,030				(3,931	)
		$	90,717			$	(635	)		$	112,732			$	(4,013	)		$	203,449			$	(4,648	)
December 31, 2013
Non-agency CMOs		$	1,219			$	(7	)		$	4,776			$	(246	)		$	5,995			$	(253	)
Government sponsored agency mortgage-backed securities (1)			47,480				(723	)			—				—				47,480				(723	)
GNMA mortgage-backed securities			140,824				(5,143	)			25,449				(2,012	)			166,273				(7,155	)
		$	189,523			$	(5,873	)		$	30,225			$	(2,258	)		$	219,748			$	(8,131	)

 

(1)	Includes mortgage-backed securities and CMOs.

In 2008, the Company received proceeds in connection with shares redeemed as part of the Visa, Inc. initial public offering. The Bank was a member of the former Visa, Inc. payments organization and was issued shares when Visa, Inc. was organized. Approximately 39% of those shares were redeemed in connection with the public offering. The remaining shares are restricted because of unsettled litigation pending against Visa, Inc. At its discretion, Visa, Inc. may redeem additional shares in order to resolve pending litigation. The restriction expires upon resolution of the pending litigation. Accordingly, the Company has recorded these shares at zero in the Consolidated Balance Sheets. Upon expiration of the restriction, the Company expects to record the fair value of the remaining shares.

Other-Than-Temporary Impairment

The number of individual securities in the tables above total 36 at September 30, 2014 and 35 at December 31, 2013. Although these securities have declined in value at some point, the unrealized losses are considered temporary. Management evaluates securities for other-than-temporary impairment on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. In estimating other-than-temporary impairment losses on investment securities, management considers many factors which include: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment for a period of time sufficient to allow for any anticipated recovery in fair value.

To determine if an other-than-temporary impairment exists on a debt security with an unrealized loss, the Corporation first determines if (a) it intends to sell the security or (b) it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of the conditions is met, an other-than-temporary impairment loss is recognized in earnings equal to the difference between the security’s fair value and its amortized cost basis. If neither condition is met, the Corporation determines (a) the amount of the impairment related to credit loss and (b) the amount of the impairment due to all other factors. The difference between the present values of the cash flows expected to be collected, discounted at the purchase yield or current accounting yield of the security, and the amortized cost basis is the credit loss. The credit loss is the portion of the impairment that is deemed other-than-temporary and recognized in earnings and is a reduction in the cost basis of the security. The portion of impairment related to all other factors is deemed temporary and included in other comprehensive loss.

 

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An independent pricing service is utilized to run a discounted cash flow model in the calculation of other-than-temporary impairment losses on non-agency CMOs. This model determines the portion of the impairment that is other-than-temporary due to credit losses, and the portion that is temporary due to all other factors.

The significant inputs used for calculating the credit loss portion of securities with other-than-temporary impairment include prepayment assumptions, loss severities, original FICO scores, historical rates of delinquency, percentage of loans with limited underwriting, historical rates of default, original loan-to-value ratio, aggregate property location by metropolitan statistical area, original credit support, current credit support, and weighted-average maturity.

The discount rates used to establish the net present value of expected cash flows for purposes of determining OTTI ranged from 4.0% to 6.5%. These rates equate to the effective yield implicit in the security at the date of acquisition of the bonds for which OTTI has not been previously incurred. For bonds with previously recorded OTTI, the discount rate used equates to the accounting yield on the security as of the valuation date.

Default rates were calculated separately for each category of underlying borrower based on delinquency status (i.e. current, 30 to 59 days delinquent, 60 to 89 days delinquent, 90+ days delinquent, and foreclosure balances) of the underlying loans as of September 30, 2014. This data is entered into a loss migration model to calculate projected default rates, which are benchmarked against results that have recently been experienced by other major servicers of non-agency CMOs with similar attributes. The month one to month 24 constant default rate in the model ranged from 5.77% to 12.5%.

At September 30, 2014, five non-agency CMOs with a fair value of $5.6 million and an adjusted cost basis of $5.6 million were other-than-temporarily impaired. At December 31, 2013, six non-agency CMOs with a fair value of $6.2 million and an adjusted cost basis of $6.4 million were other-than-temporarily impaired. Unrealized other-than-temporary impairment due to credit losses of $30,000 and $64,000 was included in earnings for the three and nine months ended September 30, 2014 and zero and $83,000 for the three and nine months ended September 30, 2013, respectively. For the three months ended September 30, 2014 and 2013, net realized losses of $48,000 and $90,000, respectively, and $161,000 and $331,000 for the nine month periods ended September 30, 2014 and 2013, respectively, related to credit issues (i.e. – principal reduced without a receipt of cash) were incurred that were previously recognized in earnings as unrealized other-than-temporary impairment.

Unrealized losses on U.S. government sponsored and federal agency obligations, corporate stocks and bonds and GNMA mortgage-backed securities as of September 30, 2014 and December 31, 2013 due to changes in interest rates and other non-credit related factors totaled $4.6 million and $7.9 million, respectively. The Corporation has analyzed these securities for evidence of other-than-temporary impairment and concluded that no OTTI exists and that the unrealized losses are properly classified in accumulated other comprehensive loss.

 

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The following table is a roll forward of the amount of other-than-temporary impairment related to credit losses that have been recognized in earnings for which a portion of impairment was deemed temporary and recognized in other comprehensive loss for the periods presented:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(In thousands)
Beginning balance of unrealized OTTI related to credit losses		$	722			$	934			$	801			$	1,778
Additional unrealized OTTI related to credit losses for which OTTI was previously recognized			30				—				64				83
Debit related OTTI previously recognized for OTTI recovery during the period			—				1				3				4
Credit related OTTI previously recognized for securities sold during the period			—				—				—				(686	)
Decrease for realized amount of credit losses for which unrealized credit related OTTI was previously recognized			(48	)			(91	)			(164	)			(335	)
Ending balance of unrealized OTTI related to credit losses		$	704			$	844			$	704			$	844

On a cumulative basis, other-than-temporary impairment losses recognized in earnings by year of vintage were as follows:

 

		September 30,
Year of Vintage		2014
		(In thousands)
Prior to 2005		$	7
2005			207
2006			—
2007			490
		$	704

The cost of investment securities sold is determined using the specific identification method. Sales of investment securities available for sale are summarized below:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Proceeds from sales		$	11,781			$	—			$	12,169			$	6,420
Gross gains		$	482			$	—			$	783			$	1
Gross losses			—				—				—				(201	)
Net gain/(loss) on sales		$	482			$	—			$	783			$	(200	)

At September 30, 2014 and December 31, 2013, investment securities available for sale with a fair value of approximately $119.9 million and $162.8 million, respectively, were pledged to secure deposits, borrowings and for other purposes as permitted or required by law.

 

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The fair values of investment securities by contractual maturity at September 30, 2014 are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties.

 

		Within 1 Year				After 1 Year through 5 Years				After 5 Years through 10 Years				Over Ten Years				Total
		(In thousands)
U.S. government sponsored and federal agency obligations		$	—			$	3,291			$	—			$	—			$	3,291
Corporate stock and bonds			—				—				—				4				4
Non-agency CMOs			—				—				3				5,658				5,661
Government sponsored agency mortgage-backed securities (1)			—				105				12,507				91,186				103,798
GNMA mortgage-backed securities			—				214				—				178,899				179,113
Total		$	—			$	3,610			$	12,510			$	275,747			$	291,867

 

(1)	Includes mortgage-backed securities and CMOs.

 

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Note 5 – Loans Receivable

Loans receivable held for investment consist of the following:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Residential		$	541,598			$	529,777
Commercial and industrial			14,443				21,591
Commercial real estate:
Land and construction			99,394				92,050
Multi-family			264,425				281,917
Retail/office			143,510				154,075
Other commercial real estate			162,344				174,313
Consumer:
Education			112,668				129,520
Other consumer			230,556				238,311
Total unpaid principal balance			1,568,938				1,621,554
Undisbursed loan proceeds(1)			(10,950	)			(10,322	)
Unamortized loan fees, net			(1,701	)			(1,722	)
Unearned interest			(4	)			(4	)
Total loan contra balances			(12,655	)			(12,048	)
Loans held for investment			1,556,283				1,609,506
Allowance for loan losses			(47,037	)			(65,182	)
Loans held for investment, net		$	1,509,246			$	1,544,324

 

(1)	Undisbursed loan proceeds are funds to be released upon a draw request approved by the Corporation.

Residential Loans

At September 30, 2014, $541.6 million, or 34.5%, of the total loans unpaid principal balance receivable consisted of residential loans, substantially all of which were 1-to-4 family dwellings. Residential loans consist of both adjustable and fixed-rate loans. The adjustable-rate loans currently in the portfolio were originated with up to 30-year maturities and terms which provide for annual increases or decreases of the rate on the loans, based on a designated index. These rate changes are generally subject to a limit of 2% per adjustment and an aggregate 6% adjustment over the life of the loan. These loans are documented according to standard industry practices. The Corporation makes a limited number of interest-only loans which tend to have a shorter term to maturity and does not originate negative amortization and option payment adjustable rate mortgages.

Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, thereby increasing the potential for default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates. These risks, which have not had a material adverse effect to date, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment. Also, as interest rates decline, borrowers may refinance their mortgages into fixed-rate loans thereby prepaying the balance of the loan prior to maturity. At September 30, 2014, approximately $316.1 million, or 58.4%, of the held for investment residential loans unpaid principal balance consisted of loans with adjustable interest rates.

The Corporation continues to originate long-term, fixed-rate conventional mortgage loans. Current production of these loans with terms of 15 years or more are generally sold to Fannie Mae, Freddie Mac and other institutional investors, while a portion of loan production is retained in the held for investment portfolio. In order to provide a full range of products to its customers, the Corporation also participates in the loan origination programs of Wisconsin Housing and Economic Development Authority, Wisconsin Department of Veterans Affairs and the Federal Housing Administration. The right to service substantially all loans sold is retained.

 

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At September 30, 2014, approximately $225.5 million, or 41.6%, of the held for investment residential loans unpaid principal balance consisted of loans with fixed rates of interest. Although these loans generally provide for repayments of principal over a fixed period of 10 to 30 years, because of prepayments and due-on-sale clauses, such loans generally remain outstanding for a shorter period of time.

Commercial and Industrial Loans

The Corporation originates loans for commercial and business purposes, including issuing letters of credit. At September 30, 2014, the unpaid principal balance receivable of commercial and industrial loans amounted to $14.4 million, or 0.9%, of the total loans unpaid principal balance receivable. The commercial and industrial loan portfolio is comprised of loans for a variety of business purposes which are generally secured by equipment, machinery and other corporate assets. These loans generally have terms of seven years or less and interest rates that float in accordance with a designated published index. Substantially all such loans are secured and backed by the personal guarantees of the owners of the business.

Commercial Real Estate Loans

The Corporation originates commercial real estate loans which include land and construction, multi-family, retail/office and other commercial real estate. Such loans generally have adjustable rates and shorter terms than single-family residential loans, thus increasing the earnings sensitivity of the loan portfolio to changes in interest rates, as well as providing higher fees and rates than residential loans. At September 30, 2014, $669.7 million of loans unpaid principal balance receivable were secured by commercial real estate, which represented 42.7% of the total loans unpaid principal balance. The origination of such loans is generally limited to the Corporation’s primary market area, concentrated in Wisconsin’s greater Madison, Fox Valley and Milwaukee regions. Loans are made in contiguous states when appropriate.

Commercial real estate loans are primarily secured by apartment buildings, office and industrial buildings, land, warehouses, small retail shopping centers and various special purpose properties, including community-based residential facilities and senior housing. Although terms vary, commercial real estate loans generally have fixed interest rates, amortization periods of 15 to 30 years, as well as balloon payments of two to seven years.

Consumer Loans

The Corporation offers consumer loans in order to provide a wider range of financial services to its customers. At September 30, 2014, $343.2 million, or 21.9%, of the total loans unpaid principal balance receivable consisted of consumer loans. Consumer loans consist of education loans, first and second mortgages, credit cards, vehicles and other unsecured personal loans. Consumer loans typically have higher interest rates than mortgage loans and generally involve more risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral.

Approximately $112.7 million, or 7.2%, of the total loans unpaid principal balance receivable at September 30, 2014 consisted of education loans. These loans are generally made for a maximum of $3,500 per year for undergraduate studies and $8,500 per year for graduate studies and are placed in repayment status on an installment basis within nine months following graduation. Education loans generally have interest rates that adjust annually in accordance with a designated index. Both the principal amount of an education loan and interest thereon are generally guaranteed by the Great Lakes Higher Education Corporation up to 97% of the balance of the loan, which typically obtains reinsurance of its obligations from the U.S. Department of Education. The origination of student loans was discontinued October 1, 2010 following the March 2010 law ending loan guarantees provided by the U.S. Department of Education. Although direct student loans, without a government guarantee, may be originated, risk-adjusted returns for these loans continue to be unattractive. Education loans may be sold to the U.S. Department of Education or to other investors. No education loans were sold during the three and nine months ended September 30, 2014 or 2013.

 

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The residential loans included in the consumer portfolio include both first and second mortgages and consist primarily of the Express loan product (the Bank’s expedited first mortgage refinance and home equity loan product). Express loans are available for owner occupied one- to two-family residential properties, with loan amounts up to $200,000, a fixed interest rate, up to 15 year amortization, low fees and rapid closing timeframes. The primary home equity loan product has an adjustable rate that is linked to the prime interest rate and is secured by a mortgage, either a primary or a junior lien, on the borrower’s residence. New home equity lines do not exceed 90% of appraised value of the property at the loan origination date. A fixed-rate home equity second mortgage term product is also offered.

Other consumer loans consist of credit cards, vehicle loans and other secured and unsecured loans made for a variety of consumer purposes. Credit is extended to Bank customers through credit cards issued by a third party, ELAN Financial Services (ELAN), pursuant to an agency arrangement under which the Corporation participates in outstanding balances, currently at 25% to 28%. The Corporation also shares 33% to 37% of annual fees, and 30% of late payment, over limit and cash advance fees, as well as 25% to 30% of interchange income from the underlying portfolio net of our share of losses.

Allowances for Loan Losses

The allowance for loan losses consists of general and specific components even though the entire allowance is available to cover losses on any loan. The specific allowance component relates to impaired loans (i.e. – non-accrual) and all loans reported as troubled debt restructurings. For such loans, an allowance is established when the discounted cash flows (or collateral value if repayment relies solely on the operation or sale of the collateral) of the impaired loan are lower than the carrying value of that loan. The general allowance component is based on historical loss experience adjusted for various qualitative factors. Loans graded substandard and below are individually examined to determine the appropriate loan loss reserve. In addition, reserves for unfunded commitments, letters of credit and repurchase of sold loans are maintained and classified in other liabilities.

Beginning with the quarter ended June 30, 2014, the Bank modified its general allowance methodology to increase the historical loss period by an additional period each quarter until the historical look-back period is built to a 12 quarter look back period. For the quarter ended September 30, 2014, the Bank utilized a ten quarter look-back period compared to a nine quarter look back period for the quarter ended June 30, 2014. The modification is being done to reflect a more stable economic environment and to capture additional loss statistics considered reflective of the current portfolio. The impact to the allowance for loan losses at September 30, 2014 after implementing the above modification was a reduction of the required reserve of $92,000 as compared to the previous methodology. See the Company’s annual report on Form 10-K/T for the nine months ended December 31, 2013 for a full description of the allowance methodology.

The following table presents the allowance for loan losses by component:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
General reserve		$	33,447			$	35,844
Substandard reserve			8,083				6,225
Specific reserve			5,507				23,113
Total allowance for loan losses		$	47,037			$	65,182

 

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The following table presents the unpaid principal balance of loans by risk category:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Pass (1)		$	1,491,285			$	1,460,457
Special mention			6,211				24,203
Total pass and special mention rated loans			1,497,496				1,484,660
Substandard rated loans, excluding TDR accrual (2)			21,294				35,310
Troubled debt restructurings—accrual			11,796				33,087
Non-accrual			38,352				68,497
Total impaired loans			50,148				101,584
Total unpaid principal balance		$	1,568,938			$	1,621,554

 

(1)	Includes TDR accruing loans of $53.2 million and $31.2 million at September 30, 2014 and December 30, 2013, respectively.

(2)	Includes residential and consumer loans identified as substandard that are not necessarily on non-accrual.

The following table presents activity in the allowance for loan losses by portfolio segment:

 

For the Three Months Ended:		Residential				Commercial and Industrial				Commercial Real Estate				Consumer				Total
		(In thousands)
September 30, 2014
Beginning balance		$	10,325			$	2,596			$	31,170			$	5,084			$	49,175
Provision			(303	)			(2,727	)			852				874				(1,304	)
Charge-offs			(194	)			(168	)			(3,260	)			(380	)			(4,002	)
Recoveries			31				1,757				1,331				49				3,168
Ending balance		$	9,859			$	1,458			$	30,093			$	5,627			$	47,037
September 30, 2013
Beginning balance		$	15,122			$	5,842			$	50,806			$	4,102			$	75,872
Provision			(790	)			907				(332	)			215				—
Charge-offs			(712	)			(2,357	)			(1,849	)			(486	)			(5,404	)
Recoveries			83				316				861				125				1,385
Ending balance		$	13,703			$	4,708			$	49,486			$	3,956			$	71,853

 

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For the Nine Months Ended:		Residential				Commercial and Industrial				Commercial Real Estate				Consumer				Total
		(In thousands)
September 30, 2014
Beginning balance		$	13,059			$	6,402			$	42,065			$	3,656			$	65,182
Provision			(1,731	)			(2,354	)			(699	)			3,480				(1,304	)
Charge-offs			(1,856	)			(5,123	)			(15,162	)			(1,815	)			(23,956	)
Recoveries			387				2,533				3,889				306				7,115
Ending balance		$	9,859			$	1,458			$	30,093			$	5,627			$	47,037
September 30, 2013
Beginning balance		$	12,174			$	6,591			$	62,269			$	2,727			$	83,761
Provision			5,506				1,006				(10,327	)			4,765				950
Charge-offs			(4,241	)			(3,492	)			(5,361	)			(3,806	)			(16,900	)
Recoveries			264				603				2,905				270				4,042
Ending balance		$	13,703			$	4,708			$	49,486			$	3,956			$	71,853

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method:

 

		Residential				Commercial and Industrial				Commercial Real Estate				Consumer				Total
		(In thousands)
September 30, 2014
Allowance for loan losses:
Associated with impaired loans		$	503			$	147			$	4,428			$	429			$	5,507
Associated with all other loans			9,356				1,311				25,665				5,198				41,530
Total		$	9,859			$	1,458			$	30,093			$	5,627			$	47,037
Loans:
Impaired loans individually evaluated		$	8,829			$	193			$	39,659			$	1,467			$	50,148
All other loans			532,769				14,250				630,014				341,757				1,518,790
Total		$	541,598			$	14,443			$	669,673			$	343,224			$	1,568,938
December 31, 2013
Allowance for loan losses:
Associated with impaired loans		$	2,375			$	1,745			$	18,516			$	477			$	23,113
Associated with all other loans			10,684				4,657				23,549				3,179				42,069
Total		$	13,059			$	6,402			$	42,065			$	3,656			$	65,182
Loans:
Impaired loans individually evaluated		$	19,060			$	2,314			$	77,047			$	3,163			$	101,584
All other loans			510,717				19,277				625,308				364,668				1,519,970
Total		$	529,777			$	21,591			$	702,355			$	367,831			$	1,621,554

At September 30, 2014, $50.1 million of unpaid principal balance of loans are deemed impaired which includes performing troubled debt restructurings. At December 31, 2013, impaired loans were $101.6 million. A loan is identified as impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement may not be collected and thus are placed on non-accrual status. Interest income on certain impaired loans is recognized on a cash basis.

 

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A substantial portion of loans are collateralized by real estate in Wisconsin and adjacent states. Accordingly, the ultimate collectability of the loan portfolio is susceptible to changes in real estate market conditions in that area.

The following table presents impaired loans segregated by loans with no specific allowance and loans with an allowance by class of loans. The carrying amounts represent the unpaid principal balance less the associated allowance. The interest income recognized column represents all interest income recorded either on a cash or accrual basis after the loan became impaired.

 

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		Unpaid												Average				Year-to-Date
		Principal				Associated				Carrying				Carrying				Interest Income
		Balance				Allowance				Amount				Amount (1)				Recognized
		(In thousands)
September 30, 2014
With no specific allowance recorded:
Residential		$	4,751			$	—			$	4,751			$	5,221			$	100
Commercial and industrial			—				—				—				1,552				77
Land and construction			11,325				—				11,325				13,617				457
Multi-family			6,373				—				6,373				5,996				417
Retail/office			3,305				—				3,305				3,520				144
Other commercial real estate			8,149				—				8,149				8,712				531
Education			209				—				209				240				—
Other consumer			706				—				706				1,037				52
Subtotal			34,818				—				34,818				39,895				1,778
With an allowance recorded (2):
Residential		$	4,078			$	503			$	3,575			$	3,598			$	134
Commercial and industrial			193				147				46				108				—
Land and construction			7,153				3,675				3,478				4,552				141
Multi-family			450				104				346				338				9
Retail/office			1,857				455				1,402				1,700				65
Other commercial real estate			1,047				194				853				909				26
Education (3)			—				—				—				—				—
Other consumer			552				429				123				352				19
Subtotal			15,330				5,507				9,823				11,557				394
Total
Residential		$	8,829			$	503			$	8,326			$	8,819			$	234
Commercial and industrial			193				147				46				1,660				77
Land and construction			18,478				3,675				14,803				18,169				598
Multi-family			6,823				104				6,719				6,334				426
Retail/office			5,162				455				4,707				5,220				209
Other commercial real estate			9,196				194				9,002				9,621				557
Education (3)			209				—				209				240				—
Other consumer			1,258				429				829				1,389				71
		$	50,148			$	5,507			$	44,641			$	51,452			$	2,172

 

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																		Nine Months Ended
		Unpaid												Average				December 31, 2013
		Principal				Associated				Carrying				Carrying				Interest Income
		Balance				Allowance				Amount				Amount (1)				Recognized
		(In thousands)
December 31, 2013
With no specific allowance recorded:
Residential		$	3,751			$	—			$	3,751			$	4,032			$	43
Commercial and industrial			60				—				60				79				39
Land and construction			4,311				—				4,311				4,707				91
Multi-family			9,848				—				9,848				5,845				221
Retail/office			6,896				—				6,896				7,659				210
Other commercial real estate			9,216				—				9,216				9,737				456
Education			—				—				—				—				—
Other consumer			343				—				343				631				87
Subtotal			34,425				—				34,425				32,690				1,147
With an allowance recorded (2):
Residential		$	15,309			$	2,375			$	12,934			$	13,140			$	422
Commercial and industrial			2,254				1,745				509				658				44
Land and construction			20,418				7,512				12,906				15,193				252
Multi-family			14,312				3,693				10,619				6,286				228
Retail/office			9,347				6,925				2,422				4,948				128
Other commercial real estate			2,699				386				2,313				2,270				99
Education (3)			276				—				276				338				—
Other consumer			2,544				477				2,067				2,211				105
Subtotal			67,159				23,113				44,046				45,044				1,278
Total
Residential		$	19,060			$	2,375			$	16,685			$	17,172			$	465
Commercial and industrial			2,314				1,745				569				737				83
Land and construction			24,729				7,512				17,217				19,900				343
Multi-family			24,160				3,693				20,467				12,131				449
Retail/office			16,243				6,925				9,318				12,607				338
Other commercial real estate			11,915				386				11,529				12,007				555
Education (3)			276				—				276				338				—
Other consumer			2,887				477				2,410				2,842				192
		$	101,584			$	23,113			$	78,471			$	77,734			$	2,425

 

(1)	Calculated on a trailing 12 month basis for September 30, 2014, and a trailing 9 month basis for December 31, 2013.

(2)

Includes ratio-based allowance for loan losses of $0.4 million and $2.1 million associated with loans totaling $0.9 million and $12.5 million at September 30, 2014, and December 31, 2013, respectively, for which individual reviews have not been completed but an allowance established based on the ratio of allowance for loan losses to unpaid principal balance for the loans individually reviewed, by class of loan.

(3)

Excludes the guaranteed portion of education loans 90+ days past due with unpaid principal balance of $6,747 and $8,930 and average carrying amounts totaling $8,628 and $13,730 at September 30, 2014, and December 31, 2013, respectively, that are not considered impaired based on a guarantee provided by government agencies.

 

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The average recorded investment in impaired loans and interest income recognized on impaired loans follows:

 

						Interest Income Recognized												Interest Income Recognized
		Average Carrying Amount(1)				Three Months Ended				Nine Months Ended				Average Carrying Amount(1)				Three Months Ended				Nine Months Ended
						September 30, 2014												September 30, 2013
		(In Thousands)
Residential		$	8,819			$	60			$	234			$	24,114			$	191			$	795
Commercial and industrial			1,660				(2	)			77				955				33				22
Land and construction			18,169				145				598				24,783				139				210
Multi-family			6,334				114				426				18,492				205				638
Retail/office			5,220				107				209				15,341				158				(147	)
Other commercial real estate			9,621				166				557				26,925				306				778
Education			240				—				—				493				—				—
Other consumer			1,389				33				71				3,337				74				157
		$	51,452			$	623			$	2,172			$	114,440			$	1,106			$	2,453

 

(1)	The average carrying amount was calculated on a trailing 12 month basis.

The following is additional information regarding impaired loans:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Carrying amount of impaired loans		$	44,641			$	78,471
Average carrying amount of impaired loans			51,452				77,734
Loans and troubled debt restructurings on non-accrual status			38,352				68,497
Troubled debt restructurings—accrual			11,796				33,087
Troubled debt restructurings—non-accrual (1)			17,980				29,346
Troubled debt restructurings valuation allowance			4,482				12,216
Loans past due ninety days or more and still accruing (2)			6,747				8,930

 

(1)	Troubled debt restructurings—non-accrual are included in the loans and troubled debt restructurings on non-accrual status line item above.

(2)	Represents the guaranteed portion of education loans that were 90+ days past due which continue to accrue interest due to a guarantee provided by government agencies covering approximately 97% of the outstanding balance.

Although the Corporation is currently not committed to lend any additional funds on impaired loans in accordance with the original terms of these loans, it is not legally obligated to, and will cautiously disburse additional funds on any loans while in nonaccrual status or if the borrower is in default.

 

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The	following table presents the aging of the recorded investment in past due loans by class of loans:

 

		Days Past Due												Total
		30-59				60-89				90 or More
		(In thousands)
September 30, 2014
Residential		$	1,287			$	318			$	3,200			$	4,805
Commercial and industrial			1,549				2				376				1,927
Land and construction			79				—				2,669				2,748
Multi-family			—				—				5,131				5,131
Retail/office			114				817				3,045				3,976
Other commercial real estate			—				—				3,370				3,370
Education			2,813				2,394				6,956				12,163
Other consumer			469				137				1,056				1,662
		$	6,311			$	3,668			$	25,803			$	35,782
December 31, 2013
Residential		$	1,287			$	564			$	8,897			$	10,748
Commercial and industrial			1,609				—				1,461				3,070
Land and construction			105				—				11,307				11,412
Multi-family			1,612				—				1,079				2,691
Retail/office			968				83				10,887				11,938
Other commercial real estate			184				506				3,785				4,475
Education			5,210				2,914				9,206				17,330
Other consumer			910				213				2,395				3,518
		$	11,885			$	4,280			$	49,017			$	65,182

Total delinquencies (loans past due 30 days or more) at September 30, 2014 were $35.8 million. The Corporation has experienced a significant reduction in delinquencies since December 31, 2013 primarily due to improving credit conditions and $9.1 million of loans moving to OREO. The Corporation has $6.7 million of education loans past due 90 days or more at September 30, 2014 that are still accruing interest due to the approximate 97% guarantee provided by governmental agencies. Loans less than 90 days delinquent may be placed on non-accrual status when the probability of collection of principal and interest is deemed to be insufficient to warrant further accrual.

Credit Quality Indicators:

The Corporation groups commercial and industrial loans and commercial real estate loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. This analysis is updated on a monthly basis. The following definitions are used for risk ratings:

Pass. Loans classified as pass represent assets that are evaluated and are performing under the stated terms. Pass rated assets are analyzed by the pay capacity of the obligor, current net worth of the obligor and/or by the value of the loan collateral. A subcategory of loans classified as pass are watch loans.

Watch. Loans classified as watch possess potential weaknesses that require management attention, but do not yet warrant adverse classification. While the status of an asset put on this list does not technically trigger their classification as substandard or non-accrual, it is considered a proactive way to identify potential issues and address them before the situation deteriorates further and results in a loss.

Special Mention. Loans classified as special mention exhibit material negative financial trends due to company specific or industry conditions which, if not corrected or mitigated, threaten their capacity to meet current or continuing debt obligations. These borrowers still demonstrate the financial flexibility to address and cure the root cause of these adverse financial trends without significant deviations from their current business plan. Their potential weakness deserves close attention and warrants enhanced monitoring on the part of management. The expectation is these borrowers will return to a pass rating given reasonable time; or will be further downgraded.

 

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Substandard. Loans classified as substandard are inadequately protected by the current net worth, paying capacity of the obligor, or by the collateral pledged. Substandard assets must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that a loss will be sustained if the deficiencies are not corrected.

Non-Accrual. Loans classified as non-accrual have the weaknesses of those classified as Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans that fall into this category are deemed collateral dependent and an individual impairment evaluation is performed for all relationships greater than $500,000. Loans in this category are allocated a specific reserve if the collateral does not support the outstanding loan balance or charged off if deemed uncollectible.

The risk category of loans by class of loans, and based on the most recent analysis performed, is as follows:

 

																		Total Unpaid
						Special												Principal
		Pass (1)				Mention				Substandard				Non-Accrual				Balance
		(In thousands)
September 30, 2014
Commercial and industrial		$	12,296			$	—			$	1,954			$	193			$	14,443
Commercial real estate:
Land and construction			77,321				954				3,246				17,873				99,394
Multi-family			257,603				—				1,566				5,256				264,425
Retail/office			130,093				4,707				4,272				4,438				143,510
Other			146,267				176				11,938				3,963				162,344
		$	623,580			$	5,837			$	22,976			$	31,723			$	684,116
Percent of total unpaid principal balance			91.2	%			0.9	%			3.4	%			4.6	%			100.0	%
December 31, 2013
Commercial and industrial		$	16,542			$	—			$	3,540			$	1,509			$	21,591
Commercial real estate:
Land and construction			57,221				75				10,025				24,729				92,050
Multi-family			255,741				465				22,053				3,658				281,917
Retail/office			130,966				2,967				5,777				14,365				154,075
Other			135,045				20,696				11,770				6,802				174,313
		$	595,515			$	24,203			$	53,165			$	51,063			$	723,946
Percent of total unpaid principal balance			82.3	%			3.3	%			7.3	%			7.1	%			100.0	%

 

(1)	Includes TDR accruing loans.

 

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Residential and consumer loans are managed on a pool basis due to their homogeneous nature. Loans that are delinquent 90 days or more are considered non-accrual. The following table presents the unpaid principal balance of residential and consumer loans based on accrual status:

 

		September 30, 2014												December 31, 2013
		Accrual (1)				Non-Accrual				Total Unpaid Principal Balance				Accrual (1)				Non-Accrual				Total Unpaid Principal Balance
		(In thousands)
Residential		$	536,337			$	5,261			$	541,598			$	515,373			$	14,404			$	529,777
Consumer
Education (2)			112,459				209				112,668				129,244				276				129,520
Other consumer			229,397				1,159				230,556				235,557				2,754				238,311
		$	878,193			$	6,629			$	884,822			$	880,174			$	17,434			$	897,608

 

(1)	Accrual residential and consumer loans includes substandard rated loans including TDR-accrual.

(2)	Non-accrual education loans represent the portion of these loans 90+ days past due that are not covered by a guarantee provided by government agencies that is limited to approximately 97% of the outstanding balance.

Troubled Debt Restructurings

Modifications of loan terms in a troubled debt restructuring (“TDR”) are generally in the form of an extension of payment terms or lowering of the interest rate, although occasionally the Corporation has reduced the outstanding principal balance.

Loans modified in a troubled debt restructuring that are currently on non-accrual status will remain on non-accrual status for a period of at least six months. If after six months, or a longer period sufficient to demonstrate the willingness and ability of the borrower to perform under the modified terms, the borrower has made payments in accordance with the modified terms, the loan is returned to accrual status but retains its designation as a TDR. Once a TDR loan is returned to accrual, further review of the credit could take place resulting in a further upgrade into the pass category but still remaining as a TDR. As a result, TDR accruals are reported in the pass and impaired categories as appropriate. The designation as a TDR is removed at year end after the time in which both of the following conditions exist: (a) the restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of restructuring for a new loan with comparable risk and (b) the loan is not impaired based on the terms specified by the restructuring agreement.

 

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The following table presents information related to loans modified in a troubled debt restructuring by class:

 

		Three Months Ended September 30,
		2014												2013
Troubled Debt Restructurings (1)		Number of Modifications				Unpaid Principal Balance (at beginning of period)				Unpaid Principal Balance (2) (at period end)				Number of Modifications				Unpaid Principal Balance (at beginning of period)				Unpaid Principal Balance (2) (at period end)
		(Dollars in thousands)
Residential			1			$	138			$	123				2			$	344			$	377
Commercial and industrial			—				—				—				4				7,639				7,562
Land and construction			1				55				63				—				—				—
Multi-family			—				—				—				—				—				—
Retail/office			—				—				—				—				—				—
Other commercial real estate			—				—				—				1				149				146
Education			—				—				—				—				—				—
Other consumer			—				—				—				7				159				190
			2			$	193			$	186				14			$	8,292			$	8,275
		Nine Months Ended September 30,
		2014												2013
Troubled Debt Restructurings (1)		Number of Modifications				Unpaid Principal Balance (at beginning of period)				Unpaid Principal Balance (2) (at period end)				Number of Modifications				Unpaid Principal Balance (at beginning of period)				Unpaid Principal Balance (2) (at period end)
		(Dollars in thousands)
Residential			11			$	1,431			$	1,398				2			$	349			$	377
Commercial and industrial			1				48				48				4				7,699				7,562
Land and construction			3				427				410				1				438				241
Multi-family			3				1,283				1,183				—				—				—
Retail/office			—				—				—				2				267				260
Other commercial real estate			2				251				256				4				835				816
Education			—				—				—				—				—				—
Other consumer			11				353				305				7				160				190
			31			$	3,793			$	3,600				20			$	9,748			$	9,446

 

(1)	Loans modified in a TDR that were fully paid down, charged-off or foreclosed upon by period end are not reported in this table.

(2)	The unpaid principal balance is inclusive of all partial paydowns and charge-offs since the modification date.

 

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The following tables present the unpaid principal balance of loans modified in a troubled debt restructuring by class and by type of modification:

 

		Three Months Ended September 30, 2014
		Principal and Interest to Interest												Below Market
						Interest Rate Reduction
						To Below				To Interest
Troubled Debt Restructurings (1)(2)		Only				Market Rate				Only (3)				Rate (4)				Other (5)				Total
		(In thousands)
Residential		$	—			$	123			$	—			$	—			$	—			$	123
Commercial and industrial			—				—				—				—				—				—
Land and construction			—				63				—				—				—				63
Multi-family			—				—				—				—				—				—
Retail/office			—				—				—				—				—				—
Other commercial real estate			—				—				—				—				—				—
Education			—				—				—				—				—				—
Other consumer			—				—				—				—				—				—
		$	—			$	186			$	—			$	—			$	—			$	186
		Three Months Ended September 30, 2013
		Principal and Interest to Interest				Interest Rate Reduction								Below Market
						To Below				To Interest
Troubled Debt Restructurings (1)(2)		Only				Market Rate				Only (3)				Rate (4)				Other (5)				Total
		(In thousands)
Residential		$	—			$	377			$	—			$	—			$	—			$	377
Commercial and industrial			—				—				—				—				7,562				7,562
Land and construction			—				—				—				—				—				—
Multi-family			—				—				—				—				—				—
Retail/office			—				—				—				—				—				—
Other commercial real estate			—				—				—				146				—				146
Education			—				—				—				—				—				—
Other consumer			—				177				—				—				13				190
		$	—			$	554			$	—			$	146			$	7,575			$	8,275

 

(1)	Loans modified in a TDR that were fully paid down, charged-off or foreclosed upon by period end are not reported in this table.

(2)	The unpaid principal balance is inclusive of all partial paydowns and charge-offs since the modification date.

(3)	Includes modifications of loan repayment terms from principal and interest to interest only, along with a reduction in the contractual interest rate.

(4)	Includes loans modified at below market rates for borrowers with similar risk profiles and having comparable loan terms and conditions. Market rates are determined by reference to internal new loan pricing grids that specify credit spreads based on loan risk rating and term to maturity.

(5)	Other modifications primarily include providing for the deferral of interest currently due to the new maturity date of the loan.

 

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		Nine Months Ended September 30, 2014
		Principal and Interest to Interest												Below Market Rate (4)
						Interest Rate Reduction
						To Below				To Interest
Troubled Debt Restructurings (1)(2)		Only				Market Rate				Only (3)								Other (5)				Total
		(In thousands)
Residential		$	175			$	567			$	—			$	119			$	537			$	1,398
Commercial and industrial			—				—				—				—				48				48
Land and construction			—				63				—				—				347				410
Multi-family			—				—				—				921				262				1,183
Retail/office			—				—				—				—				—				—
Other commercial real estate			—				—				—				214				42				256
Education			—				—				—				—				—				—
Other consumer			—				252				—				—				53				305
		$	175			$	882			$	—			$	1,254			$	1,289			$	3,600
		Nine Months Ended September 30, 2013
		Principal
		and Interest				Interest Rate Reduction								Below
		to Interest				To Below				To Interest				Market
Troubled Debt Restructurings (1)(2)		Only				Market Rate				Only (3)				Rate (4)				Other (5)				Total
		(In thousands)
Residential		$	—			$	377			$	—			$	—			$	—			$	377
Commercial and industrial			—				—				—				—				7,562				7,562
Land and construction			—				—				—				241				—				241
Multi-family			—				—				—				—				—				—
Retail/office			—				260				—				—				—				260
Other commercial real estate			531				139				—				146				—				816
Education			—				—				—				—				—				—
Other consumer			—				177				—				—				13				190
		$	531			$	953			$	—			$	387			$	7,575			$	9,446

 

(1)	Loans modified in a TDR that were fully paid down, charged-off or foreclosed upon by period end are not reported in this table.

(2)	The unpaid principal balance is inclusive of all partial paydowns and charge-offs since the modification date.

(3)	Includes modifications of loan repayment terms from principal and interest to interest only, along with a reduction in the contractual interest rate.

(4)	Includes loans modified at below market rates for borrowers with similar risk profiles and having comparable loan terms and conditions. Market rates are determined by reference to internal new loan pricing grids that specify credit spreads based on loan risk rating and term to maturity.

(5)	Other modifications primarily include providing for the deferral of interest currently due to the new maturity date of the loan.

 

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The following table presents loans modified in a troubled debt restructuring during the twelve months prior to the dates indicated, by portfolio segment, that subsequently defaulted (i.e.: 90 days or more past due following a modification) during the three and nine periods ended September 30, 2014 and 2013:

 

		Three Months Ended September 30,																Nine Months Ended September 30,
		2014								2013								2014								2013
						Unpaid								Unpaid								Unpaid								Unpaid
		Number of				Principal				Number of				Principal				Number of				Principal				Number of				Principal
		Modified				Balance (2)				Modified				Balance (2)				Modified				Balance (2)				Modified				Balance (2)
Troubled Debt Restructurings (1)		Loans				(at period end)				Loans				(at period end)				Loans				(at period end)				Loans				(at period end)
		(Dollars in thousands)																(Dollars in thousands)
Residential			—			$	—				—			$	—				—			$	—				—			$	—
Commercial and industrial			—				—				—				—				—				—				2				34
Land and construction			—				—				—				—				—				—				2				369
Multi-family			—				—				—				—				—				—				—				—
Retail/office			—				—				—				—				—				—				2				261
Other commercial real estate			—				—				7				1,362				—				—				12				2,391
Education			—				—				—				—				—				—				—				—
Other consumer			—				—				—				—				—				—				1				13
			—			$	—				7			$	1,362				—			$	—				19			$	3,068

 

(1)	Loans modified in a TDR that were fully paid down, charged-off or foreclosed upon by period end are not reported in this table.

(2)	The unpaid principal balance is inclusive of all partial paydowns and charge-offs since the modification date.

Unfunded Commitments and Repurchase Loan Reserve

In addition to the allowance for loan losses reflected on the Consolidated Balance Sheets, a reserve is also provided for unfunded loan commitments and for the repurchase of previously sold loans. The reserve for unfunded loan commitments includes unfunded commitments to lend and commercial letters of credit. These reserves are classified in other liabilities on the Consolidated Balance Sheets. The balances of these reserves for the periods presented is as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013				2014				2013
		(Unaudited)
		(In thousands)
Reserve for unfunded commitment losses beginning balance		$	5,444			$	3,690			$	4,664			$	1,531
Provision for unfunded commitments			(2,401	)			974				(1,621	)			3,133
Ending reserve for unfunded commitment losses		$	3,043			$	4,664			$	3,043			$	4,664
Reserve for repurchased loans beginning balance		$	2,351			$	2,600			$	2,600			$	570
Provision for repurchased loans			(97	)			—				(346	)			2,030
Ending reserve for repurchased loans		$	2,254			$	2,600			$	2,254			$	2,600

The amount of the allowance for unfunded loan commitments is determined using the average reserve rate by risk rating that applies to the associated funded loan category multiplied by the unfunded commitment amount multiplied by an estimated utilization factor. The reserve also covers potential loss on letters of credit outstanding for which the Bank may be unable to recover the amount outstanding. At September 30, 2014, a liability of $3.0 million was required and reflects a decrease primarily due to the release of a $2.7 million specific reserve related to the letter of credit litigation that was resolved during the quarter.

 

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Loans intended to be sold are originated in accordance with specific criteria established by the investor agencies – these are known as “conforming loans”. During the sale of these loans, certain representations and warranties are made that the loans conform to these previously established underwriting standards. In the event that any of these representations and warranties or standards are found to be out of compliance, the Corporation may be responsible for repurchasing the loan at the unpaid principal balance or indemnifying the buyer against loss related to that loan.

The amount of the reserve for repurchased loans is determined using the serviced portfolio balances multiplied by historical and expected loss rates to provide for the probable losses related to sold mortgage loans. The reserve declined $97,000 and $346,000 during both the three and nine month periods ended September 30, 2014, respectively compared to zero and an increase of $2.0 million during the three and nine months ended September 30, 2013, respectively. Total expense incurred for investor loss reimbursements including any provision recorded or reserve released was $136,000 and $50,000 for the three and nine months ended September 30, 2014, respectively and $223,000 and $3.4 million for the three and nine months ended September 30, 2013, respectively. Losses may result from the repurchase of loans or indemnification of loss incurred upon foreclosure and disposition of related collateral. The analysis of the reserve at September 30, 2014 required a liability of $2.3 million.

Pledged Loans

At September 30, 2014 and December 31, 2013, residential, multi-family, education and other consumer loans receivable with unpaid principal of approximately $727.5 million and $744.1 million were pledged to secure borrowings and for other purposes as permitted or required by law. Certain real-estate related loans are pledged as collateral for FHLB of Chicago borrowings. See Note 9.

Related Party Loans

In the ordinary course of business, the Bank has granted loans to principal officers and directors and their affiliates with outstanding balances amounting to $57,000 and $83,000 at September 30, 2014 and December 31, 2013, respectively. During the nine months ended September 30, 2014, principal additions were zero and principal payments totaled $26,000.

Note 6 – Other Real Estate Owned

Real estate acquired by foreclosure or by deed in lieu of foreclosure as well as other repossessed assets (OREO) are held for sale and are initially recorded at fair value less a discount for estimated selling costs at the date of foreclosure. Any write down to fair value less estimated selling costs is charged to the allowance for loan losses. If the discounted fair value exceeds the net carrying value of the loans, recoveries to the allowance for loan losses are recorded to the extent of previous charge-offs, with any excess, which is infrequent, recognized as a gain in non-interest income. Subsequent to foreclosure, valuations are periodically performed and a valuation allowance is established if the carrying value exceeds the fair value less estimated selling costs. Costs relating to the development and improvement of the property may be capitalized, generally those greater than $10,000; holding period costs and subsequent changes to the valuation allowance are charged to OREO expense, net included in non-interest expense. Incremental valuation adjustments may be recognized in the Statements of Operations if, in the opinion of management, such additional losses are deemed probable.

 

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A summary of the activity in other real estate owned is as follows:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Balance at beginning of period		$	56,170			$	68,241			$	63,460			$	90,000
Additions			1,425				9,443				9,084				25,866
Capitalized improvements			—				255				28				607
OREO valuation adjustments, net (1)			(2,348	)			(1,972	)			(4,627	)			(13,575	)
Sales			(8,522	)			(10,070	)			(21,220	)			(37,001	)
Balance at end of period		$	46,725			$	65,897			$	46,725			$	65,897

 

(1)	Includes adjustments to the OREO reserve for probable losses and property writedowns.

The balances at end of period above are net of a valuation allowance of $22.4 million at September 30, 2014 and $34.5 million at September 30, 2013, recognized during the holding period for declines in fair value subsequent to foreclosure or acceptance of deed in lieu of foreclosure. A summary of activity in the OREO valuation allowance is as follows:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Balance at beginning of period		$	24,515			$	35,448			$	30,842			$	31,128
Valuation adjustments (1)			2,348				1,972				4,627				13,575
Sales			(4,472	)			(2,921	)			(13,078	)			(10,204	)
Balance at end of period		$	22,391			$	34,499			$	22,391			$	34,499

 

(1)	Includes adjustments to the OREO reserve for probable losses and property writedowns.

Net OREO expense consisted of the following components:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Valuation adjustments		$	2,348			$	1,972			$	4,627			$	13,575
Foreclosure cost expense			140				314				471				1,381
Expenses from operations, net			511				928				1,353				4,806
OREO expense, net		$	2,999			$	3,214			$	6,451			$	19,762

Note 7 – Mortgage Servicing Rights

Mortgage servicing rights (MSRs) are recorded when loans are sold to third parties with servicing of those loans retained. In addition, MSRs are recorded when acquiring or assuming an obligation to service a financial (loan) asset that does not relate to an asset that is owned. Servicing assets are initially measured at fair value determined using a discounted cash flow model based on market assumptions at the time of origination. Subsequently, the MSR asset is carried at the lower of amortized cost or fair value. MSRs are assessed for impairment using a discounted cash flow model provided by a third party that is based on current market assumptions at the end of each reporting period. For purposes of measuring impairment, the servicing rights are stratified into relatively homogeneous pools based on characteristics such as product type and interest rate bands. Impairment is recognized, if necessary, at the pool level rather than for each individual servicing right asset.

 

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Accounting for MSRs is based on the amortization method. Under this method, servicing assets are amortized in proportion to and over the period of net servicing income. Income generated as the result of the capitalization of new servicing assets is reported as net gain on sale of loans and the amortization of servicing assets is reported as a reduction to loan servicing income in the Consolidated Statements of Operations. Ancillary income is recorded in other non-interest income.

Information regarding the Corporation’s mortgage servicing rights is as follows:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Balance at beginning of period		$	21,772			$	23,871			$	23,041			$	24,348
Additions			426				963				1,025				3,999
Amortization			(930	)			(1,127	)			(2,798	)			(4,640	)
Balance at end of period—before valuation allowance			21,268				23,707				21,268				23,707
Valuation allowance			(789	)			(687	)			(789	)			(687	)
Balance at end of period		$	20,479			$	23,020			$	20,479			$	23,020
		As of September 30,
		2014				2013
Fair value at the end of the period		$	21,064			$	24,203
Key assumptions:
Weighted average discount rate			11.97	%			10.64	%
Weighted average prepayment speed			11.13	%			9.04	%

The projections of amortization expense for mortgage servicing rights set forth below are based on asset balances as of September 30, 2014 and an assumed amortization rate of 20% per year. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

 

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		MSR
		Amortization
		(In thousands)
Nine months ended September 30, 2014		$	2,798
Estimate for the year ended December 31,
2014		$	1,063
2015			4,041
2016			3,233
2017			2,586
2018			2,069
Thereafter			8,276
Total		$	21,268

The unpaid principal balance of mortgage loans serviced for others is not included in the Consolidated Balance Sheets. The unpaid principal of mortgage loans serviced for others was approximately $2.53 billion at September 30, 2014 and $2.71 billion at December 31, 2013.

 

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Note 8 – Deposits

Deposits are summarized as follows:

 

		September 30, 2014								December 31, 2013
						Weighted								Weighted
		Carrying				Average				Carrying				Average
		Amount				Rate				Amount				Rate
		(Dollars in thousands)
Non-interest-bearing checking		$	274,945				—	%		$	259,926				—	%
Interest-bearing checking			280,393				0.05				301,956				0.07
Total checking accounts			555,338				0.03				561,882				0.04
Money market accounts			457,640				0.20				468,461				0.19
Regular savings			314,644				0.10				293,159				0.10
Advance payments by borrowers for taxes and insurance			58,312				0.14				822				0.21
Certificates of deposit:
0.00% to 0.99%			387,950				0.32				457,407				0.33
1.00% to 1.99%			71,252				1.27				67,762				1.28
2.00% to 2.99%			13,671				2.32				16,116				2.37
3.00% to 3.99%			—				—				7,310				3.59
4.00% and above			—				—				2,374				4.24
Total certificates of deposit			472,873				0.52				550,969				0.57
Total deposits		$	1,858,807				0.21	%		$	1,875,293				0.24	%

Annual maturities of certificates of deposit outstanding at September 30, 2014 are summarized as follows:

 

		Amount
		(In thousands)
Matures During Year Ending December 31:
2014		$	85,779
2015			243,222
2016			80,917
2017			30,327
2018			21,060
2019			11,568
Total		$	472,873

At September 30, 2014 and December 31, 2013, certificates of deposit with balances greater than or equal to $100,000 totaled $73.5 million and $88.7 million, respectively.

The Bank has entered into agreements with certain brokers that will provide deposits obtained from their customers at specified interest rates for an identified fee, or so called “brokered deposits.” The Bank had no brokered deposits at September 30, 2014 and December 31, 2013. There were no out of network certificates of deposit at September 30, 2014 and December 31, 2013. These out of network certificates of deposit, which are not considered brokered deposits, are opened via internet listing services and are kept within FDIC insured balance limits.

 

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Note 9 – Other Borrowed Funds

Other borrowed funds consist of the following:

 

						September 30, 2014								December 31, 2013
										Weighted								Weighted
		Matures During Year								Average								Average
		Ending December 31,				Amount				Rate				Amount				Rate
		(Dollars in thousands)
FHLB advances			2018			$	10,000				2.33	%		$	10,000				2.33	%
Repurchase agreements							2,819				0.10				2,636				0.10
Long term lease obligation							241				2.46				241				2.46
						$	13,060				1.85	%		$	12,877				1.88	%

FHLB of Chicago Advances

The Bank pledges certain loans that meet underwriting criteria established by the Federal Home Loan Bank of Chicago (“FHLB of Chicago”) as collateral for outstanding advances. The unpaid principal balance of loans pledged to secure FHLB of Chicago borrowings totaled $652.0 million and $659.4 million at September 30, 2014 and December 31, 2013, respectively. The FHLB of Chicago borrowings are also collateralized by mortgage-related securities totaling $93.8 million and $122.2 million at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014, there were no FHLB of Chicago borrowings with call features that may be exercised by the FHLB of Chicago.

Note 10 – Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by bank regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Qualitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of tier 1 leverage, tier 1 risk-based and total risk-based capital. Under standard regulatory guidelines, a bank must have a total risk-based capital ratio of 8% or greater to be considered “adequately capitalized.”

 

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The following table summarizes the Bank’s capital ratios to be considered adequately or well capitalized under standard regulatory guidelines:

 

										Minimum Required
										To be Adequately								To be Well
		Actual								Capitalized								Capitalized
		Capital				Ratio				Capital				Ratio				Capital				Ratio
		(Dollars in thousands)
September 30, 2014
Tier 1 leverage (1)		$	211,502				10.07	%		$	83,977				4.00	%		$	104,972				5.00	%
Tier 1 risk-based capital (2)			211,502				16.68				50,731				4.00				76,096				6.00
Total risk-based capital (3)			227,778				17.96				101,461				8.00				126,826				10.00
December 31, 2013
Tier 1 leverage (1)		$	201,995				9.60	%		$	84,170				4.00	%		$	105,212				5.00	%
Tier 1 risk-based capital (2)			201,995				15.77				51,226				4.00				76,839				6.00
Total risk-based capital (3)			218,668				17.07				102,452				8.00				128,065				10.00

 

(1)	Tier 1 capital divided by adjusted total assets.

(2)	Tier 1 capital divided by total risk-weighted assets.

(3)	Total risk-based capital divided by total risk-weighted assets.

The following table presents the components of the Bank’s regulatory capital:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Stockholders’ equity of the Bank		$	209,084			$	196,469
Less: Disallowed servicing assets			(1,520	)			(1,096	)
Accumulated other comprehensive loss			3,938				6,622
Tier 1 capital			211,502				201,995
Plus: Allowable allowance for loan losses			16,276				16,673
Total risk-based capital		$	227,778			$	218,668

The Bank may not declare or pay a cash dividend if such declaration and payment would violate regulatory requirements.

Note 11 – Stock Compensation Plans

On August 12, 2014, the Board of Directors (Board) of the Corporation approved a new incentive plan, the Anchor Bancorp Wisconsin Inc. 2014 Omnibus Incentive Plan (the “Plan”) which was subsequently approved by shareholders. The Plan provides for the issuance of awards of incentive or nonqualified stock options, stock appreciation rights, performance and restricted stock awards or units, dividend equivalent units and other stock based awards as determined by the Board or the Plan administrator. The purpose of the Plan is to promote the interest of the Corporation and its stockholders by attracting, retaining and motivating executives and other selected employees, directors, consultants and advisors by enabling such individuals to partipate in the long-term growth and financial success of the Corporation.

The maximum number of shares of common stock (each, a “Share”) that may be issued to participants pursuant to awards under the 2014 Plan will be equal to 600,000. Such Shares may be either authorized and unissued Shares or Shares reacquired at any time and now or hereafter held as treasury stock. At September 30, 2014, 404,700 Shares were available to grant pursuant to the 2014 Plan.

 

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Restricted Stock

Restricted stock grants vest over various periods of time typically from one to three years and are included in outstanding shares at the time of grant. Absent a market in the Company’s common stock, the fair value of the restricted stock granted during the quarter ended September 30, 2014 equaled 90% of the most recent prior month end book value as of the date of grant. The fair value of restricted stock grants determined at the grant date is amortized to compensation and benefits expense over the vesting period. The restricted stock grant plan expense for the three and nine months ended September 30, 2014 was $328,000.

The restricted stock activity is summarized as follows:

 

		Three and Nine Months Ended September 30,
		2014
						Weighted
						Average
						Grant Date
		Shares				Fair Value
Balance at beginning of year			—			$	—
Granted			195,300				20.95
Vested			—				—
Forfeited			—				—
Balance outstanding at end of period			195,300			$	20.95
Available to grant			404,700

As of September 30, 2014, there was approximately $3.8 million of unrecognized compensation expense related to nonvested restricted stock awards granted under the Plan. The weighted average term of nonvested awards is 2.5 years. No restricted stock grants vested during the quarter ended September 30, 2014.

Note 12 – Offsetting Assets and Liabilities

ASC 210-20-50 – Disclosures of Offsetting Assets and Liabilities, requires entities to provide disclosures of both gross information and net information about instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of GAAP and those entities that prepare their financial statements on the basis of International Financial Reporting Standards (IFRS).

Offsetting, otherwise known as netting, takes place when entities present their rights and obligations to each other as a net amount in their statement of financial condition. The Company has certain assets and liabilities on the Consolidated Balance Sheets which could be subject to the right of setoff and related arrangements associated with financial instruments and derivatives. Derivative instruments reported are used as part of a risk management strategy to address exposure to changes in interest rates inherent in the Company’s origination and sale of certain residential mortgages into the secondary market, as presented in Note 14 – Derivative Financial Instruments. A repurchase agreement is a transaction that involves the “sale” of financial assets by one party to another, subject to an agreement by the “seller” to repurchase the assets at a specified date or in specified circumstances.

 

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The following table reflects the gross and net amounts of such assets and liabilities:

 

		Gross Amounts of Recognized Assets or Liabilities				Gross Amounts Offset in the Consolidated Balance Sheets				Net Amount of Assets Presented in the Consolidated Balance Sheets
As of September 30, 2014
Assets
Interest rate commitments		$	155			$	—			$	155
Forward sale contracts			—				—				—
Liabilities
Interest rate commitments			3				—				3
Forward sale contracts			150				—				150
Repurchase Agreements			2,819				—				2,819
As of December 31, 2013
Assets
Interest rate commitments		$	40			$	—			$	40
Forward sale contracts			33				(1	)			32
Liabilities
Interest rate commitments			16				—				16
Forward sale contracts			1				(1	)			—
Repurchase Agreements			2,636				—				2,636

Note 13 – Commitments and Contingent Liabilities

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and financial guarantees which involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The contract amounts of those instruments reflect the extent of involvement and exposure to credit loss the Corporation has in particular classes of financial instruments. The same credit policies are used in making commitments and conditional obligations as for on-balance-sheet instruments.

Financial instruments whose contract amounts represent credit risk are as follows:

 

		September 30, 2014				December 31, 2013
		(In thousands)
Commitments to extend credit		$	39,789			$	26,054
Unused commitments			—				657
Unused lines of credit:
Home equity			111,853				109,414
Credit cards			23,126				22,751
Commercial			129,772				54,840
Letters of credit			14,082				17,131
Credit enhancement under the Federal Home Loan Bank of Chicago Mortgage Partnership Finance Program			15,877				15,877

Commitments to extend credit are in the form of a loan in the near future. Unused lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and may be drawn upon at the borrowers’ discretion. Letters of credit commit the Corporation to make payments on behalf of customers when certain specified future events occur. Commitments and letters of credit primarily have fixed expiration dates or other termination clauses and may require payment of a fee. As some such commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. With the exception of credit card lines of credit, the Corporation primarily extends credit on a secured basis. Collateral obtained consists primarily of single-family residences and income-producing commercial properties.

 

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At September 30, 2014, the Corporation has $3.0 million of reserves on unfunded commitments, unused lines of credit, letters of credit and $2.3 million of reserves for repurchase of sold loans classified in other liabilities. The Corporation intends to fund commitments through current liquidity.

The Corporation previously participated in the Mortgage Partnership Finance Program of the FHLB of Chicago (“MPF Program”). Pursuant to the credit enhancement feature of the MPF Program, the Corporation retained a secondary credit loss exposure in the amount of $15.9 million at September 30, 2014 related to approximately $178.9 million of residential mortgage loans that the Corporation has originated and is still outstanding as agent for the FHLB of Chicago. Under the credit enhancement, the FHLB of Chicago is liable for losses on loans up to one percent of the original delivered loan balances in each pool up to the point the credit enhancement is reset. After the credit enhancement resets, the FHLB of Chicago loss contingency could be reduced depending upon losses experienced and loan balances. The Corporation is then liable for losses over and above the FHLB of Chicago first loss position up to a contractually agreed-upon maximum amount in each pool that was delivered to the Program. The Corporation receives a monthly fee for this credit enhancement obligation based on the outstanding loan balances. The monthly fee received is net of losses under the MPF Program. The MPF Program was discontinued in 2008 in its present format and the Corporation no longer funds loans through the MPF Program.

Other loans sold to investors with recourse to the Corporation met the underwriting standards of the investor and the Corporation at the time of origination. In the event of default by the borrower, the investor may resell the loans to the Corporation at par value. As the Corporation expects relatively few such loans to become delinquent, the total amount of loans sold with recourse does not necessarily represent future cash requirements. Collateral obtained on such loans consists primarily of single-family residences. The unpaid principal balance of loans repurchased from investors totaled $304,000 and $953,000 for the three and nine months ended September 30, 2014, respectively, and $376,000 and $604,000 for each of the three and nine month periods ended September 30, 2013, respectively. Alternatively, investors make requests to be made whole on a loan whereby the property has been disposed of at a loss. The related amounts for requests by the investor to be made whole was $233,000 and $396,000 for the three and nine months ended September 30, 2014 and $223,000 and $1.4 million for the three and nine months ended September 30, 2013. All losses incurred are recorded against the reserve for repurchased loans on the Consolidated Balance Sheets.

In the ordinary course of business, there are legal proceedings against the Corporation and its subsidiaries. Management considers that the aggregate liabilities, if any, resulting from such actions would not have a material, adverse effect on the consolidated financial position of the Corporation.

We were a defendant in a pending lawsuit captioned Village of Kronenwetter v. AnchorBank, fsb, Marathon County, Wisconsin, Case No. 11-CV-1370, which was an action brought by the Village of Kronenwetter, Wisconsin (“the Village”) on November 14, 2011 to enforce and collect on a $4.4 million letter of credit issued by the Bank in support of the development of a mixed use TIF development in the Village of Kronenwetter, Wisconsin. The complaint alleges that the Bank wrongfully refused to honor a full draw on the letter of credit and that the developer failed to notify the plaintiff of the renewal of the letter of credit or to renew the letter of credit within the time limitations set forth in the development agreement. A specific reserve for loss on unfunded loan commitments was established at June 30, 2013 due to a shortfall in the value of the residential real estate development supporting the letter of credit. On August 18, 2014, the court decided in favor of the Village, rejecting all defenses raised by the Bank. The lawsuit was settled during the quarter ended September 30, 2014. The Bank funded the letter of credit and paid accrued interest and attorney fees as ordered by the judgment. The specific reserve totaled $2.7 million at the time of the judgement. During the quarter , the Bank recorded expense of $1.1 million in connection with this case, which included accrued interest payable through the date of the summary judgment decision, an additional specific reserve for loss based upon additional collateral shortfall and legal fees.

 

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We are the plaintiff/counterclaim defendant in a pending lawsuit captioned AnchorBank, fsb v. Henriette McLean et al., Dane County, Wisconsin, Case No. 13-CV-811. The Bank is seeking to enforce personal guarantees executed by McLean related to amounts borrowed by Mineral Point Road Holdings, LLC (“MPRH”). At the time of the commencement of the lawsuit, March 7, 2013, McLean owed the Bank $363,302 under the guarantees. As a result of the recent sale of real estate owned by MPRH, the amount of the debt is now $300,127. The Bank has the right to obtain its attorneys’ fees incurred in collecting on the guarantees if it prevails in the lawsuit. On January 27, 2014, McLean filed a 196-paragraph Counterclaim against the Bank. McLean alleges various misconduct by the Bank related to its loans to MPRH and the procurement of her guarantees. Most of the counterclaims are based upon alleged misrepresentations and/or misrepresentations by omission. McLean is seeking the return of the $182,629 she paid to the Bank in 2012 under her guarantees, treble damages, and punitive damages. McLean has also filed a third-party complaint seeking contribution/indemnity from Joseph Gallina (the managing member of MPRH) and various entities controlled by Gallina.

On February 21, 2013, we received a “Wells Notice” from the SEC indicating its intent to bring a civil injunctive action against us alleging that we violated Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(2)(B) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rules 10b-5 and 13a-13 thereunder. On August 14, 2013, the SEC filed a complaint alleging that we and our former chief financial officer, Dale Ringgenberg, made material misstatements in our quarterly report on Form 10-Q for the period ended June 30, 2009. Without admitting or denying the allegations in the SEC’s complaint, we agreed to settle the action against us by consenting to the entry of a final judgment permanently enjoining us from violating Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5 and 13a-13 thereunder. There was no monetary fine or penalty assessed to us for the settlement of this action. Final entry of judgment was made on November 26, 2013, and accordingly, this matter is concluded.

Note 14 – Derivative Financial Instruments

The Corporation enters into contracts that meet the definition of derivative financial instruments in accordance with ASC 815—Derivative and Hedging. Derivatives are used as part of a risk management strategy to address exposure to changes in interest rates inherent in the Corporation’s origination and sale of certain residential mortgages into the secondary market. These derivative contracts used for risk management purposes include: (1) interest rate lock commitments provided to customers to fund mortgage loans intended to be sold; and (2) forward sale contracts for the future delivery of funded residential mortgages.

Forward sale contracts are entered into when interest rate lock commitments are granted to customers in an effort to economically hedge the effect of future changes in interest rates on the commitments to fund mortgage loans intended to be sold (the “pipeline”), as well as on the portfolio of funded mortgages not yet sold (the “warehouse”). For accounting purposes, these derivatives are not designated as being in a hedging relationship. The contracts are carried at fair value on the Consolidated Balance Sheets, with changes in fair value recorded in the Consolidated Statements of Operations.

 

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Derivative financial instruments are summarized as follows:

 

				September 30, 2014								December 31, 2013
		Balance						Estimated								Estimated
		Sheet		Notional				Fair				Notional				Fair
		Location		Amount				Value				Amount				Value
				(In thousands)
Derivative assets:
Interest rate lock commitments (1)		Other assets		$	14,896			$	155			$	3,863			$	37
Unused commitments (2)		Other assets			—				—				369				3
Forward contracts to sell mortgage loans (3)		Other assets			—				—				8,000				33
Derivative liabilities:
Interest rate lock commitments (1)		Other liabilities			937				3				2,172				12
Unused commitments (2)		Other liabilities			—				—				288				4
Forward contracts to sell mortgage loans (3)		Other assets			18,000				150				1,000				1

 

(1)

Interest rate lock commitments include $13.8 million and $1.5 million of commitments not yet approved in the credit underwriting process at September 30, 2014 and December 31, 2013, respectively, yet represent potential interest rate risk exposure to the extent of those mortgage loan applications eventually approved for funding.

(2)	The Corporation recognizes fair value of unused commitments held for trading which consists of closed residential real estate loans in recission at period end.

(3)	The Corporation has elected to offset the fair value of individual forward sale contracts and present a net amount on the Consolidated Balance Sheets in accordance with ASC 815-45, Derivatives and Hedging.

Net gains (losses) included in the Consolidated Statements of Operations related to derivative financial instruments, recognized in net gain on sale of loans, are summarized as follows:

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Interest rate lock commitments		$	(3	)		$	733			$	153			$	(831	)
Unused commitments			(15	)			241				(26	)			15
Forward contracts to sell mortgage loans			(130	)			(103	)			(460	)			2,293
Total		$	(148	)		$	871			$	(333	)		$	1,477

Note 15 – Fair Value of Financial Instruments

ASC Topic 820 establishes a framework for measuring fair value and disclosures about fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

In determining fair value, various valuation methods are used including market, income and cost approaches. Assumptions that market participants would use in pricing the asset or liability are utilized in these valuation methods, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs may be readily observable, market corroborated or generally unobservable inputs. Valuation methodologies are employed that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on observability of the inputs used in the valuation methodologies, financial assets and liabilities measured at fair value on a recurring and nonrecurring basis are categorized according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities that are adjusted to fair value are classified in one of the following three categories:

 

•

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.

 

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•

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.

Fair Value on a Recurring Basis

The table below presents the financial instruments carried at fair value by the valuation hierarchy (as described above):

 

		Level 1				Level 2				Level 3				Total
		(In Thousands)
September 30, 2014
Financial assets
Investment securities available for sale:
U.S. government sponsored and federal agency obligations		$	—			$	3,291			$	—			$	3,291
Corporate stock and bonds			4				—				—				4
Non-agency CMOs			—				—				5,661				5,661
Government sponsored agency mortgage-backed securities			—				103,798				—				103,798
GNMA mortgage-backed securities			—				179,113				—				179,113
Loans held for sale			—				4,937				—				4,937
Other assets:
Interest rate lock commitments			—				155				—				155
Unused commitments			—				—				—				—
Forward contracts to sell mortgage loans			—				—				—				—
Total		$	4			$	291,294			$	5,661			$	296,959
Financial liabilities
Other liabilities:
Interest rate lock commitments		$	—			$	3			$	—			$	3
Unused commitments			—				—				—				—
Forward contracts to sell mortgage loans			—				150				—				150
Total		$	—			$	153			$	—			$	153

 

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		Level 1				Level 2				Level 3				Total
		(In Thousands)
December 31, 2013
Financial assets
Investment securities available for sale:
U.S. government sponsored and federal agency obligations		$	—			$	3,376			$	—			$	3,376
Corporate stock and bonds			355				—				—				355
Non-agency CMOs			—				—				6,208				6,208
Government sponsored agency mortgage-backed securities			—				50,158				—				50,158
GNMA mortgage-backed securities			—				217,775				—				217,775
Loans held for sale			—				3,085				—				3,085
Other assets:
Interest rate lock commitments			—				37				—				37
Unused commitments			—				3				—				3
Forward contracts to sell mortgage loans			—				33				—				33
Total		$	355			$	274,467			$	6,208			$	281,030
Financial liabilities
Other liabilities:
Interest rate lock commitments		$	—			$	12			$	—			$	12
Unused commitments			—				4				—				4
Forward contracts to sell mortgage loans			—				1				—				1
Total		$	—			$	17			$	—			$	17

An independent service is used to price available-for-sale U.S. government sponsored and federal agency obligations, government sponsored agency mortgage-backed securities, and GNMA mortgage-backed securities using a market data model under Level 2. The significant inputs used to price GNMA mortgage-backed securities are as follows:

 

										Weighted												Weighted
		September 30, 2014								Average				December 31, 2013								Average
		From				To								From				To
Coupon rate			2.0	%			4.6	%			2.5	%			1.6	%			4.6	%			2.4	%
Duration (in years)			0.8				6.3				3.8				1.1				5.7				3.6
PSA prepayment speed			144				363				205				128				458				346

 

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The Corporation had 99.1% of its non-agency CMOs valued by an independent pricing service that used a discounted cash flow model that incorporates inputs considered Level 3 by the accounting guidance.

 

										Weighted												Weighted
		September 30, 2014								Average				December 31, 2013								Average
		From				To								From				To
Observable inputs:
30 to 59 day delinquency rate			1.2	%			6.2	%			4.1	%			1.6	%			5.8	%			4.0	%
60 to 89 day delinquency rate			0.3				2.5				1.4				0.8				2.5				1.9
90 plus day delinquency rate			1.9				7.6				4.7				4.6				9.9				6.5
Loss severity			50.9				64.9				58.1				52.0				68.5				57.1
Coupon rate			5.0				6.0				5.5				5.0				6.0				5.5
Current credit support			—				3.0				—				—				4.3				—
Unobservable inputs:
Month 1 to month 24 constant default rate			5.8				12.5				8.6				5.3				11.6				8.2
Discount rate			4.0				6.5				6.1				4.0				7.0				6.6

Other assets and other liabilities include interest rate lock commitments provided to customers to fund mortgage loans intended to be sold and forward sale contracts for future delivery of funded residential mortgages to investors. The Corporation relies on an internal valuation model to estimate the fair value of its interest rate lock commitments, which includes applying an estimated pull-through rate (the percentage of commitments expected to result in a closed loan) based on historical experience; multiplied by quoted investor prices on closed loans for future delivery determined to be reasonably applicable to the loan commitment based on interest rate, terms and rate lock expiration.

The Corporation also relies on an internal valuation model to estimate the fair value of its forward contracts to sell residential mortgage loans (i.e., an estimate of what the Corporation would receive or pay to terminate the forward delivery contract) based on market prices for similar financial instruments, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.

The following is a reconciliation of assets measured at fair value on a recurring basis using significant unobservable inputs (level 3):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(In thousands)
Non-agency CMOs
Beginning balance		$	5,856			$	7,181			$	6,208			$	14,158
Total realized/unrealized gains (losses):
Included in earnings			—				1				—				(197	)
Included in other comprehensive income			67				82				199				1,054
Included in earnings as unrealized other-than-temporary impairment			(30	)			—				(63	)			(83	)
Included in earnings as realized other-than-temporary impairment			48				90				160				331
Principal repayments			(280	)			(748	)			(843	)			(2,237	)
Sales			—				—				—				(6,420	)
Ending balance		$	5,661			$	6,606			$	5,661			$	6,606

 

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There were no transfers in or out of Levels 1, 2 or 3 during the three and nine months ended September 30, 2014 or 2013. The Corporation’s policy for determining transfers between levels occurs at the end of the reporting period when circumstances in the underlying valuation criteria changes and result in transfers between levels.

Fair Value on a Nonrecurring Basis

Certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Loans held for sale and mortgage servicing rights includes only those items that were adjusted to fair value as of the dates indicated.

The following table presents such assets carried on the Consolidated Balance Sheets by caption and by level within the fair value hierarchy:

 

		Level 1				Level 2				Level 3				Total
		(In thousands)
September 30, 2014
Impaired loans, with an allowance recorded, net		$	—			$	—			$	9,823			$	9,823
Mortgage servicing rights			—				—				7,369				7,369
Other real estate owned			—				—				46,725				46,725
Total assets at fair value		$	—			$	—			$	63,917			$	63,917
December 31, 2013
Impaired loans, with an allowance recorded, net		$	—			$	—			$	44,046			$	44,046
Mortgage servicing rights			—				—				6,448				6,448
Other real estate owned			—				—				63,460				63,460
Total assets at fair value		$	—			$	—			$	113,954			$	113,954

The significant inputs for those assets measured at fair value on a nonrecurring basis are as follows:

 

		September 30, 2014
		Method		Inputs
Impaired loans, with an allowance recorded, net		Appraised Values		External appraised values- adjustments made to values due to management factors including age of appraisal, age of comparables, known changes in the market and in the collateral and selling and commission cost of 15 % to 35%.
Mortgage servicing rights		Discounted Cash Flow		Weighted average prepayment speed 11.13%; weighted average discount rate 11.97%.
Other real estate owned		Appraised Values		External appraised values less selling and commission cost of 15 % to 35%.

The Corporation does not adjust loans held for investment to fair value on a recurring basis. However, some loans are considered impaired and an allowance for loan losses is established. The specific reserves for collateral dependent impaired loans are based on the fair value of the underlying collateral less estimated costs to sell. The fair value of collateral is usually determined based on appraisals. In some cases, adjustments are made to appraised values due to various factors including age of the appraisal, age of comparables included in the appraisal, and known changes in the market and in the collateral. Since adjustments to appraised values are based on unobservable inputs, the resulting fair value measurement is categorized as a Level 3 measurement.

 

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Mortgage servicing rights (MSR) are recorded as an asset when loans are sold to third parties with servicing rights retained. Mortgage servicing rights are initially recorded at fair value and subsequently amortized in proportion to, and over the period of, estimated net servicing revenues. The carrying value of these assets is reviewed for impairment on a monthly basis using a lower of carrying value or fair value methodology. The fair value of servicing rights is determined by estimating the present value of future net cash flows using a discounted cash flow model, taking into consideration market loan prepayment speeds, discount rates, servicing costs and other economic factors. For purposes of measuring impairment, the rights are stratified based on predominant risk characteristics of the underlying loans which include product type (i.e., fixed, adjustable or balloon) and interest rate bands. If the aggregate carrying value of the capitalized mortgage servicing rights for a stratum exceeds its fair value, the difference is recognized in non-interest expense as an impairment loss.

Critical assumptions used in the MSR discounted cash flow model include mortgage prepayment speeds, discount rates, costs to service, ancillary and late fee income. Variations in the assumptions could materially affect the estimated fair values. Changes to the assumptions are made when market data indicate that new trends have developed. Current market participant assumptions based on loan product types – fixed rate, adjustable rate and balloon loans—include discount rates in the range of 11.5% to 25.0% as well as portfolio weighted average prepayment speeds of 3.5% to 52.7% annual CPR. Many of these assumptions are subjective and involve a high degree of management judgment. MSR valuation assumptions are reviewed and approved by management on a quarterly basis.

Prepayment speeds may be affected by economic factors such as changes in home prices, market interest rates, the availability of other credit products to borrowers and customer payment patterns. Prepayment speeds include the impact of all borrower prepayments, including full payoffs, additional principal payments and the impact of loans paid off due to foreclosure liquidations. As market interest rates decline, prepayment speeds will generally increase as customers refinance existing mortgages to more favorable interest rate terms. As prepayment speeds increase, anticipated cash flows will generally decline resulting in a potential reduction, or impairment, of the fair value of the capitalized MSRs. Alternatively, an increase in market interest rates may cause a decrease in prepayment speeds and therefore an increase in fair value of MSRs. Annually, external data is obtained to test the values and assumptions that are used for the initial valuations in the discounted cash flow model.

Real estate acquired by foreclosure, real estate acquired by deed in lieu of foreclosure and other repossessed assets (OREO) are held for sale and are initially recorded at fair value less estimated selling expenses at the date of foreclosure. OREO is re-measured at the lower of cost or fair value after initial recognition and reported using a valuation allowance on foreclosed assets. Fair value is generally based on third party appraisals subject to discounting and is therefore considered a Level 3 measurement.

Fair Value Summary

ASC Topic 825 requires disclosure of fair value information about financial instruments, for which it is practicable to estimate that value, whether or not recognized in the Consolidated Balance Sheets, including those financial assets and liabilities that are not measured and reported at fair value on a recurring or nonrecurring basis. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Results from these techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in immediate settlement of the instruments. Certain financial instruments with a fair value that is not practicable to estimate and all non-financial instruments are excluded from the disclosure requirements. Accordingly, the aggregate fair value amounts presented in the table below do not necessarily represent the underlying value of the Corporation.

 

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The following methods and assumptions were used in estimating the fair value of financial instruments that were not previously disclosed:

Cash and cash equivalents and accrued interest: The carrying amounts reported in the balance sheets approximate the fair values for those assets and liabilities. In accordance with ASC Topic 820, cash and cash equivalents and accrued interest have been categorized as a Level 2 fair value measurement.

Loans held for investment: The fair value of residential mortgage loans held for investment, commercial real estate loans, commercial and industrial loans, and consumer and other loans held for investment are estimated using observable inputs including estimated cash flows, and discount rates based on interest rates currently being offered for loans with similar terms, to borrowers of similar credit quality. In accordance with ASC Topic 820, loans held for investment that are not included with impaired loans in the preceding section titled Fair Value on a Nonrecurring Basis have been categorized as a Level 2 fair value measurement.

Federal Home Loan Bank stock: The carrying amount of FHLB stock approximates its fair value as it can only be redeemed with the FHLB at par value. In accordance with ASC Topic 820, Federal Home Loan Bank stock has been categorized as a Level 2 fair value measurement.

Deposits: The fair value of checking, savings and money market accounts are reported at book value, which is the amount payable on demand. The fair values of fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates being offered on certificates of deposit to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. In accordance with ASC Topic 820, deposits have been categorized as a Level 2 fair value measurement.

Other borrowed funds: The fair value of FHLB advances and repurchase agreements are estimated using discounted cash flow analysis, based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements. The fair value of the long-term lease obligation is reported at book value, which represents the present value of the cash flows at the time of inception and is indicative of the fair value in the current stable rate environment. In accordance with ASC Topic 820, other borrowed funds have been categorized as a Level 2 fair value measurement.

Off-balance-sheet instruments: The fair value of off-balance-sheet instruments (held for investment lending commitments and unused lines of credit) are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the counterparties’ credit standing and discounted cash flow analyses. The fair value of these off-balance-sheet items approximates the recorded amounts of the related fees and is not material at September 30, 2014 and December 31, 2013.

 

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The carrying amount and fair value of the Corporation’s financial instruments consist of the following:

 

		September 30, 2014								December 31, 2013
		Carrying				Fair				Carrying				Fair
		Amount				Value				Amount				Value
		(In thousands)
Financial assets:
Cash and cash equivalents		$	174,024			$	174,024			$	143,396			$	143,396
Investment securities available for sale			291,867				291,867				277,872				277,872
Loans held for sale			4,937				4,937				3,085				3,085
Loans held for investment			1,509,246				1,463,444				1,544,324				1,488,677
Mortgage servicing rights			20,479				21,064				22,294				23,553
Federal Home Loan Bank stock			11,940				11,940				11,940				11,940
Accrued interest receivable			7,467				7,467				8,216				8,216
Interest rate lock commitments			155				155				37				37
Unused commitments			—				—				3				3
Forward contracts to sell mortgage loans (1)			—				—				33				33
Financial liabilities:
Non-maturity deposits			1,385,934				1,385,934				1,324,324				1,324,324
Deposits with stated maturities			472,873				471,392				550,969				549,668
Other borrowed funds			13,060				13,352				12,877				13,121
Accrued interest payable—borrowings			19				19				22				22
Accrued interest payable—deposits			377				377				393				393
Interest rate lock commitments			3				3				12				12
Unused commitments			—				—				4				4
Forward contracts to sell mortgage loans (1)			150				150				1				1

 

(1)	The Corporation has elected to offset the fair value of individual forward sale contracts and present a net amount on the Consolidated Balance Sheets in accordance with ASC 815-45, Derivatives and Hedging.

Note 16 – Income Taxes

The Corporation accounts for income taxes based on the asset and liability method. Deferred tax assets and liabilities are recorded based on the difference between the tax basis of assets and liabilities and their carrying amounts for financial reporting purposes, computed using enacted tax rates. Significant net deferred tax assets have been created for net operating loss (NOL) carryforwards and deductible temporary differences, the largest of which relates to our allowance for loan losses. For income tax purposes, only net charge-offs on uncollectible loans are deductible, not the provision for credit losses.

Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s evaluation and judgment of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of the current and future economic and business conditions. The Corporation considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the existence of taxes paid in available carry back years as well as the probability that taxable income will be generated in future periods while negative evidence includes significant cumulative losses in the past several years as well as general business and economic trends.

 

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At September 30, 2014 and December 31, 2013, the Corporation determined that a valuation allowance relating to the deferred tax asset was necessary. This determination was based largely on the negative evidence represented by the losses in the prior fiscal years caused by the significant loss provisions associated with the loan portfolio. Therefore, a valuation allowance of $114.9 million and $119.8 million at September 30, 2014 and December 31, 2013, respectively, was recorded to offset net deferred tax assets.

The significant components of deferred tax assets (liabilities) are as follows:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Deferred tax assets:
Allowance for loan losses		$	18,871			$	27,193
OREO valuation allowance and other loss reserves			11,718				15,026
Federal NOL carryforwards			72,597				66,359
State NOL carryforwards			16,812				15,710
Unrealized securities losses, net			1,580				2,657
Other			2,956				3,154
Total deferred tax assets			124,534				130,099
Valuation allowance			(114,943	)			(119,780	)
Adjusted deferred tax assets			9,591				10,319
Deferred tax liabilities:
FHLB stock dividends			(833	)			(833	)
Mortgage servicing rights			(8,216	)			(8,944	)
Other			(542	)			(542	)
Total deferred tax liabilities			(9,591	)			(10,319	)
Net deferred tax assets		$	—			$	—

The Corporation is subject to U.S. federal income tax as well as income tax of various state jurisdictions. The tax years 2010-2013 remain open to examination by the Internal Revenue Service and certain state jurisdictions while the years 2009-2013 remain open to examination by certain other state jurisdictions.

The Corporation recognizes any interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2014 and December 31, 2013, the Corporation has not recognized any accrued interest and penalties related to uncertain tax positions.

Note 17 – Earnings Per Share

Basic earnings per share for the three and nine months ended September 30, 2014 and 2013 have been determined by dividing net income available to common equity for the respective periods by the weighted average number of shares of common stock outstanding. Unvested shares of restricted stock are not considered outstanding for purposes of basic earnings per share. Diluted earnings per share is computed by dividing net income available to common equity by the weighted average number of common shares outstanding plus the effect of dilutive securities. The effects of dilutive securities, if any, are computed using the treasury stock method.

 

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The computation of earnings per share is as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2014				2013 (1)				2014				2013 (1)
		(In thousands, except per share data)
Numerator:
Numerator for basic and diluted earnings per share—income available to common stockholders		$	4,962			$	212,109			$	9,499			$	185,639
Denominator:
Denominator for basic earnings per share—weighted average shares			9,050				20,717				9,050				21,069
Effect of dilutive securities:
Restricted stock			8				—				8				—
Denominator for diluted earnings per share—weighted average shares			9,058				20,717				9,058				21,069
Basic earnings per common share		$	0.55			$	10.24			$	1.05			$	8.81
Diluted earnings per common share		$	0.55			$	10.24			$	1.05			$	8.81

 

(1)	The calculation of weighted average shares included 21,247,000 shares of Legacy Common Stock outstanding through September 26, 2013 and 9,050,000 shares of common stock outstanding from September 27 through December 31, 2013.

 

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ANCHOR BANCORP WISCONSIN INC.

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

Set forth below is management’s discussion and analysis of the consolidated results of operations and financial condition of Anchor BanCorp Wisconsin Inc. (the “Corporation” or the “Company”) and its wholly-owned subsidiaries, AnchorBank fsb (the “Bank”) and Investment Directions Inc. (“IDI”), which includes information regarding significant regulatory developments and the Corporation’s risk management activities, including asset/liability management strategies, sources of liquidity and capital resources. This discussion should be read in conjunction with the unaudited consolidated financial statements and supplemental data contained elsewhere in this quarterly report filed on Form 10-Q.

On December 18, 2013, the Board approved the change of the Company’s fiscal year end from March 31 to December 31, beginning with December 31, 2013. References to any of the Company’s previous fiscal years mean the fiscal years ended on March 31. This quarterly report on Form 10-Q includes results for the year to date period beginning on January 1, 2013 through September 30, 2013 which have not been previously disclosed.

EXECUTIVE OVERVIEW

Financial Results

Results as of and for the quarter ending September 30, 2014 include:

 

•

Basic and diluted earnings per common share were $0.55 for the three months ended September 30, 2014, compared to basic and diluted earnings per common share of $10.24 for the same period in 2013;

 

•

Net income and net income available to common equity was $5.0 million for the three months ended September 30, 2014 compared to net income of $113.3 million or $212.1 million net income available to common equity for the prior year period;

 

•

The net interest margin increased 60 basis points to 3.40% for the quarter ended September 30, 2014 from 2.80% in the prior year period largely due to lower average balances and rates paid on borrowings. Average balances declined due to the settlement of the credit agreement (credit agreement with U.S. Bank) and prepayments of Federal Home Loan Bank of Chicago (“FHLB of Chicago”) borrowings during the year ago quarter;

 

•

Loans held for investment declined $53.2 million, or 2.3%, since December 31, 2013 primarily due to repayments and other adjustments outpacing loan originations for a net decline of $24.1 million. The allowance for loan losses (ALLL) declined $18.1 million since December 31, 2013, and $9.1 million of loans were transferred to other real estate owned;

 

•

A release of provision for loan losses of $1.3 million was recorded for the three months ended September 30, 2014, with no provision for loan loss recorded for the three months ended September 30, 2013;

 

•

Total non-performing loans decreased $30.1 million, or 44.0%, to $38.4 million at September 30, 2014 from $68.5 million at December 31, 2013;

 

•

Total non-performing assets (total non-performing loans and other real estate owned) decreased $46.9 million, or 35.5%, to $85.1 million at September 30, 2014 from $132.0 million at December 31, 2013, as the Bank continues its efforts to reduce problem asset levels.

 

•

Delinquencies (loans past due 30 days or more) decreased $29.4 million, or 45.1%, to $35.8 million at September 30, 2014 from $65.2 million at December 31, 2013.

 

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•

Deposits decreased $16.5 million, less than one percent, since December 31, 2013 primarily due to runoff of time deposits of $78.1 million and a decline of $10.8 million in money market accounts which were mostly offset by increases in regular savings balances of $21.5 million and seasonal increases in advance payments of $57.5 million;

 

•

The Bank was well capitalized as of September 30, 2014. Total risk-based capital ratio was 17.96% as of September 30, 2014, compared to 17.07% at December 31, 2013. Tier 1 capital was 10.07% as of September 30, 2014, compared to 9.60% at December 31, 2013.

Termination of Orders to Cease and Desist

The Bank’s primary regulator is the Office of the Comptroller of the Currency (“OCC”). The Federal Reserve is the primary regulator of the Corporation. On June 26, 2009, the Corporation and the Bank each consented to the issuance of an Order to Cease and Desist (the “Corporation Order” and the “Bank Order,” respectively, ). On August 31, 2010, a Prompt and Corrective Action Directive (“PCA Directive”) was issued for the Bank.

The Corporation Order required the Corporation to notify, and in certain cases to obtain the permission of, the Federal Reserve prior to making dividends or capital distributions, incurring debt, making changes to or entering into contracts with directors or executive officers.

The Bank Order required the Bank to notify, or in certain cases obtain the permission of, the OCC prior to increases above a certain threshold in total assets, entering into brokered deposits, making changes to or entering into contracts with directors or executives officers, entering into certain transactions with affiliates or entering into third-party contracts outside the normal course of business and to meet and maintain both a core capital ratio and a total risk-based capital ratio.

On April 2, 2014, the Bank was notified that the Bank Order and the PCA Directive were terminated. On July 31, 2014, the Corporation was notified that the Corporation Order was terminated.

Credit Highlights

The Corporation has continued to see improvement in early stage and overall delinquencies during the past two years. This, coupled with the Bank’s ongoing efforts to aggressively work out of troubled credits, has led to a decline in the level of non-performing loans. At September 30, 2014, non-performing loans (consisting of loans past due more than 90 days, loans less than 90 days delinquent but placed on non-accrual status due to anticipated probable loss and non-accrual troubled debt restructurings (“TDRs”)) were $38.4 million, a decline of $30.1 million from the $68.5 million at December 31, 2013. Foreclosed properties declined $16.7 million to $46.7 million at September 30, 2014 from $63.5 million at December 31, 2013, a 26.4% decrease. Non-performing assets have had, and are expected to continue to have, a negative impact on net interest income and expenses related to managing the troubled loan portfolio and foreclosed properties.

The ALLL declined to $47.0 million at September 30, 2014 from $65.2 million at December 31, 2013, a 27.8% decrease. Net charge-offs during the three and nine months ended September 30, 2014 were $834,000 and $16.8 million, respectively, compared to $4.0 million and $12.9 million during the same periods in 2013, respectively. A release of provision for loan losses of $1.3 million was recorded during the three and nine month periods ended September 30, 2014 compared to no provision expense and $950,000 for the three and nine months ended September 30, 2013, respectively. While the balance of the ALLL declined 27.8% during the nine months ended September 30, 2014, the allowance compared to total non-performing loans increased to 122.7% at September 30, 2014, an increase from 95.2% at December 31, 2013 as a result of a larger decrease in non-performing loans. At September 30, 2014, the ratio of the allowance to total loans was 3.02% compared to 4.05% at December 31, 2013.

 

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Recent Market and Industry Developments

The economic turmoil that began in the middle of 2007 and continued through recent years appears to have settled into a slow economic recovery. At this time, the recovery has somewhat uncertain prospects. This has been accompanied by dramatic changes in the competitive landscape of the financial services industry and a wholesale reformation of the legislative and regulatory landscape with the passage of Dodd-Frank and other legislation.

Dodd-Frank is an extensive, complex and comprehensive piece of legislation that impacts many aspects of banking organizations. Dodd-Frank is likely to negatively impact our revenue and increase both the direct and indirect costs of doing business, as it includes provisions that could increase regulatory fees and deposit insurance assessments and impose heightened capital standards, while at the same time impacting the nature and costs of our businesses.

Until such time as the regulatory agencies issue proposed and final regulations implementing the numerous provisions of Dodd-Frank, a process that may last several years, management will not be able to fully assess the impact the legislation will have on its business and, accordingly, results of operations may vary from period to period.

Other Developments

Purchase Agreement to Sell Bank Headquarters

In February 2014, the Bank entered into a purchase agreement with an unrelated third party to sell the Bank’s main office building located at 25 West Main Street, Madison, Wisconsin, the adjacent surface parking lot immediately behind the main office building at 115 South Carroll Street and the 261-stall parking ramp located at 126 South Carroll Street. The sale is now expected to close during the fourth quarter of 2014 and the Bank will lease a portion of the space after the sale. We expect to record a gain on the sale of the office building for the quarterly period ending December 31, 2014.

Potential Sale of Branch

On September 30, 2014, we entered into a non-binding letter of intent with an interested party containing a proposal for the purchase of one of our branches in rural Wisconsin. Subsequently, negotiations resulted in the signing of a definitive branch sale agreement on October 30, 2014 and a targeted closing by the end of December 2014. Any gain from the sale of the branch or any proceeds therefrom are not expected to have a material affect on the financial results of the Corporation. Management regularly and periodically evaluates and assesses all aspects of the Corporation’s operations, including, but not limited to, retail branch delivery and placement of its support functions, for opportunities to improve the profitability of the Corporation. In the case of branch delivery, this could include the closure, sale or other disposal of a branch or addition to the current branch structure. During the September quarter, the Board of Directors approved a branch application for a Madison, Wisconsin area branch which is targeted to open for business in early 2015. As normal course, any management recommendations are reviewed with the Board of Directors for approval.

 

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Selected quarterly data are set forth in the following tables.

 

		Three Months Ended
		9/30/2014				6/30/2014				3/31/2014				12/31/2013				9/30/2013
		(Dollars in thousands—except per share amounts)
Operations Data:
Net interest income		$	17,558			$	17,862			$	18,315			$	18,877			$	15,812
Provision for loan losses			(1,304	)			—				—				—				—
Non-interest income			8,015				7,610				5,932				8,002				142,679
Non-interest expense			21,915				22,855				22,317				23,125				45,232
Income before income tax expense			4,962				2,617				1,930				3,754				113,259
Income tax expense			—				10				—				—				9
Net income			4,962				2,607				1,930				3,754				113,250
Preferred stock dividends in arrears(1)			—				—				—				—				103,163
Preferred stock discount accretion			—				—				—				—				(4,304	)
Net income available to common equity			4,962				2,607				1,930				3,754				212,109
Selected Financial Ratios (2):
Yield on interest-earning assets			3.60	%			3.72	%			3.89	%			3.86	%			3.71	%
Cost of funds			0.22				0.23				0.25				0.27				0.88
Interest rate spread			3.38				3.49				3.64				3.59				2.83
Net interest margin			3.40				3.51				3.66				3.61				2.80
Return on average assets			0.93				0.49				0.37				0.68				19.60
Average equity to average assets			9.99				9.88				9.81				9.32				(2.67	)
Non-interest expense to average assets			4.10				4.33				4.32				4.21				7.83
Per Share:
Basic earnings per common share		$	0.55			$	0.29			$	0.21			$	0.41			$	10.24
Diluted earnings per common share			0.55				0.29				0.21				0.41				10.24
Dividends per common share			—				—				—				—				—
Book value per common share			23.22				23.37				22.84				22.34				22.21
Financial Condition:
Total assets		$	2,106,520			$	2,121,249			$	2,109,824			$	2,112,474			$	2,191,001
Loans receivable
Held for sale			4,937				5,261				2,944				3,085				4,571
Held for investment, net			1,509,246				1,506,963				1,513,720				1,544,324				1,582,554
Deposits			1,858,807				1,873,240				1,868,751				1,875,293				1,943,144
Other borrowed funds			13,060				13,781				13,210				12,877				19,748
Stockholders’ equity			214,709				211,507				206,708				202,198				201,037
Allowance for loan losses			47,037				49,175				53,497				65,182				71,853
Non-performing assets(3)			85,077				98,337				102,118				131,957				162,899

 

(1)	Including compounding, and $104,000 in quarter ended 9/30/2013 for retirement of preferred shares.

(2)	Annualized when appropriate.

(3)	Non-performing assets consist of loans past due ninety days or more and on non-accrual status, loans past due less than ninety days but placed on non-accrual status due to anticipated probable loss, non-accrual troubled debt restructurings and OREO.

 

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RESULTS OF OPERATIONS

Overview – Three months Ended September 30, 2014

Net results from operations for the three months ended September 30, 2014 declined $108.3 million to net income of $5.0 million from net income of $113.3 million in the prior year period. The decline in results was due to a decline of $134.7 million in non-interest income from the prior year period, primarily the result of $134.5 million extinguishment of debt recorded related to the payoff of the Company’s short term line of credit with U. S. Bank and other lenders. Partially offsetting this decline was an increase of $1.7 million in net interest income and a decline of $23.3 million in non-interest expense. The discussion that follows in this section provides additional details regarding these results for the three month periods.

Net Interest Income

The following table shows the Corporation’s average balances, interest, average rates, the spread between the combined average rates earned on interest-earning assets and average cost of interest-bearing liabilities, net interest margin, which represents net interest income as a percentage of average interest-earning assets, and the ratio of average interest-earning assets to average interest-bearing liabilities for the years indicated. The average balances are derived from daily balances.

 

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		Three Months Ended September 30,
		2014												2013
										Average												Average
		Average								Yield/				Average								Yield/
		Balance				Interest				Cost(1)				Balance				Interest				Cost(1)
		(Dollars in thousands)
Interest-Earning Assets
Mortgage loans		$	1,190,522			$	12,631				4.15	%		$	1,271,394			$	14,037				4.32	%
Consumer loans			346,236				4,146				4.75				386,613				4,733				4.86
Commercial business loans			16,252				267				6.43				25,679				461				7.02
Total loans receivable (2) (3)			1,553,010				17,044				4.29				1,683,686				19,231				4.47
Investment securities (4)			294,105				1,450				1.93				292,406				1,487				1.99
Interest-earning deposits			162,329				103				0.25				195,774				122				0.25
Federal Home Loan Bank stock			11,940				15				0.50				25,630				19				0.29
Total interest-earning assets			2,021,384				18,612				3.60				2,197,496				20,859				3.71
Non-interest-earning assets			99,560												95,471
Total assets		$	2,120,944											$	2,292,967
Interest-Bearing Liabilities
Demand deposits		$	1,023,487				282				0.11			$	1,014,897				298				0.12
Regular savings			365,876				90				0.10				351,609				101				0.11
Certificates of deposit			482,999				622				0.51				602,030				975				0.64
Total deposits			1,872,362				994				0.21				1,968,536				1,374				0.28
Other borrowed funds			14,520				60				1.64				297,716				3,673				4.87
Total interest-bearing liabilities			1,886,882				1,054				0.22				2,266,252				5,047				0.88
Non-interest-bearing liabilities			22,186												87,835
Total liabilities			1,909,068												2,354,087
Stockholders’ equity (deficit)			211,876												(61,120	)
Total liabilities and stockholders’ equity (deficit)		$	2,120,944											$	2,292,967
Net interest income/interest rate spread (5)						$	17,558				3.38	%						$	15,812				2.83	%
Net interest-earning assets		$	134,502											$	(68,756	)
Net interest margin (6)											3.40	%											2.80	%
Ratio of average interest-earning assets to average interest-bearing liabilities			1.07												0.97

 

(1)	Annualized

(2)	For the purpose of these computations, non-accrual loans are included in the average loan amounts outstanding.

(3)	Interest earned on loans includes loan fees (which are not material in amount) and interest income which has been received from borrowers whose loans were removed from non-accrual status during the period indicated.

(4)	Average balances of securities available-for-sale are based on fair value.

(5)	Interest rate spread represents the difference between the weighted-average yield on interest-earning assets and the weighted- average cost of interest-bearing liabilities and is represented on a fully tax equivalent basis if applicable.

(6)	Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

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Net interest income increased $1.7 million, or 11.0%, for the three months ended September 30, 2014, as compared to the same period in the prior year. Interest income decreased $2.2 million, or 10.8%, for the three months ended September 30, 2014, compared to the same period in the prior year. This was primarily the result of a decline of $130.7 million in average balance of total loans accompanied by a decrease in yield on total loans of 18 basis points. Investment securities balances increased slightly from the prior year period while yields decreased. Interest expense decreased $4.0 million, or 79.1%, for the three months ended September 30, 2014, as compared to the same period in the prior year due to the settlement of the Credit Agreement with U.S. Bank and prepayment of FHLB of Chicago borrowings resulting in lower borrowed funds balances and rates paid on borrowings. Lower deposit balances and rates paid, primarily on certificates of deposits, also contributed to the decline in interest expense. The net interest margin increased to 3.40% for the three month period ended September 30, 2014 from 2.80% for the respective period in the prior year.

Loan portfolio average balances declined $130.7 million for the quarter ended September 30, 2014 when compared to the year ago same quarter largely due to principal and interest payments net of new loan originations. New loan originations had been limited as part of our capital improvement strategy to reduce risk-weighted assets by shrinking the overall size of the balance sheet. However, we have recently developed and are implementing strategies to increase profitability by slowing asset runoff and generating new loan volume to improve the net interest margin. Investment securities average balances increased $1.7 million when compared to the prior year quarter as purchases of securities outpaced sales and principal collections. The average balance of interest-earning deposits declined $33.4 million as the flow of funds from the loan and investment securities portfolios were used to reinvest in higher yielding investment securities and fund deposit run off.

Other borrowed funds average balances declined by $283.2 million for the three months ended September 30, 2014 when compared to the same period in the prior year due to the payoff and settlement of $116.3 million under the Credit Agreement and prepayment of $187.5 million of FHLB of Chicago borrowings during the quarter ended September 30, 2013. The average balance of certificates of deposit decreased $119.0 million for the three months ended September 30, 2014 compared to the same period in the previous year. Likewise, the average rate paid on certificates of deposit fell by 13 basis points year over year. The decline in certificates of deposit average balances and interest rates was largely the result of lower rates offered in the market and pricing discipline as a result of reduced funding needs.

Provision for Loan Losses

Provision for loan losses decreased $1.3 million for the three month period ended September 30, 2014, as compared to the same period in the previous year. The decrease in provision for loan losses for the three months ended September 30, 2014 was primarily due to a reduction in net charge offs resulting from unanticipated recoveries of loans previously charged off and non-perfoming loans compared to the same period in the prior year. Non-performing loans totaled $38.4 million at September 30, 2014, down from $68.5 million at December 31, 2013.

Future provisions for loan losses will continue to be based upon management’s assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions and other relevant factors in order to maintain the ALLL at adequate levels to provide for probable and estimable future losses. The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the adequacy of the allowance, which ultimately may change. Higher rates of loan defaults than anticipated would likely result in a need to increase provisions in future periods. Conversely, the amount of provision for loan losses could decline or a reversal of expense may be warranted should credit metrics such as net charge-offs and the amount of non-performing loans continue to improve in the future.

 

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Non-Interest Income

The following table presents non-interest income by major category for the periods indicated:

 

		Three Months Ended September 30,								Increase (Decrease)
		2014				2013				Amount				Percent
		(Dollars in thousands)
Net impairment losses recognized in earnings		$	(30	)		$	—			$	(30	)			N/M
Loan servicing income, net of amortization			705				646				59				9.1	%
Service charges on deposits			2,626				2,667				(41	)			(1.5	)
Investment and insurance commissions			1,015				893				122				13.7
Net gain on sale of loans			837				1,565				(728	)			(46.5	)
Net gain on sale of investment securities			482				—				482				N/M
Net gain on sale of OREO			987				1,217				(230	)			(18.9	)
Extinguishment of debt			—				134,514				(134,514	)			(100.0	)
Other income			1,393				1,177				216				18.4
Total non-interest income		$	8,015			$	142,679			$	(134,664	)			(94.4	)%

N/M = Not Meaningful

Non-interest income decreased $134.7 million, or 94.4%, to $8.0 million for the three months ended September 30, 2014, compared to $142.7 million for the same period in 2013 due to the extinguishment of debt recorded as a result of the payoff of the U.S. Bank borrowings. Net gain on sale of loans decreased by $728,000 and was partly offset by an increase in net gain on sale of investments of $482,000.

The decrease in net gain on sale of loans of $728,000 was primarily attributable to a significantly lower volume of residential mortgage loan sales in the current year period of $44.1 million compared to $82.5 million in the same three month period a year ago. Market mortgage rates reached historic lows during the fourth calendar quarter of 2012 into the first quarter of 2013 and have increased since March 31, 2013, causing a reduction in demand for mortgage loans.

Gain on sale of investment securities increased $482,000 in the current period compared to the respective period a year ago as a result of security sales net of gains/losses of $11.4 million in the current period.

 

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Non-Interest Expense

The following table presents non-interest expense by major category for the periods indicated:

 

		Three Months Ended September 30,								Increase (Decrease)
		2014				2013				Amount				Percent
		(Dollars in thousands)
Compensation and benefits		$	10,872			$	10,727			$	145				1.4	%
Occupancy			1,685				2,703				(1,018	)			(37.7	)
Furniture and equipment			758				902				(144	)			(16.0	)
Federal deposit insurance premiums			701				1,276				(575	)			(45.1	)
Data processing			1,340				1,264				76				6.0
Communications			611				497				114				22.9
Marketing			962				848				114				13.4
OREO expense, net			2,999				3,214				(215	)			(6.7	)
Investor loss reimbursement			136				223				(87	)			(39.0	)
Mortgage servicing rights impairment (recovery)			(53	)			(466	)			413				(88.6	)
Provision for unfunded loan commitments			(2,401	)			974				(3,375	)			N/M
Loan processing and servicing expense			577				795				(218	)			(27.4	)
Legal services			502				1,047				(545	)			(52.1	)
Other professional fees			404				878				(474	)			(54.0	)
Insurance			259				1,773				(1,514	)			(85.4	)
Debt prepayment penalty			—				16,149				(16,149	)			N/M
Reorganization costs			—				1,866				(1,866	)			N/M
Other expense			2,563				562				2,001				356.0
Total non-interest expense		$	21,915			$	45,232			$	(23,317	)			(51.5	)%

N/M = Not Meaningful

Non-interest expense decreased $23.3 million, or 51.5%, to $21.9 million for the three months ended September 30, 2014, as compared to $45.2 million for the respective period in 2013. Most categories of expense experienced a decline when compared to the prior year period in part due to ongoing expense control efforts. The favorable variance was primarily due to a debt prepayment penalty of $16.1 million for the early payoff of $176.0 million of FHLB borrowings, reorganization costs resulting from the bankruptcy filing and higher insurance expense related to additional pre-bankruptcy coverage costs in the three months ended September 30, 2013. Other significant decreases were due to lower provision for unfunded loan commitments, net occupancy expense, legal services and deposit insurance premiums. Slightly offsetting these decreases was an increase in other expense of $2.0 million.

The provision for unfunded loan commitments declined by $3.4 million when compared with the prior year as the result of the release of a specific reserve of $2.7 million related to the settlement ofthe Village of Kronenwetter loan commitment litigation. Occupancy expense declined from the prior year period by $1.0 million primarily due to property repairs made in the prior year period. Legal services declined during the period due to lower expense related to commercial loan workouts as non-performing loans continue to decline. Deposit insurance premiums have declined due to a reduced rate being charged to the Bank beginning in December 2013.

Other expense increased by $2.0 million during the quarter ended September 30, 2014 primarily due to the settlement of the Village of Kronenwetter litigation which included interest expense and legal fees.

Income Taxes

No income tax expense was recorded for the three month period ended September 30, 2014 compared to $9,000 for the same period in 2013. While previously unrecognized net operating loss carryforwards were used to substantially offset taxable income, some states in which we operate have a minimum tax requirement which resulted in $9,000 of tax expense in the prior year period. A full valuation allowance has been recorded on the remaining net deferred tax asset due to the uncertainty of our ability to create sufficient taxable income to utilize the tax asset.

 

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Overview – Nine months Ended September 30, 2014

Net income from operations for the nine months ended September 30, 2014 declined $84.4 million to $9.5 million from $93.9 million in the prior year period. The decline in results was primarily the result of a decline in non-interest income of $137.5 million partially offset by a $41.2 million decline in non-interest expense and an increase in net interest income of $9.7 million compared to the nine months ended September 30, 2013. Non-interest income declined due to the $134.5 extinguishment of debt recorded related to the payoff of the Company’s short term line of credit with U. S. Bank and other lenders in the prior year period. The discussion that follows in this section provides additional details regarding these results for the nine month periods.

Net Interest Income

The following table shows the Corporation’s average balances, interest, average rates, the spread between the combined average rates earned on interest-earning assets and average cost of interest-bearing liabilities, net interest margin, which represents net interest income as a percentage of average interest-earning assets, and the ratio of average interest-earning assets to average interest-bearing liabilities for the years indicated. The average balances are derived from daily balances.

 

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		Nine Months Ended September 30,
		2014												2013
										Average												Average
		Average								Yield/				Average								Yield/
		Balance				Interest				Cost(1)				Balance				Interest				Cost(1)
		(Dollars in thousands)
Interest-Earning Assets
Mortgage loans		$	1,196,369			$	38,747				4.27	%		$	1,317,323			$	44,150				4.42	%
Consumer loans			353,011				12,648				4.79				405,102				14,737				4.86
Commercial business loans			19,814				846				5.63				25,511				1,298				6.71
Total loans receivable (2) (3)			1,569,194				52,241				4.39				1,747,936				60,185				4.54
Investment securities (4)			289,304				4,478				2.04				275,727				4,162				1.99
Interest-earning deposits			141,218				262				0.25				188,037				347				0.25
Federal Home Loan Bank stock			11,940				49				0.55				25,630				57				0.30
Total interest-earning assets			2,011,656				57,030				3.74				2,237,330				64,751				3.82
Non-interest-earning assets			98,982												101,199
Total assets		$	2,110,638											$	2,338,529
Interest-Bearing Liabilities
Demand deposits		$	1,016,808				883				0.12			$	1,025,746				965				0.13
Regular savings			341,087				263				0.10				324,120				266				0.11
Certificates of deposit			507,250				1,969				0.52				645,599				3,357				0.70
Total deposits			1,865,145				3,115				0.22				1,995,465				4,588				0.31
Other borrowed funds			14,817				180				1.60				311,757				16,114				6.88
Total interest-bearing liabilities			1,879,962				3,295				0.23				2,307,222				20,702				1.20
Non-interest-bearing liabilities			21,831												88,470
Total liabilities			1,901,793												2,395,692
Stockholders’ equity (deficit)			208,845												(57,163	)
Total liabilities and stockholders’ equity (deficit)		$	2,110,638											$	2,338,529
Net interest income/interest rate spread (5)						$	53,735				3.51	%						$	44,049				2.62	%
Net interest-earning assets		$	131,694											$	(69,892	)
Net interest margin (6)											3.52	%											2.58	%
Ratio of average interest-earning assets to average interest-bearing liabilities			1.07												0.97

 

(1)	Annualized

(2)	For the purpose of these computations, non-accrual loans are included in the average loan amounts outstanding.

(3)	Interest earned on loans includes loan fees (which are not material in amount) and interest income which has been received from borrowers whose loans were removed from non-accrual status during the period indicated.

(4)	Average balances of securities available-for-sale are based on fair value.

(5)	Interest rate spread represents the difference between the weighted-average yield on interest-earning assets and the weighted- average cost of interest-bearing liabilities and is represented on a fully tax equivalent basis if applicable.

(6)	Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

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Net interest income increased $9.7 million, or 22.0%, for the nine months ended September 30, 2014, as compared to the same period in the prior year. Interest income decreased $7.7 million, or 11.9%, for the nine months ended September 30, 2014, compared to the same period in the prior year due to declines in average balances and yields in all loan categories but primarily declines in the residential and commercial real estate loan portfolios. Investment securities average balance and yield increased modestly over the prior year period. Interest expense declined $17.4 million, or 84.1%, for the nine months ended September 30, 2014, as compared to the same period in the prior year due to the settlement of the credit agreement with U.S. Bank and prepayment of FHLB of Chicago borrowings which resulted in lower borrowed funds balances. A reduction in certificate of deposit average balances and the rate paid on these accounts also contributed to the decline in interest expense. The net interest margin increased to 3.52% for the nine month period ended September 30, 2014 from 2.58% for the respective period in the prior year.

Loan portfolio average balances declined $178.7 million from September 30, 2013 largely due to principal payments net of new loan originations and loan sales. New loan originations had been limited as part of our capital improvement strategy to reduce risk-weighted assets by shrinking the overall size of the balance sheet. However, as problem loans have been steadily rolling off, we are now replacing them but at a slower rate with the intent of generating new loan volume to improve the net interest margin. During the nine months ended September 30, 2014, investment securities average balances increased $13.6 million primarily due to the purchase of securities totaling $63.6 million and partially offset by proceeds from sales net of gains/losses of $11.4 million and principal collections of $39.7 million. The average balance of interest-earning deposits declined $46.8 million as the flow of funds from the loan and investment securities portfolios were used to reinvest in higher yielding investment securities and fund deposit run off.

Other borrowed funds average balances declined by $296.9 million for the nine months ended September 30, 2014 when compared to the same period in the prior year primarily due to the payoff and settlement of $116.3 million under the Credit Agreement and prepayment of $187.5 million of FHLB of Chicago borrowings during the quarter ended September 30, 2013. The average balance of certificates of deposit decreased $138.3 million for the nine months ended September 30, 2014 compared to the same period in the previous year. Likewise, the average rate paid on certificates of deposit fell by 18 basis points year over year. The decline in certificates of deposit average balances and interest rates was largely the result of lower rates offered in the market and pricing discipline as a result of reduced funding needs.

Provision for Loan Losses

Provision for loan losses declined $2.3 million for the nine month period ended September 30, 2014 to a recovery of $1.3 million for the period, as compared to expense of $950,000 for the same period in the previous year. The decrease in provision for loan losses for the nine months ended September 30, 2014 was primarily due to a reduction in net charge offs resulting from unanticipated recoveries of loans previously charged off and non-performing loans compared to the same period in the prior year. Non-performing loans totaled $38.4 million at September 30, 2014, down from $68.5 million at December 31, 2013.

Future provisions for loan losses will continue to be based upon management’s assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions and other relevant factors in order to maintain the ALLL at adequate levels to provide for probable and estimable future losses. The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the adequacy of the allowance, which ultimately may change. Higher rates of loan defaults than anticipated would likely result in a need to increase provisions in future periods. Conversely, the amount of provision for loan losses recorded could decline or a reversal expense may be warranted should credit metrics such as net charge-offs and the amount of non-performing loans continue to improve in the future.

 

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Non-Interest Income

The following table presents non-interest income by major category for the periods indicated:

 

		Nine Months Ended September 30,								Increase (Decrease)
		2014				2013				Amount				Percent
		(Dollars in thousands)
Net impairment losses recognized in earnings		$	(64	)		$	(83	)		$	19				22.9	%
Loan servicing income, net of amortization			2,219				756				1,463				N/M
Service charges on deposits			7,415				7,616				(201	)			(2.6	)
Investment and insurance commissions			3,002				2,908				94				3.2
Net gain on sale of loans			2,127				7,388				(5,261	)			(71.2	)
Net gain on sale of investment securities			783				(200	)			983				N/M
Net gain on sale of OREO			2,188				3,479				(1,291	)			(37.1	)
Extinguishment of debt			—				134,514				(134,514	)			(100.0	)
Other income			3,887				2,656				1,231				46.3
Total non-interest income		$	21,557			$	159,034			$	(137,477	)			(86.4	)%

N/M = Not Meaningful

Non-interest income decreased $137.5 million, or 86.4%, to $21.6 million for the nine months ended September 30, 2014, compared to $159.0 million for the same period in 2013. The decrease was primarily due to the $134.5 million extinguishment of debt recorded in the prior year period as a result of the payoff of the U.S. Bank borrowing, declines in gain on sale of loans of $5.3 million and net gain on sale of OREO of $1.3 million. These unfavorable items were partially offset by increases in loan servicing income of $1.5 million, other income of $1.2 million, and gain on sale of securities of $983,000.

The decrease in net gain on sale of loans of $5.3 million was primarily attributable to a significantly lower volume of residential mortgage loan sales in the current year period of $101.2 million compared to $395.3 million in the same nine month period a year ago. Market mortgage rates reached historic lows during the fourth calendar quarter of 2012 into the first quarter of 2013 and have increased significantly since March 31, 2013, which caused a reduction in demand for mortgage loans which resulted in lower financing activity. Net gain on sale of OREO decreased by $1.3 million in the nine months ended September 30, 2014 from $3.5 million in the year ago period largely due to the impact of lower sales volume with smaller gains per property as the OREO portfolio balances continue to decline and we realize smaller margins per property.

Loan servicing income increased $1.5 million in the current period compared to the respective period a year ago primarily due to lower amortization charges related to the MSR asset. Other income increased by $1.2 million over the prior year due to income from real estate partnerships, increased rental income of bank property and increased credit card income. Sales of investment securities reflect a $783,000 gain during the nine months ended September 30, 2014 as a result of securities sales net of gains/losses of $11.4 million compared to a loss of $200,000 in the same period in 2013.

 

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Non-Interest Expense

The following table presents non-interest expense by major category for the periods indicated:

 

		Nine Months Ended September 30,								Increase (Decrease)
		2014				2013				Amount				Percent
		(Dollars in thousands)
Compensation and benefits		$	32,773			$	31,999			$	774				2.4	%
Occupancy			5,537				7,000				(1,463	)			(20.9	)
Furniture and equipment			2,315				2,514				(199	)			(7.9	)
Federal deposit insurance premiums			2,449				3,962				(1,513	)			(38.2	)
Data processing			4,026				4,546				(520	)			(11.4	)
Communications			1,647				1,445				202				14.0
Marketing			2,494				1,750				744				42.5
OREO expense, net			6,451				19,762				(13,311	)			(67.4	)
Investor loss reimbursement			50				3,404				(3,354	)			(98.5	)
Mortgage servicing rights impairment (recovery)			42				(3,914	)			3,956				N/M
Provision for unfunded loan commitments			(1,621	)			3,133				(4,754	)			N/M
Loan processing and servicing expense			1,853				2,989				(1,136	)			(38.0	)
Legal services			1,457				3,418				(1,961	)			(57.4	)
Other professional fees			1,162				2,032				(870	)			(42.8	)
Insurance			775				2,567				(1,792	)			(69.8	)
Debt prepayment penalty			—				16,149				(16,149	)			N/M
Reorganization costs			—				1,866				(1,866	)			N/M
Other expense			5,677				3,653				2,024				55.4
Total non-interest expense		$	67,087			$	108,275			$	(41,188	)			(38.0	)%

N/M = Not Meaningful

Non-interest expense decreased $41.2 million, or 38.0%, to $67.1 million for the nine months ended September 30, 2014, as compared to $108.3 million for the respective period in 2013. The favorable variance was partially the result of one-time expenses in the prior year of a $16.1 million debt prepayment penalty for the early payoff of $176.0 million of FHLB borrowings, $1.9 million of reorganization costs resulting from the bankruptcy filing and higher insurance expense related to additional pre-bankruptcy coverage costs. Other significant decreases were net OREO expense, lower provision for unfunded loan commitments, investor loss reimbursement, legal services, deposit insurance premiums and net occupancy expense. These decreases were partly offset by an increase in mortgage servicing rights impairment of $4.0 million due to a recovery recorded in the prior year period.

The significant decline in OREO expense of $13.3 million during the nine months ended September 30, 2014 was primarily the result of a decline of $8.9 million in valuation adjustments on repossessed property. OREO real estate taxes also declined by $2.6 million over the prior year period as the number of properties held has declined. The provision for unfunded loan commitments reflected a reversal in the current period as compared to a provision in the prior year period which included a specific reserve of $1.7 million related to one credit. Investor loss reimbursement declined primarily due to a $2.0 million reserve recorded in the prior year period compared to no reserve in the first nine months of 2014. Legal fees declined $2.0 million due to lower expense related to commercial loan workouts as non-performing loans continue to decline. Deposit insurance premiums have declined from the prior year period as a result of a reduced rate being charged to the Bank beginning in December 2013. Occupancy expense declined from the prior year period by $1.5 million primarily due to property repairs made in the prior year period. Most other categories of expense reflected declines over the prior year period in part due to ongoing expense control efforts.

 

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MSR impairment expense was $42,000 in the nine months ended September 30, 2014 as rates have increased and prepayment has slowed versus a recovery of $3.9 million in the prior year period. Other non-interest expense increased primarily due to the settlement of the Village of Kronenwetter litigation during the quarter ended September 30, 2014. Other increases include marketing expense of $744,000 which has been ramped up to support the growth objectives of the bank and compensation and benefits have increased $774,000 as new commercial lending staff has been added to support commercial banking growth initiatives.

Income Taxes

Income tax expense of $10,000 was recorded for the nine month periods ended September 30, 2014 compared to $9,000 for the same period in 2013. While previously unrecognized net operating loss carryforwards were used to substantially offset taxable income, some states in which we operate have a minimum tax requirement which resulted in $10,000 of tax expense in the current period. State income tax estimates paid were recorded on the Consolidated Balance Sheets during the period. A full valuation allowance has been recorded on the remaining net deferred tax asset due to the uncertainty of our ability to create sufficient taxable income to utilize the tax asset.

FINANCIAL CONDITION

General

Total assets of the Corporation decreased $6.0 million, or less than one percent, to $2.11 billion at September 30, 2014. This decrease was primarily attributable to lower balances in net loans held for investment and OREO which were mostly offset by higher cash and cash equivalents and investment securities balances.

Investment Securities

Investment securities available-for-sale increased $14.0 million, or 5.0%, during the nine months ended September 30, 2014, primarily due to purchases of $63.6 million and a decrease in fair market value net loss adjustments of $2.7 million. These increases were partially offset by principal repayments of $39.7 million, sales net of gains/losses of $11.4 million and $163,000 of other-than-temporary impairment losses that were recognized in earnings. See Note 4 to the Consolidated Financial Statements.

Investment securities are subject to inherent risks based upon the future performance of the underlying collateral (i.e., mortgage loans) for these securities. Among these risks are prepayment risk, interest rate risk and credit risk. Should general interest rate levels decline, the mortgage-related securities portfolio would be subject to (i) prepayments as borrowers typically would seek to obtain financing at lower rates, (ii) a decline in interest income received on adjustable-rate mortgage-related securities, and (iii) an increase in fair value of fixed-rate mortgage-related securities. Conversely, should general interest rate levels increase, the mortgage-related securities portfolio would be subject to (i) a longer term to maturity as borrowers would be less likely to prepay their loans, (ii) an increase in interest income received on adjustable-rate mortgage-related securities, (iii) a decline in fair value of fixed-rate mortgage-related securities, (iv) a decline in fair value of adjustable-rate mortgage-related securities to the extent dependent upon the level of interest rate increases, the time period to the next interest rate repricing date for individual loans within the security and the applicable periodic (annual and/or lifetime) cap which could limit the degree to which an individual loan could reprice within a given time period, and (v) should default rates and loss severities increase on the underlying collateral of mortgage-related securities, the Corporation may experience credit losses that need to be recognized in earnings as other-than-temporary impairment.

Loans Held for Investment

Loans held for investment decreased $53.2 million during the nine months ended September 30, 2014 from $1.61 billion at December 31, 2013 to $1.56 billion at September 30, 2014. The activity included principal repayments and other adjustments (the majority of which relate to undisbursed loan proceeds) of $294.8 million and transfers to other real estate owned of $9.1 million, mostly offset by originations and refinances of $250.7 million. During the three months ended September 30, 2014, the Corporation originated $95.4 million of loans for investment, as compared to $97.9 million during the three months ended June 30, 2014.

 

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Loans Held for Sale

Residential mortgage loans originated for sale amounted to $100.9 million for the nine months ended September 30, 2014 compared to $361.0 million for the same period ended September 30, 2013. At December 31, 2013, loans held for sale, which consisted solely of single-family residential mortgage loans, amounted to $3.1 million, and increased $1.8 million to $4.9 million at September 30, 2014.

Other Real Estate Owned

OREO, net decreased $16.7 million to $46.7 million at September 30, 2014 from $63.5 million at December 31, 2013 due to sales of $21.2 million offset by additions during the nine months of $9.1 million, net of $4.6 million in valuation adjustments.

Deposits

Deposits decreased $16.5 million during the nine months ended September 30, 2014 to $1.86 billion, due to declines of $78.1 million in certificates of deposit (“CDs”) and $10.8 million in money market accounts which was mostly offset by increases in advance payments of $57.5 million and regular savings of $21.5 million. A significant portion of the CD decreases were due to planned reductions in deposits from single service special rate households. Deposits obtained from brokerage firms which solicit deposits from their customers amounted to zero at September 30, 2014 and December 31, 2013. The weighted average rate of CDs decreased to 0.52% at September 30, 2014 compared to 0.57% at December 31, 2013.

Other Liabilities

Total liabilities declined $18.5 million from December 31, 2013 to September 30, 2014 primarily due to declines in deposits of $16.5 million. Other liabilities declined $1.4 million and accrued taxes, insurance and employee related expenses declined $769,000 since December 31, 2013. Other borrowed funds increased slightly to $13.1 million at September 30, 2014 from $12.9 million at December 31, 2013. Other borrowed funds as of September 30, 2014 consist of FHLB of Chicago borrowings of $10.0 million and retail repurchase agreements of $2.8 million. At September 30, 2014 and December 31, 2013, FHLB of Chicago advances totaled $10.0 million and had a weighted average interest rate of 2.33%.

Stockholders’ Equity (Deficit)

Stockholders’ equity increased $12.5 million to $214.7 million at September 30, 2014 compared to $202.2 million at December 31, 2013. The increase during the nine months ended September 30, 2014 was primarily the result of net income during the period of $9.5 million and a decline in accumulated other comprehensive loss of $2.7 million primarily related to AFS securities.

RISK MANAGEMENT

The Company encounters risk as part of its normal course of business and designs risk management processes to help manage these risks. This section describes the Bank’s risk management philosophy, principles, governance and various aspects of its risk management process.

Risk Management Philosophy

The Bank’s risk management philosophy is to manage to an overall level of risk while still allowing it to capture opportunities and optimize shareholder value. However, due to the general state of the economy and the elevated risk in the loan portfolio, the Bank’s risk profile does not currently meet our desired risk level. While improvements have occurred, the Bank continues to work toward reducing the overall risk level to a more desired risk profile.

 

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The Bank views risk management as not about eliminating risks, but about identifying and accepting risks and then working to effectively manage them so as to optimize shareholder value. Risk management includes, but is not limited to the following:

 

•

Taking only risks consistent with the Bank’s strategy and within its capability to manage,

 

•

Ensuring strong underwriting and credit risk management practices,

 

•

Practicing disciplined capital and liquidity management,

 

•

Helping ensure that risks and earnings volatility are appropriately understood and measured,

 

•

Avoiding excessive concentrations, and

 

•

Helping support external stakeholder confidence.

Although the Board of Directors (the “Board”) is primarily responsible for oversight of risk management, committees of the Board may provide oversight to specific areas of risk with respect to the level of risk and risk management structure. The Bank uses management level risk committees to help ensure that business decisions are executed within our desired risk profile. Management provides oversight for the establishment and implementation of new risk management initiatives, reviews risk profiles and discusses key risk issues. The Chief Risk Officer is in charge of overseeing credit risk management. Our Internal Audit and Compliance departments perform an independent assessment of the internal control environment and plays a critical role in risk and compliance management, testing the operation of the internal control system and reporting findings to the Risk Committee and to the Audit Committee of the Board.

CREDIT RISK MANAGEMENT

Credit risk represents the possibility that a customer, counterparty or issuer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing investment securities and entering into certain guarantee contracts. Credit risk is one of the most significant risks facing the Bank.

In addition to credit policies and procedures and setting portfolio objectives for the level of credit risk, the Bank has established guidelines for problem loans, acceptable levels of total borrower exposure and other credit measures. Management continues to focus on loss mitigation and maximization of recoveries in the Bank’s non-performing assets portfolio. Over time, the Bank intends to return to management of portfolio returns through discrete portfolio investments within approved risk tolerances.

The Bank seeks to achieve credit portfolio objectives by maintaining a customer base that is diverse in borrower exposure and industry types. Corporate credit personnel are responsible for loan underwriting and approval processes to help ensure that newly approved loans meet policy and portfolio objectives.

The Risk Management group is responsible for monitoring credit risk, while Internal Audit provides an independent assessment of the effectiveness of the credit risk management process. An external credit risk management group also provides loan review services. Credit risk is managed taking into account regulatory guidance.

 

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Non-Performing Loans

The composition of non-performing loans is summarized as follows:

 

		September 30, 2014												December 31, 2013
		Non-Performing Loans				Percent of Non- Performing Loans				Percent of Total Gross Loans (1)				Non-Performing Loans				Percent of Non- Performing Loans				Percent of Total Gross Loans (1)
		(Dollars in thousands)
Residential		$	5,261				13.7	%			0.34	%		$	14,404				21.0	%			0.89	%
Commercial and industrial			193				0.5				0.01				1,509				2.2				0.09
Land and construction			17,873				46.7				1.14				24,729				36.1				1.52
Multi-family			5,256				13.7				0.34				3,658				5.4				0.22
Retail/office			4,438				11.6				0.28				14,365				21.0				0.89
Other commercial real estate			3,963				10.3				0.25				6,802				9.9				0.42
Education (2)			209				0.5				0.01				276				0.4				0.02
Other consumer			1,159				3.0				0.07				2,754				4.0				0.17
Total		$	38,352				100.0	%			2.44	%		$	68,497				100.0	%			4.22	%

 

(1)	Gross loans are the unpaid principal balance before the reduction for loans in process, unearned interest and loan fees and the allowance for loans losses.

(2)	Excludes the guaranteed portion of education loans 90+ days past due with an unpaid principal balance totaling $6,747 and $8,930 at September 30, 2014, and December 31, 2013, respectively, that are not considered impaired based on a guarantee provided by government agencies.

The following is a summary of non-performing loan activity:

 

		Non-																								Non-
		Performing																								Performing
		Loans								Transfer				Transfer												Loans				Remaining
		December 31,								to Accrual				to				Paid				Charged				September 30,				Balance				Associated
		2013				Additions				Status				OREO				Down				Off				2014				of Loans				ALLL
		(In thousands)
Residential		$	14,404			$	2,986			$	(5,121	)		$	(4,555	)		$	(858	)		$	(1,595	)		$	5,261			$	536,337			$	9,859
Commercial and industrial			1,509				4,844				(420	)			(57	)			(2,108	)			(3,575	)			193				14,250				1,458
Land and construction			24,729				9,642				(219	)			(1,395	)			(8,561	)			(6,323	)			17,873				81,521				10,272
Multi-family			3,658				4,592				(1,713	)			—				(559	)			(722	)			5,256				259,169				6,313
Retail/office			14,365				2,529				(1,359	)			(2,434	)			(2,058	)			(6,605	)			4,438				139,072				8,491
Other commercial real estate			6,802				2,661				(1,688	)			(140	)			(3,937	)			265				3,963				158,381				5,017
Education			276				—				—				—				(67	)			—				209				112,459				491
Other consumer			2,754				1,338				(851	)			(437	)			(414	)			(1,231	)			1,159				229,397				5,136
Total		$	68,497			$	28,592			$	(11,371	)		$	(9,018	)		$	(18,562	)		$	(19,786	)		$	38,352			$	1,530,586			$	47,037

Non-performing loans decreased $30.1 million during the nine months ended September 30, 2014. The loan categories with the largest decline in non-performing loans were retail/office of $9.9 million, residential loans of $9.1 million, land and construction of $6.9 million and other commercial real estate of $2.8 million.

The interest income that would have been recorded during the three and nine months ended September 30, 2014 if the Bank’s non-performing loans at the end of the period had been current in accordance with their terms during the period was $614,000 and $2.4 million, respectively.

 

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Non-Performing Assets

The composition of non-performing assets and related credit metrics are summarized as follows:

 

		September 30,				December 31,
		2014				2013
		(Dollars in thousands)
Non-accrual loans—excluding troubled debt restructurings		$	20,372			$	39,151
Troubled debt restructurings—non-accrual (1)			17,980				29,346
Other real estate owned (OREO)			46,725				63,460
Total non-performing assets		$	85,077			$	131,957
Non-performing loans to gross loans (2)			2.44	%			4.22	%
Non-performing assets to total assets			4.04				6.25
Allowance for loan losses to gross loans (2)			3.00				4.02
Allowance for loan losses to non-performing loans			122.65				95.16
Allowance for loan losses plus OREO valuation allowance to non-performing assets			81.61				72.77

 

(1)	Troubled debt restructurings – non-accrual represent non-accrual loans that have been modified in a troubled debt restructuring.

(2)	Gross loans are the unpaid principal balance before the reduction for loans in process, unearned interest and loan fees and the allowance for loans losses.

Loans modified in a TDR due to rate or term concessions that are currently on non-accrual status will remain on non-accrual status for a period of at least six months. If after six months, or a longer period sufficient enough to demonstrate the willingness and ability of the borrower to perform under the modified terms, the borrower has made payments in accordance with the modified terms, the loan is returned to accrual status but retains its status as a TDR. Once a TDR loan is returned to accrual, further review of the credit could take place resulting in a further upgrade into the pass category but still remaining as a TDR. As a result, TDR accruals are reported in the pass and impaired categories as appropriate. The designation as a TDR is removed in years after the restructuring if both of the following conditions exist: (a) the restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of restructuring for a new loan with comparable risk and (b) the loan is not impaired based on the terms specified by the restructuring agreement.

 

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The following is a summary of non-performing asset activity for the nine months ended September 30, 2014:

 

		Non-Performing Loans (1)				Other Real Estate Owned (OREO)				Total Non- Performing Assets
		(In thousands)
Balance at December 31, 2013		$	68,497			$	63,460			$	131,957
Additions			28,592				66				28,658
Transfer of loans to OREO			(9,018	)			9,018				—
Returned to accrual status			(11,371	)			—				(11,371	)
Sales			—				(21,220	)			(21,220	)
Loan charge-offs/OREO valuation adjustments, net			(19,786	)			(4,627	)			(24,413	)
Capitalized improvements			—				28				28
Payments			(18,562	)			—				(18,562	)
Balance at September 30, 2014		$	38,352			$	46,725			$	85,077

 

(1)	Total non-performing loans exclude the guaranteed portion of education loans of $6,747 and $8,930 that are 90 days or more past due but still accruing interest at September 30, 2014, and December 31, 2013, respectively.

Loan Delinquencies 30 Days and Over

The following table sets forth information relating to past due loans that were delinquent 30 days and over at the dates indicated.

 

		September 30, 2014								December 31, 2013
						% of Total								% of Total
Days Past Due		Balance				Gross Loans				Balance				Gross Loans
		(Dollars in thousands)
30 to 59 days		$	6,311				0.40	%		$	11,885				0.73	%
60 to 89 days			3,668				0.23				4,280				0.26
90 days and over			25,803				1.65				49,017				3.02
Total		$	35,782				2.28	%		$	65,182				4.02	%

Loans delinquent 30 to 89 days decreased $6.2 million to $10.0 million at September 30, 2014 from $16.2 million at December 31, 2013 due to a decline in substandard loans in these past due categories.

Impaired Loans

At September 30, 2014, the Corporation identified $50.1 million of loans as impaired, which includes $11.8 million of performing TDRs. At December 31, 2013, impaired loans were $101.6 million, which included $33.1 million of performing TDRs. A loan is identified as 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 and thus are placed on non-accrual status.

 

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The following is additional information regarding impaired loans.

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Carrying amount of impaired loans		$	44,641			$	78,471
Average carrying amount of impaired loans			51,452				77,734
Loans and troubled debt restructurings on non-accrual status			38,352				68,497
Troubled debt restructurings—accrual			11,796				33,087
Troubled debt restructurings—non-accrual (1)			17,980				29,346
Troubled debt restructurings valuation allowance			4,482				12,216
Loans past due ninety days or more and still accruing (2)			6,747				8,930

 

(1)	Troubled debt restructurings—non-accrual are included in the loans and troubled debt restructurings on non-accrual status line item above.

(2)	Represents the guaranteed portion of education loans that were 90+ days past due which continue to accrue interest due to a guarantee provided by government agencies covering approximately 97% of the outstanding balance.

Interest income recognized on impaired loans on a cash basis was $2.2 million and $3.6 million for the nine months ended September 30, 2014 and 2013.

Allowance for Loan Losses

Like all financial institutions, we must maintain an adequate ALLL. The ALLL is established through a provision for loan losses charged to expense. Loans are charged-off against the ALLL when we believe that repayment of principal is unlikely. Subsequent recoveries, if any, are credited to the ALLL. The balance in the ALLL is an amount that we believe will be adequate to absorb probable losses on existing loans that may become uncollectible, based on evaluation of the collectability of loans and prior credit loss experience, together with the other factors discussed in “Critical Accounting Estimates and Judgments.”

The ALLL consists of general and specific components even though the entire allowance is available to cover losses on any loan. The specific allowance component relates to impaired loans (i.e. – non-accrual) and loans reported as troubled debt restructurings. For such loans, an ALLL is established when the discounted cash flows (or collateral value if repayment relies solely on the operation or sale of the collateral) of the impaired loan are lower than the carrying value of that loan. The general allowance component is based on historical net loss experience for the past ten quarters, adjusted for qualitative factors. A reserve for unfunded commitments, letters of credit and repurchase of sold loans is also maintained which is classified in other liabilities.

Beginning with the quarter ended June 30, 2014, the Bank modified its general allowance methodology to increase the historical loss period by an additional quarter until the historical look-back period is built to a 12 quarter look back period. For the quarter ended September 30, 2014, the Bank utilized a ten quarter look back period compared to a nine quarter look-back period for the quarter ended June 30, 2014. The modification is being done to reflect a more stable economic environment and to capture additional loss statistics considered reflective of the current portfolio. The impact to the allowance for loan losses at September 30, 2014 after implementing the above modifications was a reduction of the required reserve of $92,000 as compared to the previous methodology. See the Company’s annual report on Form 10-K/T for the nine months ended December 31, 2013 for a full description of the allowance methodology.

The general component of the allowance for loan loss methodology incorporates the following qualitative risk factors to establish the appropriate general allowance for loan loss at each reporting date.

Qualitative factors include:

 

•

Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses;

 

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•

Changes in international, national, regional and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;

 

•

Changes in the nature and volume of the portfolio and in the terms of loans;

 

•

Changes in the experience, ability and depth of lending management and other relevant staff;

 

•

Changes in the volume and severity of past due loans, the volume of non-accrual loans, and volume and severity of adversely classified or graded loans;

 

•

Changes in the quality of AnchorBank’s loan review system;

 

•

Changes in the value of underlying collateral for collateral-dependent loans;

 

•

The existence and effect of any concentrations of credit, and changes in the level of such concentrations; and

 

•

The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in AnchorBank’s current portfolio.

Any changes in the risk factors are based on perceived risk of similar groups of loans classified by collateral type, purpose and terms. Statistics on local trends, peers, and an internal ten quarter net loss history are also incorporated into the allowance methodology. Due to the credit concentration of our loan portfolio in real estate secured loans, the qualitative factor related to the value of collateral is heavily dependent on real estate values in Wisconsin and surrounding states. While management uses the best information available to make its evaluation, future adjustments to the ALLL may be necessary if there are significant changes in economic or other conditions. In addition, the OCC, as an integral part of their examination processes, periodically reviews the Banks’ ALLL, and may recommend adjustments based on their assessment of the adequacy of the ALLL. Management periodically reviews the assumptions and formula used in determining the ALLL and makes adjustments if required to reflect the current risk profile of the portfolio.

The following table presents the ALLL by component:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
General reserve		$	33,447			$	35,844
Substandard reserve			8,083				6,225
Specific reserve			5,507				23,113
Total allowance for loan losses		$	47,037			$	65,182

 

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The following table presents the unpaid principal balance of loans by risk category:

 

		September 30,				December 31,
		2014				2013
		(In thousands)
Pass (1)		$	1,491,285			$	1,460,457
Special mention			6,211				24,203
Total pass and special mention rated loans			1,497,496				1,484,660
Substandard rated loans, excluding TDR accrual (2)			21,294				35,310
Troubled debt restructurings—accrual			11,796				33,087
Non-accrual			38,352				68,497
Total impaired loans			50,148				101,584
Total unpaid principal balance		$	1,568,938			$	1,621,554

 

(1)	Includes TDR accruing loans of $53.2 million and $31.2 million at September 30, 2014 and December 30, 2013, respectively.

(2)	Includes residential and consumer loans identified as substandard that are not necessarily on non-accrual.

The following table presents credit risk metrics related to the ALLL:

 

		September 30,				December 31,
		2014				2013
		(Dollars in thousands)
General ALLL / pass and special mention loans			2.2	%			2.4	%
Substandard ALLL/substandard loans			38.0	%			17.6	%
Specific ALLL / impaired loans			11.0	%			22.8	%
Loans 30 to 89 days past due		$	9,979			$	16,165

The ratio of general ALLL to pass and special mention loans remained relatively stable while the substandard ALLL to substandard loans increased from December 31, 2013 to reflect management’s assessment of risk and related potential for loss. The ratio of specific ALLL to impaired loans declined from December 31, 2013 as a result of higher charge offs and significantly lower levels of impaired loans.

 

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The following table summarizes the activity in the ALLL for the periods indicated.

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
		(Dollars in thousands)
Allowance at beginning of period		$	49,175			$	75,872			$	65,182			$	83,761
Charge-offs:
Residential			(194	)			(712	)			(1,856	)			(4,241	)
Multi-family			—				(132	)			(883	)			(486	)
Commercial real estate			(86	)			(1,382	)			(7,477	)			(2,163	)
Land and construction			(3,174	)			(335	)			(6,802	)			(2,712	)
Consumer			(380	)			(486	)			(1,815	)			(3,806	)
Commercial and industrial			(168	)			(2,357	)			(5,123	)			(3,492	)
Total charge-offs			(4,002	)			(5,404	)			(23,956	)			(16,900	)
Recoveries:
Residential			31				83				387				264
Multi-family			85				29				216				137
Commercial real estate			586				710				2,880				1,773
Land and construction			660				122				793				995
Consumer			49				125				306				270
Commercial and industrial			1,757				316				2,533				603
Total recoveries			3,168				1,385				7,115				4,042
Net charge-offs			(834	)			(4,019	)			(16,841	)			(12,858	)
Provision for loan losses			(1,304	)			—				(1,304	)			950
Allowance at end of period		$	47,037			$	71,853			$	47,037			$	71,853
Net charge-offs to average loans held for sale and for investment (1)			(0.21	)%			(0.95	)%			(1.43	)%			(0.98	)%

 

(1)	Annualized.

Total charge-offs and recoveries of $4.0 million and $3.2 million, respectively, for the three months ended September 30, 2014 decreased $1.4 million and increased $1.8 million, respectively, from the three months ended September 30, 2013. Total charge-offs and recoveries of $24.0 million and $7.1 million, respectively, for the nine months ended September 30, 2014 increased $7.1 million and $3.1 million, respectively, from the nine months ended September 30, 2013.

The provision for loan losses declined $1.3 million and $2.3 million for the three and nine months ended September 30, 2014, respectively compared to the same periods in the prior year as the result of a release of provision in the current period. The improvement was largely due to significantly lower net charge offs, a lower required allowance for losses on impaired loans, reflecting the relatively steady quarter-over-quarter decrease in non-performing loans since June 2010 which resulted in the reversal of provision for the quarter. Management monitors and evaluates the portfolio on an ongoing basis and also considered the decrease in non-performing loans to total loans to 2.44% at September 30, 2014 from 4.22% at December 31, 2013 to be a factor that warranted the decrease in ALLL.

 

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Other Real Estate Owned

OREO, net decreased $16.7 million during the nine months ended September 30, 2014. Individual properties included in OREO at September 30, 2014 with a recorded balance in excess of $1 million are listed below:

 

Description		Location		Carrying Value
					(in thousands	)
Raw Land		Northeast Wisconsin		$	3,266
Commercial Building		Northwest Wisconsin			1,632
Commercial Building		South Central Wisconsin			2,890
Raw Land		South Central Wisconsin			2,231
Commercial Building		South Central Wisconsin			1,360
Raw Land		South Central Wisconsin			1,352
Raw Land		South Central Wisconsin			1,238
Commercial Lot		South Central Wisconsin			1,071
Raw Land		Southeast Wisconsin			3,680
Commercial Building		Southeast Wisconsin			3,036
Commercial Building		Southeast Wisconsin			2,054
Raw Land		Southeast Wisconsin			1,162
Other properties individually less than $1 million					21,753
				$	46,725

Foreclosed properties are recorded at fair value less cost to sell upon transfer to OREO with shortfalls, if any, charged to the ALLL. Subsequent decreases in the valuation of OREO are recorded in a valuation account for the foreclosed property with a corresponding charge to OREO expense, net. The fair value is primarily based on appraisals. On a quarterly basis, the carrying values of OREO properties are reviewed and appropriate adjustments made based upon updated appraisals, broker opinions or signed sales contracts. For appraisals received over one year ago, management considers broker and market analysis to update the estimated fair value. Incremental valuation adjustments may be recognized in the Statement of Operations if, in the opinion of management, additional losses are deemed probable.

LIQUIDITY RISK MANAGEMENT

Liquidity risk is the risk of potential loss if the Corporation were unable to meet its funding requirements at a reasonable cost. The Corporation manages liquidity risk at the bank and holding company to help ensure that it can obtain cost-effective funding to meet current and future obligations.

The largest source of liquidity on a consolidated basis is the deposit base that originates from retail and corporate banking businesses. Other borrowed funds are available from a diverse mix of short- and long-term funding sources. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain an adequate liquidity position.

 

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Liquidity

Operating Activities

Net cash provided by operations of $11.2 million for the nine months ended September 30, 2014 decreased $2.9 million when compared to the same period in 2013 primarily due to lower valuation adjustments for OREO losses and lower gains on the sale of residential first mortgage loans. The $134.5 million extinguishment of debt in 2013 was substantially offset by the decrease in net income and decreased mortgage originations and sales.

Investing Activities

Net cash from investing activities decreased $92.8 million for the nine months ended September 30, 2014 as compared to the same period in 2013 due to a decline in the origination of loans held for investment, a decline in net cash outflows from all investment activity and lower proceeds from sales of OREO.

Financing Activities

Net cash used for financing activities decreased $165.0 million for the nine months ended September 30, 2014 as compared to the same period in 2013 primarily due to a decline in the level of run off on deposit balances during the period and decreases in the net repayment of borrowings and issuance of common stock.

Liquidity and Capital Resources

On an unconsolidated basis, the Corporation’s typical sources of funds could include dividends from its subsidiaries, including the Bank, interest on its investments and returns on its real estate held for sale. The Corporation currently finances its operations through cash on hand and, to a lesser extent, interest on investments and dividends from its non-Bank subsidiary. A significant amount of our consolidated operating expenses are incurred by and paid directly by the Corporation’s subsidiaries. The Bank is currently not paying dividends.

The Bank’s primary sources of funds are payments on loans and securities, deposits from retail and corporate banking businesses and wholesale funding sources (FHLB of Chicago advances, other borrowings and broker/internet CDs). As of September 30, 2014, the Corporation had outstanding borrowings from the FHLB of Chicago of $10.0 million. The total maximum credit capacity at the FHLB of Chicago based on the existing stock holding as of September 30, 2014 was $238.8 million, subject to collateral availability. Total credit capacity based on the value of the existing collateral pledged was $457.9 million as of September 30, 2014 after considering other collateral requirements for letters of credit and our participation in the Mortgage Partnership Finance Program of the FHLB of Chicago (“MPF Program”). The Bank has also been granted access to the Federal Reserve Bank of Chicago’s discount window but as of September 30, 2014, the Bank had no borrowings outstanding from this source.

Loan Commitments

At September 30, 2014, the Bank had outstanding commitments to originate loans of $39.8 million, no unused commitments and commitments to extend funds to, or on behalf of, customers pursuant to lines, and unused letters of credit of $278.8 million. Scheduled maturities of certificates of deposits during the nine months following September 30, 2014 amounted to $85.8 million. Scheduled maturities of borrowings during the same period totaled $2.8 million. Management believes adequate resources are available to fund all Bank commitments to the extent required.

Investment Securities

Investment securities are subject to inherent risks based upon the future performance of the underlying collateral (i.e., mortgage loans) for these securities. Among these risks are prepayment risk, interest rate risk and credit risk. Should general interest rate levels decline, the mortgage-related securities portfolio would be subject to (i) prepayments as borrowers typically would seek to obtain financing at lower rates, (ii) a decline in interest income received on adjustable-rate mortgage-related securities, and (iii) an increase in fair value of fixed-rate mortgage-related securities. Conversely, should general interest rate levels increase, the mortgage-related securities portfolio would be subject to (i) a longer term to maturity as borrowers would be less likely to prepay their loans, (ii) an increase in interest income received on adjustable-rate mortgage-related securities, (iii) a decline in fair value of fixed-rate mortgage-related securities, (iv) a decline in fair value of adjustable-rate mortgage-related securities to an extent dependent upon the level of interest rate increases, the time period to the next interest rate repricing date for the individual security and the applicable periodic (annual and/or lifetime) cap which could limit the degree to which

 

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the individual security may reprice within a given time period and (v) should default rates and loss severities increase on the underlying collateral of mortgage-related securities, credit losses may be experienced, which are recognized in earnings as net impairment losses.

MPF Program

The Corporation previously participated in the MPF Program of the FHLB of Chicago. Pursuant to the credit enhancement feature of the MPF Program, the Corporation retained a secondary credit loss exposure in the amount of $15.9 million at September 30, 2014 related to approximately $178.9 million of residential mortgage loans that the Corporation has originated and is still outstanding as agent for the FHLB of Chicago. Under the credit enhancement, the FHLB of Chicago is liable for losses on loans up to one percent of the original delivered loan balances in each pool up to the point the credit enhancement is reset. After the credit enhancement resets, the FHLB of Chicago and the Corporation’s loss contingency could be reduced depending upon losses experienced and loan balances. The Corporation is then liable for losses over and above the FHLB of Chicago first loss position up to a contractually agreed-upon maximum amount in each pool that was delivered to the Program. The Corporation receives a monthly fee for this credit enhancement obligation based on the outstanding loan balances. The monthly fee received is net of losses under the MPF Program. The Corporation discontinued funding loans through the MPF Program in 2008.

FHLB of Chicago Advances

The Bank pledges certain loans that meet underwriting criteria established by the FHLB of Chicago as collateral for outstanding advances. The unpaid principal balance of loans pledged to secure FHLB of Chicago borrowings totaled $652.0 million and $659.4 million at September 30, 2014 and December 31, 2013, respectively. The FHLB of Chicago borrowings are also collateralized by mortgage-related securities totaling $93.8 million and $122.2 million at September 30, 2014 and December 31, 2013, respectively. At September 30, 2014, there were no FHLB of Chicago borrowings with call features that may be exercised by the FHLB of Chicago.

Other

The Bank has, in the past, entered into agreements with certain brokers that provided deposits obtained from their customers at specified interest rates for an identified fee, or so called “brokered deposits.” At September 30, 2014, the Bank had no brokered deposits. The Bank Orders previously prohibited the Bank’s ability to accept, renew or roll over brokered deposits without prior approval of the OCC.

Regulatory Capital

Under federal law and regulation, the Bank is required to meet tier 1 leverage, tier 1 risk-based and total risk-based capital requirements. Tier 1 capital primarily consists of stockholders’ equity minus certain intangible assets and unrealized gains/losses on available-for-sale securities. Total risk-based capital primarily consists of tier 1 capital plus a qualifying portion of the allowance for loan losses. The risk-based capital requirements presently address credit risk related to both recorded and off-balance sheet commitments and obligations. At September 30, 2014, the Bank met the requirements to be considered well capitalized under these regulations.

MARKET RISK MANAGEMENT

Market risk is the risk of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices. We are exposed to market risk primarily by our involvement in, among others, traditional banking activities of taking deposits and extending loans.

While the Corporation attempts to manage its balance sheet to minimize the effect that a change in interest rates has on its net interest margin it may utilize derivative financial instruments as part of its interest rate risk management strategy. The Corporation’s Board of Directors recently approved developing a program for the prudent use of interest rate swap transactions to manage the interest rate risk of commercial loans and to manage other balance sheet interest rate risk. The Corporation intends to enter into interest rate-related transactions to facilitate the interest

 

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rate risk management strategies of commercial customers. The Corporation would then mitigate this risk by entering into equal and offsetting interest rate-related transactions with highly rated third party financial institutions. The Corporation’s objectives with the use of derivatives is to add stability to its net interest margin and to manage its exposure to movements in interest rates. There are currently no outstanding interest rate transactions or any activity during the nine months ended September 30, 2014.

Asset/Liability Management

The business of the Corporation and the composition of its consolidated balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and other securities) that are largely funded by interest-bearing liabilities (deposits and borrowings). All of the financial instruments of the Corporation as of September 30, 2014 were held for other-than-trading purposes. Such financial instruments have varying levels of sensitivity to changes in market rates of interest. The Corporation’s net interest income is dependent on the amounts of and yields on its interest-earning assets as compared to the amounts of and rates on its interest-bearing liabilities. Net interest income is therefore sensitive to changes in market rates of interest.

The Corporation’s asset/liability management strategy is to maximize net interest income while limiting exposure to risks associated with changes in interest rates. This strategy is implemented by the Corporation’s ongoing analysis and management of its interest rate risk. A principal function of asset/liability management is to coordinate the levels and mix of interest-sensitive assets and liabilities to manage net interest income changes within limits in times of fluctuating market interest rates.

Interest rate risk results when the maturity or repricing intervals and interest rate indices of the interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments are different, thus creating a risk that will result in disproportionate changes in the value of and the net earnings generated from these instruments. The Corporation’s exposure to interest rate risk is managed primarily through the strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. Because the primary source of interest-bearing liabilities is customer deposits, the Corporation’s ability to manage the types and terms of such deposits may be somewhat limited by customer maturity preferences in the market areas in which the Corporation operates. Deposit pricing is competitive with promotional rates frequently offered by competitors. Borrowings, which include FHLB of Chicago advances, short-term borrowings, and long-term borrowings, are generally structured with specific terms which, in management’s judgment, when aggregated with the terms for outstanding deposits and matched with interest-earning assets, reduce the Corporation’s exposure to interest rate risk. The rates, terms, and interest rate indices of the interest-earning assets result primarily from the Corporation’s strategy of investing in securities and loans (a portion of which have adjustable rates). This permits the Corporation to limit its exposure to interest rate risk, together with credit risk, while at the same time achieving a positive interest rate spread from the difference between the income earned on interest-earning assets and the cost of interest-bearing liabilities.

Management uses a simulation model for internal asset/liability management. The model uses maturity and repricing information for securities, loans, deposits, and borrowings plus repricing assumptions on products without specific repricing dates (e.g., savings and interest-bearing demand deposits), to calculate the cash flows, income, and expense of assets and liabilities. In addition, the model computes a theoretical market value of equity by estimating the market values of its assets and liabilities using present value methodology. The model also projects the effect on earnings and theoretical value under various interest rate change scenarios. The Corporation’s exposure to interest rates is reviewed on a monthly basis by senior management and the Board of Directors.

Net Interest Income Sensitivity Analysis

The Corporation performs a net interest income sensitivity analysis as part of its asset/liability management processes. Net interest income sensitivity analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 100 and 200 basis point increases in market interest rates. The table below presents the projected changes in twelve-month cumulative net interest income for the various rate shock levels at September 30, 2014 and December 31, 2013, respectively.

 

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		200 Basis Point				100 Basis Point
		Rate Increase				Rate Increase
September 30, 2014			3.6	%			1.6	%
December 31, 2013			3.5	%			1.4	%

As a result of current market conditions, 100 and 200 basis point decreases in market interest rates are not applicable for the periods presented as those decreases would result in some deposit interest rate assumptions falling below zero. Nonetheless, the Corporation’s net interest income may decline in declining rate environments as yields on earning assets could continue to adjust downward.

As shown above, at September 30, 2014, the effect of an immediate 200 basis point increase in interest rates would decrease the Corporation’s net interest income by 3.6%. The net interest income sensitivity was changed at December 31, 2013 to reflect a change in methodology that has been implemented to segregate nonaccrual loans in the model. Overall net interest income sensitivity remains within the Corporation’s guidelines.

The changes in the Corporation’s net interest income reflected above were due, in large part, to the optionality on both sides of the balance sheet. The changes in net interest income over the one year horizon for September 30, 2014 under the 100 basis point and 200 basis point increases in market interest rates scenarios are reflective of this optionality. In general, in a rising rate environment, yields on loans and investment securities are expected to re-price upwards more quickly than the cost of funds.

Mortgage-backed securities, including adjustable rate mortgage pools, are modeled in the above analysis based on their estimated repricing or principal paydowns obtained from outside analytical sources. Loans are modeled in the above analysis based on contractual maturity or contractual repricing dates, coupled with principal prepayment assumptions. Deposits are modeled based on management’s analysis of industry trends and customer behavior.

The Corporation also uses these assumptions to estimate the market value of equity and the market risk to this value due to changes in interest rates. This focus helps model risks embedded in the balance sheet over a longer time horizon than the net interest income simulation. The calculation is based on the present value of projected future cash flows. As of September 30, 2014, the projected changes for the market value of equity were within the Corporation’s policy limits.

Computations of the prospective effects of hypothetical interest rate changes are dependent on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates. These computations should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. Because such assumptions can be no more than estimates, certain assets and liabilities modeled as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the rate sensitivity results included above do not and cannot necessarily indicate the actual future impact of general interest rate movements on the Company’s net interest income.

COMPLIANCE RISK MANAGEMENT

Compliance risk represents the risk of regulatory sanctions, reputational impact or financial loss resulting from the Corporation’s failure to comply with regulations and standards of good banking practice. Activities which may expose the Corporation to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, community reinvestment initiatives, fair lending challenges and employment and tax matters. The Corporation has a separate department with individuals having specialized training and experience tasked with ensuring compliance with state and federal public interest, consumer, and civil rights oriented banking laws and regulations.

 

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STRATEGIC AND/OR REPUTATION RISK MANAGEMENT

Strategic and/or reputation risk represents the risk of loss due to damage to reputation, failure to fully develop and execute business plans, failure to assess current and new opportunities in business, markets and products and any other event not identified in the defined risk types mentioned previously. Mitigation of the various risk elements that represent strategic and/or reputation risk is achieved through initiatives to help the Corporation better understand, monitor and report on the various risks.

REGULATORY DEVELOPMENTS

The Dodd-Frank Act

On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act is having a broad impact on the financial services industry, and imposes significant regulatory and compliance requirements, including the imposition of increased capital, leverage, and liquidity requirements, and numerous other provisions designed to improve supervision and oversight of, and strengthen safety and soundness within, the financial services sector. The Dodd-Frank Act also created the Consumer Financial Protection Bureau (the “CFPB”). The CFPB is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. Additionally, the Dodd-Frank Act established a new framework of authority to conduct systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve, the OCC, and the FDIC.

As a result of the Dodd-Frank Act, primary jurisdiction for the supervision and regulation of federal thrifts, including the Bank, was transferred to the OCC, while supervision and regulation of SLHCs, including the Company, was transferred to the Federal Reserve. Although the Dodd-Frank Act maintained the federal thrift charter, it eliminated certain benefits of the charter and imposed new penalties for failure to comply with the qualified thrift investment (“QTL”) test. Under the Dodd-Frank Act, the risk-based and leverage capital standards currently applicable to U.S. insured depository institutions will be imposed on U.S. bank holding companies and SLHCs, and depository institutions and their holding companies will be subject to minimum risk-based and leverage capital requirements on a consolidated basis. In addition, the Dodd-Frank Act requires that SLHCs be well capitalized and well managed in the same manner as bank holding companies in order to engage in the expanded financial activities permissible only for a financial holding company.

Many of the requirements of the Dodd-Frank Act are in the process of being implemented and most will be subject to regulations implemented over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements.

Basel III Capital Rules

In July 2013, the federal banking agencies published final rules (the “Basel III Capital Rules”) that revised their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to implement, in part, agreements reached by the Basel Committee on Banking Supervision (“Basel Committee”) and certain provisions of the Dodd-Frank Act. The Basel III Capital Rules will apply to banking organizations, including the Company and the Bank.

 

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The Basel III Capital Rules are intended to increase both the amount and quality of regulatory capital. Among other things, the Basel III Capital Rules: (i) introduce a new capital measure entitled “Common Equity Tier 1” (“CET1”); (ii) specify that tier 1 capital consist of CET1 and additional financial instruments satisfying specified requirements that permit inclusion in tier 1 capital; (iii) define CET1 narrowly by requiring that most deductions or adjustments to regulatory capital measures be made to CET1 and not to the other components of capital; and (iv) expand the scope of the deductions or adjustments from capital as compared to the existing regulations. The Basel III Capital Rules also provide a permanent exemption from the proposed phase out of existing trust preferred securities and cumulative perpetual preferred stock from regulatory capital for banking organizations with less than $15 billion in total consolidated assets as of December 31, 2009.

The Basel III Capital Rules provide for the following minimum capital to risk-weighted assets ratios: (i) 4.5% based upon CET1; (ii) 6.0% based upon tier 1 capital; and (iii) 8.0% based upon total regulatory capital.

A minimum leverage ratio (tier 1 capital as a percentage of total assets) of 4.0% is also required under the Basel III Capital Rules (even for highly rated institutions). The Basel III Capital Rules additionally require institutions to retain a capital conservation buffer of 2.5% above these required minimum capital ratio levels. Banking organizations that fail to maintain the minimum 2.5% capital conservation buffer could face restrictions on capital distributions or discretionary bonus payments to executive officers.

The Basel III Capital Rules did not address the proposed liquidity coverage ratio (“LCR”) called for by the Basel Committee’s Basel III framework. On October 24, 2013, the Federal Reserve issued a proposed rule implementing a LCR requirement in the United States for larger banking organizations. Neither the Company nor the Bank would be subject to the LCR requirement as proposed.

Finally, the Basel III Capital Rules amend the thresholds under the “prompt corrective action” framework enforced with respect to the Bank by the OCC to reflect both (i) the generally heightened requirements for regulatory capital ratios as well as (ii) the introduction of the CET1 capital measure.

The enactment of the Basel III Capital Rules could increase the required capital levels of the Bank, and the Holding Company will become subject to consolidated capital rules. The Basel III Capital Rules become effective as applied to us and the Bank on January 1, 2015, with a phase in period that generally extends from January 1, 2015 through January 1, 2019. The ultimate impact of the new capital and liquidity standards on the Company and Bank is currently being reviewed and will depend on a number of factors, including additional developments in the implementation of the Basel III Capital Rules and any additional related rulemaking by the U.S. banking agencies.

The Volcker Rule

On December 10, 2013, five U.S. financial regulators, including the Federal Reserve and the OCC, adopted a final rule implementing the so-called “Volcker Rule.” The Volcker Rule was created by Section 619 of the Dodd-Frank Act and generally prohibits “banking entities” from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds” and “hedge funds.”

Although the final rule provides some tiering of compliance and reporting obligations based on size, the fundamental prohibitions of the Volcker Rule apply to banking entities of any size, including the Company and the Bank. The final regulations were published in the Federal Register on January 31, 2014, and became effective April 1, 2014; however, at the time the agencies released the final Volcker Rule, the Federal Reserve announced an extension of the conformance period for all banking entities until July 21, 2015.

In response to industry questions regarding the final Volcker Rule, the OCC, Federal Reserve, the FDIC, the SEC, and the CFTC issued a clarifying interim final rule on January 14, 2014, permitting banking entities to retain interests in certain collateralized debt obligations (“CDOs”) backed by trust preferred securities if the CDO meets certain requirements.

We are currently reviewing the scope of the regulations implementing the Volcker Rule to determine the impact of the rule on our operations.

 

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CRITICAL ACCOUNTING ESTIMATES AND JUDGMENTS

The consolidated financial statements are prepared by applying certain accounting policies. Certain of these policies require management to make estimates, assumptions, judgments and strategic or economic assumptions that may prove inaccurate or are subject to variations that may significantly affect the reported results and financial position for the period or in future periods. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Management believes the following policies are both important to the portrayal of our financial condition and results of operations and require subjective or complex judgments; therefore, management considers the following to be its critical accounting policies. Management has reviewed the application of these polices with the Audit Committee of our Board of Directors. Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and supplemental data contained elsewhere in this report. Some of the more significant policies are as follows:

Fair Value Measurements

Management must use estimates, assumptions, and judgments when assets and liabilities are required to be recorded at, or adjusted to reflect, fair value under generally accepted accounting principles. This includes the initial measurement at fair value of the assets acquired and liabilities assumed in acquisitions qualifying as business combinations, foreclosed properties and repossessed assets and the capitalization of MSRs. The valuation of both financial and nonfinancial assets and liabilities in these transactions requires numerous assumptions and estimates and the use of third-party sources including appraisers and valuation specialists.

Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Assets and liabilities measured at fair value on a recurring basis include available for sale securities, loans held for sale, interest rate lock commitments and forward contracts to sell mortgage loans. Assets and liabilities measured at fair value on a non-recurring basis may include MSRs, certain impaired loans and OREO. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such third-party information is not available, fair value is estimated primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact future financial condition and results of operations.

Available-for-Sale Securities

Declines in the fair value of available-for-sale securities below their amortized cost that are deemed to be other-than- temporary are reflected in earnings as unrealized losses. In estimating other-than-temporary impairment losses on debt securities, management considers many factors which include: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its ownership in a security for a period of time sufficient to allow for any anticipated recovery in fair value. To determine if other-than-temporary impairment exists on a debt security, the Corporation first determines if (a) it intends to sell the security or (b) it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of the conditions is met, the Corporation will recognize an other-than-temporary impairment loss in earnings equal to the difference between the fair value of the security and its amortized cost. If neither of the conditions is met, the Corporation determines (a) the amount of the impairment related to credit loss and (b) the amount of the impairment due to all other factors. The difference between the present values of the cash flows expected to be collected, discounted at the purchase yield or current accounting yield of the security, and the amortized cost basis is the credit loss. The credit loss is the amount of impairment deemed other-than-temporary and recognized in earnings and is a reduction to the cost basis of the security. The amount of impairment related to all other factors (i.e. non-credit) is deemed temporary and included in accumulated other comprehensive income (loss).

 

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Allowance for Loan Losses

The allowance for loan losses is a valuation account for probable and inherent losses incurred in the loan portfolio. Management maintains an allowance for loan losses—and separately a reserve for unfunded loan commitments, letters of credit and repurchase of sold loans in other liabilities—at levels that we believe to be adequate to absorb estimated probable credit losses incurred in the loan portfolio. The adequacy of the ALLL is determined based on periodic evaluations of the loan portfolios and other relevant factors. The ALLL is comprised of general and specific components. Even though the entire allowance is available to cover losses on any loan, specific allowances are provided on impaired loans pursuant to accounting standards. The general allowance is based on historical loss experience, adjusted for qualitative factors. At least quarterly, management reviews the assumptions and methodology related to the general and specific allowances in an effort to update and refine the estimate.

In determining the general allowance, the loan portfolio is segregated by purpose and collateral type. By doing so, trends in borrower behavior and loss severity are more easily identified. For each class of loan, a historical loss factor is computed. In determining the appropriate period of activity to use in computing the historical loss factor we look at trends in quarterly net charge-off rates. It is management’s intention to utilize a period of activity that is most reflective of current experience. Changes in the historical period are made when there is a distinct change in the trend of net charge-off experience or other factors. Given the changes in the credit market that have occurred since 2008, management reviews each class’ historical losses by quarter for any trends that would indicate a different look back period would be more representative of current experience.

Historical loss rates used to calculate the general allowance are adjusted by values assigned to nine qualitative factors which are listed in the section titled “Allowance for Loan Losses” within “Credit Risk Management”. In determining the appropriate value to assign to a particular factor, if any, management compares the current underlying facts and circumstances with respect to that factor with those in the historical periods. Values assigned to factors are modified when changes in the environment relative to that quantitative or qualitative factor are deemed to be significant. Management will continue to analyze the factors on a quarterly basis, adjusting the historical loss rates as necessary, to a rate believed to be appropriate for the probable and inherent risk of loss in the portfolio.

Beginning with the quarter ended June 30, 2014, the Bank modified its general allowance methodology to increase the historical loss period by an additional quarter until the historical look-back period is built to a 12 quarter look back period. For the quarter ended September 30, 2014, the Bank utilized a ten quarter look-back period compared to a nine quarter look-back period for the quarter ended June 30, 2014. The modification is being done to reflect a more stable economic environment and to capture additional loss statistics considered reflective of the current portfolio. The impact to the allowance for loan losses at September 30, 2014 after implementing the above modifications was a reduction of the required reserve of $92,000 as compared to the previous methodology. See the Company’s annual report on Form 10-K/T for the nine months ended December 31, 2013 for a full description of the allowance methodology.

The Corporation regularly obtains updated appraisals for real estate collateral dependent loans for which it calculates impairment based on the fair value of collateral. Loans having an unpaid principal balance of $500,000 or less in a homogenous pool of assets do not require an impairment analysis. Due to certain limitations, including, but not limited to, the availability of qualified appraisers, the time necessary to complete acceptable appraisals, the availability of comparable market data and information, and other considerations, in certain instances current appraisals are not readily available. In those cases, evaluations are being utilized for smaller properties when an appraisal has been done within five years and no market deterioration is evident.

The determination of value on an individually reviewed loan is estimated using an appraisal discounted by 15%, 25% or 35% depending on whether the appraisal is a) current (less than one year old), b) improved land or commercial real estate (CRE) greater than a year old, or c) unimproved land greater than a year old, respectively. The 15% discount represents an estimate of selling costs and potential taxes and other expenses the Bank may need to incur to dispose of a property. The additional discounts on appraisals greater than a year old of 10% and 20% on improved land/CRE and unimproved land, respectively, reflect the decrease in collateral values during years beginning 2011 through the current period. These percentages are supported by the Bank’s analysis of appraisal activity over the past 12 months.

 

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Loans are considered to be non-performing at such time that they become ninety days past due or earlier if a loss is deemed probable. At the time a loan is determined to be non-performing it is downgraded per the Corporation’s loan rating system, it is placed on non-accrual, and an allowance consistent with the Corporation’s historical experience for similar “substandard” loans is established. Within ninety days of this determination a comprehensive analysis of the loans is completed, including ordering new appraisals, where necessary, and an adjustment to the estimated allowance is recognized to reflect the impaired value of the loan based on the underlying collateral or the discounted cash flows. Until such date at which an updated appraisal is obtained, when deemed necessary, the Corporation applies discounts to the existing appraisals in estimating the fair value of collateral as described above.

Management considers the ALLL at September 30, 2014 to be at an adequate level, although changes may be necessary if future economic and other conditions differ substantially from the current environment. Although the best information available is used, the level of the ALLL remains an estimate that is subject to significant judgment and short-term change. To the extent actual outcomes differ from our estimates, additional provision for loan losses may be required that would reduce future earnings.

Foreclosure

Real estate acquired by foreclosure or by deed in lieu of foreclosure and other repossessed assets are held for sale and are initially recorded at fair value less estimated selling costs at the date of foreclosure, establishing a new cost basis. Any write down to fair value less estimated selling costs is charged to the allowance for loan losses. If the fair value exceeds the net carrying value of the loans, recoveries to the allowance for loan losses are recorded to the extent of previous charge-offs, with any excess, which is infrequent, recognized as a gain in non-interest income. Subsequent to foreclosure, updated appraisals are generally obtained on an annual basis and the assets are adjusted to the lower of cost or fair value, less estimated selling expenses. Costs relating to the development and improvement of the property may be capitalized. Holding period costs and subsequent changes to the valuation allowance are charged to OREO expense, net included in non-interest expense. Incremental valuation adjustments may be recognized in the Statement of Operations if, in the opinion of management, additional losses are deemed probable.

Mortgage Servicing Rights

MSRs are initially recorded as an asset, measured at fair value, when loans are sold to third parties with servicing rights retained. MSR assets are amortized in proportion to, and over the period of, estimated net servicing revenues. The carrying value of these assets is periodically reviewed for impairment using a lower of amortized cost or fair value methodology. The fair value of the servicing rights is determined by estimating the present value of future net cash flows, taking into consideration market loan prepayment speeds, discount rates, servicing costs and other economic factors. For purposes of measuring impairment, the underlying loans are stratified into relatively homogeneous pools based on predominant risk characteristics which include product type (i.e., fixed, adjustable or balloon) and interest rate bands. If the aggregate carrying value of the capitalized MSRs for a stratum exceeds its fair value, MSR impairment is recognized in earnings for the difference. As the loans are repaid and net servicing revenue is earned, the MSR asset is amortized as an offset in loan servicing income. Servicing revenues are expected to exceed this amortization expense. However, if actual prepayment experience or defaults exceed what was originally anticipated, net servicing revenues may be less than expected and MSRs may be impaired.

Income Taxes

The Corporation’s provision for federal income taxes results in the recognition of a deferred tax liability or deferred tax asset computed by applying the current statutory tax rates to net taxable or deductible differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will produce taxable income or deductible expenses in future periods. The Corporation regularly reviews the carrying amount of its net deferred tax assets (net of deferred tax liabilities) to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of the Corporation’s net deferred tax assets will not be realized in future periods, a deferred tax valuation allowance would be established. Consideration is given to various positive and negative factors that could affect the realization of the net deferred tax assets.

 

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In evaluating this available evidence, management considers, among other things, historical financial performance, expectation of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with operating loss and tax credit carry forwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. The Corporation’s evaluation is based on current tax laws as well as management’s expectations of future performance.

As a result this evaluation, a full valuation allowance has been established against the net deferred tax asset.

FORWARD-LOOKING STATEMENTS

In the normal course of business, we, in an effort to help keep our shareholders and the public informed about our operations, may from time to time issue or make certain statements, either in writing or orally, that are or contain forward-looking statements, as that term is defined in the U.S. federal securities laws. This quarterly report contains “forward-looking statements” within the meaning of the federal securities laws, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to business plans or strategies, projected or anticipated benefits from strategic transactions made by or to be made by us, projections involving anticipated revenues, earnings, liquidity, profitability or other aspects of operating results or other future developments in our affairs or the industry in which we conduct business. Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology such as “anticipate,” “believe,” “project,” “continue,” “ongoing,” “expect,” “intend,” “plan,” “estimate” or similar expressions.

Although we believe that the anticipated results or other expectations reflected in our forward-looking statements are based on reasonable assumptions, we can give no assurance that those results or expectations will be attained. Forward-looking statements involve risks, uncertainties and assumptions, some of which are beyond our control, and as a result actual results may differ materially from those expressed in forward-looking statements due to several factors more fully described in “Risk Factors,” as well as elsewhere in this transition report. Factors that could cause actual results to differ from forward-looking statements include, but are not limited to, the following, as well as those discussed elsewhere herein:

 

•

our ability to successfully transform our business and implement our new business strategy;

 

•

our ability to fully realize our deferred tax assets;

 

•

on-going impact of the Recapitalization;

 

•

changes in the quality or composition of our loan and investment portfolios, other real estate owned values and allowance for loan losses;

 

•

impact of potential impairment of other intangibles in a challenging economy;

 

•

our ability to pay dividends;

 

•

our ability to address our liquidity needs;

 

•

deterioration in the value of commercial real estate, land and construction loan portfolios resulting in increased loan losses;

 

•

our ability to recruit and retain key employees;

 

•

uncertainties about market interest rates;

 

•

demand for financial services, loss of customer confidence and customer deposit account withdrawals;

 

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•

competitive pressures could intensify and affect our profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform;

 

•

security breaches of our information systems;

 

•

changes in the conditions of the securities markets, which could adversely affect, among other things, the value or credit quality of our assets, the availability and terms of funding necessary to meet our liquidity needs and our ability to originate loans;

 

•

soundness of other financial institutions with which we and the Bank engage in transactions;

 

•

the performance of third party investment products we offer;

 

•

environmental liability for properties to which we take title;

 

•

the effects of any changes to the servicing compensation structure for mortgage servicers pursuant to the programs of government sponsored-entities;

 

•

changes in accounting principles, policies or guidelines;

 

•

the impact of dilution of existing stockholders as a result of possible future capital raising transactions;

 

•

other risk factors included under Part II, Item 1A Risk Factors in this report.

You should not put undue reliance on any forward-looking statements. Forward-looking statements speak only as of the date they are made and we undertake no obligation to update them in light of new information or future events, except to the extent required by federal securities laws.

 

Item 3

Quantitative and Qualitative Disclosures About Market Risk.

The Corporation’s market risk has not materially changed from December 31, 2013. See Item 7A in the Corporation’s Annual Report on Form 10-K/T for the nine months ended December 31, 2013. See also “Asset/Liability Management” in Part I, Item 2 of this report.

 

Item 4

Controls and Procedures.

The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Corporation’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report and, based on this evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures are operating in an effective manner.

Changes in Internal Control Over Financial Reporting

There has been no change in the Corporation’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the Corporation’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

On May 14, 2013 the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) issued an updated version of its Internal Control—Integrated Framework (“2013 Framework”). Originally issued in 1992, (“1992 Framework”), the framework helps organizations design, implement, and evaluate the effectiveness of internal control concepts and simplify their use and application. The 1992 Framework will remain effective during the transition, which extends to December 15, 2014, after which time COSO will consider it as superseded by the 2013 Framework. As of September 30, 2014, the Company is using the 1992 Framework.

 

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Part II - Other Information

 

Item 1

Legal Proceedings.

We are involved in routine legal proceedings occurring in the ordinary course of business which, in the aggregate, are believed to be immaterial to our financial condition and results of operations.

We were a defendant in a pending lawsuit captioned Village of Kronenwetter v. AnchorBank, fsb, Marathon County, Wisconsin, Case No. 11-CV-1370, which was an action brought by the Village of Kronenwetter, Wisconsin (“the Village”) on November 14, 2011 to enforce and collect on a $4.4 million letter of credit issued by the Bank in support of the development of a mixed use TIF development in the Village of Kronenwetter, Wisconsin. The complaint alleges that the Bank wrongfully refused to honor a full draw on the letter of credit and that the developer failed to notify the plaintiff of the renewal of the letter of credit or to renew the letter of credit within the time limitations set forth in the development agreement. A specific reserve for loss on unfunded loan commitments was established at June 30, 2013 due to a shortfall in the value of the residential real estate development supporting the letter of credit. On August 18, 2014, the court decided in favor of the Village, rejecting all defenses raised by the Bank. The lawsuit was settled during the quarter ended September 30, 2014. The Bank funded the letter of credit and paid accrued interest and attorney fees as ordered by the judgment. The specific reserve totaled $2.7 million at the time of the judgement. During the quarter, the Bank recorded expense of $1.1 million in connection with this case, which included accrued interest payable through the date of the summary judgment decision, an additional specific reserve for loss based upon additional collateral shortfall and legal fees.

We are the plaintiff/counterclaim defendant in a pending lawsuit captioned AnchorBank, fsb v. Henriette McLean et al., Dane County, Wisconsin, Case No. 13-CV-811. The Bank is seeking to enforce personal guarantees executed by McLean related to amounts borrowed by Mineral Point Road Holdings, LLC (“MPRH”). At the time of the commencement of the lawsuit, March 7, 2013, McLean owed the Bank $363,302 under the guarantees. As a result of the recent sale of real estate owned by MPRH, the amount of the debt is now $300,127. The Bank has the right to obtain its attorneys’ fees incurred in collecting on the guarantees if it prevails in the lawsuit. On January 27, 2014, McLean filed a 196-paragraph Counterclaim against the Bank. McLean alleges various misconduct by the Bank related to its loans to MPRH and the procurement of her guarantees. Most of the counterclaims are based upon alleged misrepresentations and/or misrepresentations by omission. McLean is seeking the return of the $182,629 she paid to the Bank in 2012 under her guarantees, treble damages, and punitive damages. McLean has also filed a third-party complaint seeking contribution/indemnity from Joseph Gallina (the managing member of MPRH) and various entities controlled by Gallina.

On February 21, 2013, we received a “Wells Notice” from the SEC indicating its intent to bring a civil injunctive action against us alleging that we violated Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(2)(B) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rules 10b-5 and 13a-13 thereunder. On August 14, 2013, the SEC filed a complaint alleging that we and our former chief financial officer, Dale Ringgenberg, made material misstatements in our quarterly report on Form 10-Q for the period ended September 30, 2009. Without admitting or denying the allegations in the SEC’s complaint, we agreed to settle the action against us by consenting to the entry of a final judgment permanently enjoining us from violating Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5 and 13a-13 thereunder. There was no monetary fine or penalty assessed to us for the settlement of this action. Final entry of judgment was made on November 26, 2013, and accordingly, this matter is concluded.

 

Item 1A

Risk Factors.

In addition to the risk factors and other information discussed elsewhere in this Quarterly Report on Form 10-Q, you should carefully consider the factors described in Part I, Item 1A of our Annual Report on Form 10-K/T for the nine months ended December 31, 2013, filed with the Securities and Exchange Commission (“SEC”) on or about March 20, 2014. Those risks and uncertainties could cause actual results to differ materially from the results contemplated by the

 

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forward-looking statements contained in our Annual Report on Form 10–K/T, this Quarterly Report on Form 10-Q and in other documents we file with the SEC. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations. Our business, financial condition, results of operations or prospects could be materially and adversely affected by any of these risks. This report, including the documents incorporated by reference herein, also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors.

 

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds.

None.

 

Item 3

Defaults Upon Senior Securities.

None

 

Item 4

Mine Safety Disclosures.

Not applicable.

 

Item 5

Other Information.

None.

 

Item 6

Exhibits.

The following exhibits are filed with this report:

 

		Exhibit 31.1		Certification of Principal Executive Officer Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002 is included herein as an exhibit to this Report.
		Exhibit 31.2		Certification of Principal Financial Officer Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002 is included herein as an exhibit to this Report.
		Exhibit 32.1		Certification of the Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) is included herein as an exhibit to this Report.
		Exhibit 32.2		Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) is included herein as an exhibit to this Report.
		Exhibit 101		The following financial statements from the Anchor Bancorp Wisconsin Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 2014, formatted in Extensive Business Reporting Language (XBRL); (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations and Comprehensive Income, (iii) Consolidated Statements of Changes in Stockholders’ Equity (Deficit), (iv) Consolidated Statements of Cash Flows, and (v) the Notes to Unaudited Consolidated Financial Statements are included herein as an exhibit to this report.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

				ANCHOR BANCORP WISCONSIN INC.
Date:		November 4, 2014		By:		/s/ Chris Bauer
						Chris Bauer, President and Chief Executive Officer
Date:		November 4, 2014		By:		/s/ William T. James
						William T. James, Senior Vice President, Treasurer and Chief Financial Officer

 

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