ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Forward-Looking Statements
This report contains certain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, with respect to Horizon and the
Bank. Horizon intends such forward-looking statements to be covered by the safe
harbor provisions for forward-looking statements contained in the Private
Securities Reform Act of 1995, and is including this statement for the purposes
of these safe harbor provisions. Forward-looking statements, which are based on
certain assumptions and describe future plans, strategies and expectations of
Horizon, are generally identifiable by use of the words "believe," "expect,"
"intend," "anticipate," "estimate," "project" or similar expressions. Horizon's
ability to predict results or the actual effect of future plans or strategies is
inherently uncertain. Factors which could have a material adverse effect on
Horizon's future activities and operating results include, but are not limited
to:
• credit risk: the risk that loan customers or other parties will be unable to
perform their contractual obligations;
• market risk: the risk that changes in market rates and prices will adversely
affect our financial condition or results of operation;
• liquidity risk: the risk that Horizon or the Bank will have insufficient
cash or access to cash to meet its operating needs; and
• operational risk: the risk of loss resulting from inadequate or failed
internal processes, people and systems, or external events.
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements.
Introduction
The purpose of this discussion is to focus on Horizon's financial condition,
changes in financial condition and the results of operations in order to provide
a better understanding of the consolidated financial statements included
elsewhere herein. This discussion should be read in conjunction with the
consolidated financial statements and the related notes.
Overview
Horizon had continued improvement in net interest margin during the third
quarter of 2008, up five basis points from the 2nd quarter of 2008 and 44 basis
points from the third quarter of 2007. This was offset by an increase in the
provision for loan losses. This increase related to the deterioration of three
commercial loans. Net income for the quarter declined to $1.3 million, down $938
thousand from the 3rd quarter of 2007. However, year to date net income is $6.85
million, up $720 thousand or 11.7% from the same period of the prior year.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Critical Accounting Policies
The notes to the consolidated financial statements included in Item 8 on Form
10-K contain a summary of the Company's significant accounting policies and are
presented on pages 42-48 of Form 10-K for 2007. Certain of these policies are
important to the portrayal of the Company's financial condition, since they
require management to make difficult, complex or subjective judgments, some of
which may relate to matters that are inherently uncertain. Management has
identified the allowance for loan losses, intangible assets and hedge accounting
as critical accounting policies.
Allowance for loan and lease losses
An allowance for loan and lease losses (ALLL) is maintained to absorb loan
losses inherent in the loan portfolio. The allowance is based on regular
assessments of the probable losses inherent in the loan portfolio. The allowance
is increased by the provision for credit losses, which is charged against
current period operating results and decreased by the amount of charge offs, net
of recoveries. Horizon's methodology for assessing the appropriateness of the
allowance consists of several key elements, which include the general allowance,
specific allowances for identified problem loans and the qualitative allowance.
The general allowance is calculated by applying loss factors to pools of
outstanding loans. Loss factors are based on a historical loss experience and
may be adjusted for significant factors that, in management's judgment, affect
the collectibility of the portfolio as of the evaluation date.
Specific allowances are established in cases where management has identified
conditions or circumstances related to a credit that management believes
indicate the probability that a loss will be incurred in excess of the amount
determined by the application of the formula allowance.
The qualitative allowance is based upon management's evaluation of various
conditions, the effects of which are not directly measured in the determination
of the general and specific allowances. The evaluation of the inherent loss with
respect to these conditions is subject to a higher degree of uncertainty because
they are not identified with specific credits. The conditions evaluated in
connection with the qualitative allowance may include factors such as local,
regional and national economic conditions and forecasts, concentrations of
credit and changes in the composition of the portfolio.
Horizon considers the allowance for loan losses of $10.525 million adequate to
cover losses inherent in the loan portfolio as of September 30, 2008. However,
no assurance can be given that Horizon will not, in any particular period,
sustain loan losses that are significant in relation to the amount reserved, or
that subsequent evaluations of the loan portfolio, in light of factors then
prevailing, including economic conditions and management's ongoing quarterly
assessments of the portfolio, will not require increases in the allowance for
loan losses. Horizon has increased its allowance for loan and lease losses in
recent quarters. See "Results of Operations - Material Changes in Results of
Operations - Three months ended September 30, 2008 compared to the three months
ended September 30, 2007" beginning on page 22 for a further description of
these additional allowances.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Goodwill and intangible assets
Horizon periodically assesses the impairment of its goodwill and the
recoverability of its core deposit intangible. Indefinite-lived intangible
assets are tested annually for impairment or more frequently if there is
significant adverse change in the business climate or the company receives an
adverse action or assessment by a regulator. Impairment is the condition that
exists when the carrying amount of goodwill exceeds its implied fair value. If
actual external conditions and future operating results differ from Horizon's
judgements, impairment and/or increased amortization charges may be necessary to
reduce the carrying value of these assets to the appropriate value. Recent
negative changes in economic conditions in general, and in the financial
institutions industry in particular, have increased the potential for
impairment. Horizon believes that while the company has experienced some
negative impact from current economic conditions and the stock price has fallen
below book value, it has continued to generate strong financial results in a
difficult economic climate and while the stock price was below book value at the
end of the quarter, Horizon's stock did trade at a price approximately $2.50
above book value during the quarter. Horizon believes that goodwill and other
intangibles are not impaired at September 30, 2008.
Derivative Instruments
Horizon has entered into both fair value and cash flow derivative arrangements
during the first nine months of 2008. For both fair value and cash flow hedges,
management's objective is to ensure that changes in the fair value of the hedged
item will be offset by changes in the fair value of the hedging derivative. SFAS
133 requires that the method selected for assessing hedge effectiveness must be
reasonable, be defined at the inception of the hedging relationship and be
applied consistently throughout the hedging relationship. A change in a
derivative counterparty's creditworthiness would immediately affect the
assessment of hedge effectiveness and the measurement of ineffectiveness.
Horizon uses the dollar-offset method for assessing effectiveness of fair value
hedges using the cumulative approach. Horizon performs effectiveness testing on
a monthly basis and determined there was no hedge ineffectiveness and that the
counterparty's creditworthiness was adequate at September 30, 2008.
Fair value hedges
For fair value hedges, the dollar-offset method compares the cumulative fair
value of the hedging derivative with the cumulative fair value of the hedged
items. The calculation of dollar offset is the change in clean fair value of
hedging derivative, divided by the change in clean fair value of the hedged
exposure attributable to changes in the LIBOR curve. To the extent that the
cumulative change in fair value of the hedging derivative offsets from 80% to
125% of the cumulative change in fair value of the hedged exposure, the hedge is
deemed effective.
Cash flow hedges
For cash flow hedges, Horizon measures the degree of hedge effectiveness by
comparing the cumulative change in anticipated interest cash flows from the
hedged exposure over the hedging period to the cumulative change in anticipated
cash flows from the hedging derivative. Horizon utilizes the "Hypothetical
Derivative Method" to compute the cumulative change in anticipated interest cash
flows from the hedged exposure. To the extent that the cumulative change in
anticipated cash flows from the hedging derivative offsets from 80% to 125% of
the cumulative change in anticipated interest cash flows from the hedged
exposure, the hedge is deemed effective.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Financial Condition
Liquidity
The Bank maintains a stable base of core deposits provided by long standing
relationships with consumers and local businesses. These deposits are the
principal source of liquidity for Horizon. Other sources of liquidity for
Horizon include earnings, loan repayment, investment security sales and
maturities, sale of real estate loans and borrowing relationships with
correspondent banks, including the Federal Home Loan Bank (FHLB). Horizon
maintains a liquidity contingency plan, which requires the monitoring of certain
liquidity ratios, and based on these ratios, may require actions to acquire
additional liquidity as noted above. During the nine months ended September 30,
2008, cash and cash equivalents decreased by approximately $34.5 million.
Federal funds sold declined and borrowings increased to provide funding for a
decline in deposits. These proceeds from the liquidation of these short-term
investments and additional borrowings were used to redeem maturing certificates
of deposit. At September 30, 2008, in addition to liquidity provided from the
normal operating, funding, and investing activities of Horizon, the Bank has
available approximately $124 million in unused credit lines with various money
center banks including the FHLB.
There have been no other material changes in the liquidity of Horizon from
December 31, 2007 to September 30, 2008.
Fair Value Measurement
Horizon has Federal agency collateralized mortgage obligations totaling
$13.319 million and Federal agency mortgage-backed pools totaling
$105.807 million. These securities, which are classified as available for sale
and are therefore carried at fair value in the financial statements, are secured
by first mortgage residential loans and are guaranteed by various Government
Sponsored Enterprises.
Determinations of fair value are based on market data. Pricing models are used
that vary by asset class and incorporate available trade, bid and other market
information and for structured securities, cash flow and when available, loan
performance data. Because many fixed income securities do not trade on a daily
basis, pricing applications apply available information as applicable through
processes such as benchmark curves, benchmarking of like securities, sector
groupings and matrix pricing. Additionally, model processes such as the Option
Adjusted Spread are used to assess interest rate impact and develop prepayment
scenarios. Market inputs normally used for evaluation of securities, listed in
approximate order of priority, include: benchmark yields, reported trades,
broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities,
bids, offers and reference data.
For broker-quoted securities, quotes are obtained from market makers, broker
dealers or closing prices on stock exchanges.
At September 30, 2008, the Company's unrealized losses relating to municipal
securities are attributable to changes in interest rates and illiquidity, and
not credit quality, and because the Company has the intent and ability to hold
these securities until a recovery of fair value, which may be at maturity, the
Company does not consider these securities to be other-than-temporarily impaired
at September 30, 2008.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Capital Resources
The capital resources of Horizon and the Bank exceeded regulatory capital ratios
for "well capitalized" banks at September 30, 2008. Stockholders' equity totaled
$75.072 million as of September 30, 2008, compared to $70.645 million as of
December 31, 2007. At September 30, 2008, the ratio of stockholders' equity to
assets was 6.32% compared to 5.61% for December 31, 2007. Horizon's capital
increased during the period as a result of increased earnings, net of dividends
declared and the amortization of unearned compensation. These increases were
offset by an increase in unrealized loss on securities available for sale. The
ratio improved due to a decline in assets and the increase in equity.
Horizon declared dividends in the amount of $.49 per share during the first nine
months of 2008, and $.44 per share for the same period of 2007. The dividend
payout ratio (dividends as a percent of net income) was 23% for the first nine
months of both 2008 and 2007. For additional information regarding dividend
conditions, see page 46 of Form 10-K for 2007.
There have been no other material changes in Horizon's capital resources from
December 31, 2007 to September 30, 2008.
On October 14, 2008, the U.S. Treasury announced it will offer to non-troubled
U.S. banking organizations the opportunity to sell preferred stock, along with
warrants to purchase common stock, to the Treasury on what may be considered
attractive terms under the Troubled Asset Relief Program (TARP) and Capital
Purchase Program (CPP).
Horizon has preliminarily determined that obtaining additional Tier 1 capital
pursuant to the CPP is advisable to, among other things, enable Horizon to
better serve the banking needs of its local communities, provide a capital
cushion against unforeseen future events and provide additional capital to be
used for other purposes permitted by the program. As a result, on November 3,
2008, Horizon filed an initial application with the Treasury pursuant to the CPP
seeking approval to sell $25 million in preferred stock to the Treasury (which
will equal 2.83% of its total risk weighted assets as of June 30, 2008). The CPP
is generally only available to healthy financial institutions to provide them
with additional capital to expand the flow of credit to U.S. consumers and
businesses on competitive terms and for related purposes to promote the
sustained growth and vitality of the U.S. economy. As a result, Horizon's
participation in the CPP is not an indication that Horizon is having financial
difficulties. In fact, both Horizon and Horizon Bank currently exceed all
applicable regulatory capital requirements to be classified as well capitalized.
See "Note 7 - Subsequent Events"-to the financial statements beginning on page
13 for a complete description of the terms and conditions of the CPP.
Material Changes in Financial Condition - September 30, 2008 compared to
December 31, 2007
During the first nine months of 2008, net loans decreased by $31.6 million. The
major portion of the decline related to the sale of approximately $38 million of
adjustable rate mortgage loans. The loans were sold to reduce reliance on
non-core funding. Partially offsetting this was an increase in mortgage
warehouse loans. Commercial and installment loans have decreased slightly as new
volume was not sufficient to offset normal amortization in these portfolios.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
Deposits declined from the end of the preceding year. Consumer certificates of
deposit declined by approximately $69 million and negotiable certificates of
deposit declined by $57 million during the first nine months of 2008. The
declines in both categories came in short term, high cost deposits, which
matured during the period. These declines were offset by the decline in loans
and additional borrowings, at lower interest rates.
There have been no other material changes in the financial condition of Horizon
from December 31, 2007 to September 30, 2008.
Results of Operations
Material Changes in Results of Operations - Three months ended September 30,
2008 compared to the three months ended September 30, 2007
During the three months ended September 30, 2008, net income totaled
$1.332 million or $.41 per diluted share compared to $2.270 million or $.70 per
diluted share for the same period in 2007.
Net interest income for the quarter ended September 30, 2008 was $9.403 million,
an increase of $1.201 million from the third quarter of 2007. The net interest
margin improved 44 basis points from the third quarter of 2007 to 3.45%. The
improvement resulted primarily from reductions in funding costs that exceeded
declines in yields on earning assets. Horizon's cost of funds has dropped
approximately 109 basis points since the third quarter of 2007 while the yield
on earning assets declined only 65 basis points. Horizon reduced rates on NOW
and money market accounts in line with short-term rate decreases put in place by
the Federal Open Market Committee. In addition, a large amount of Certificates
of Deposit (CDs) matured during the quarter and were renewed in lower rate CDs
or the funding was replaced with lower cost borrowed money.
Horizon assesses the adequacy of its Allowance for Loan and Lease Losses
(ALLL) by regularly reviewing the performance of all of its loan portfolios. As
a result of its most recent review, Horizon determined that there had been
recent deterioration in the commercial and indirect loan portfolios. As a
result, a provision for loan losses of $3.137 million was taken for the third
quarter of 2008. This compares to a provision of $550 thousand for the third
quarter of 2007. This increase is primarily due to the deterioration of three
commercial loans. In addition, Horizon has experienced increased charge-offs
related to repossessions and voluntary surrenders of vehicles in its indirect
loan portfolio. To reflect these recent trends, Horizon has adjusted, to a more
recent period, the historical charge-off ratios used to determine the historical
loss component of the ALLL.
For the third quarter of 2008, Horizon's non-performing loans of approximately
$6.634 increased from the September 30, 2007 level of $2.3 million. Total
non-performing loans as of September 30, 2008 were approximately 0.77% of total
loans. Net charge-offs for the quarter were $2.423 million compared to $392
thousand for the same quarter of 2007. The current quarter charge-offs related
to deterioration in the commercial and indirect loan portfolios. Additionally,
Horizon has $1.357 million of other real estate owned, which represent an
increase from September 30, 2007 of $1.071 million. Management feels that the
total ALLL of $10.525 million or 1.23% of total loans is adequate to absorb
probable incurred losses contained in the loan portfolio.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
The following tables show the allocation of the ALLL and net charge-offs:
Allocation of the Allowance for Loan and Lease Losses
(Dollars in Thousands)
September 30, September 30,
2008 2007
Commercial $ 2,659 $ 2,579
Real estate 1,115 750
Mortgage warehousing 1,341 1,417
Installment 5,410 3,769
Unallocated - 308
Total $ 10,525 $ 8,823
Net Charge-offs
(Dollars in Thousands)
Three months Three months Nine months Nine months
ended ended ended ended
September 30, September 30, September 30, September 30,
2008 2007 2008 2007
Commercial $ 1,275 $ (21 ) $ 1,348 $ (42 )
Real estate (50 ) - 275 -
Mortgage warehousing - - - -
Installment 1,198 413 3,047 1,097
Total $ 2,423 $ 392 $ 4,671 $ 1,055
|
Non-interest income increased $221 thousand or 7.1% from the third quarter of
2007. The main contributing factors were: (a) an increase in service charges on
deposit accounts primarily due to an increase in the charge for non-sufficient
fund checks implemented in the first quarter of 2008, (b) an increase in wire
transfer fees related to an increase in mortgage warehouse loan activity.
Non-interest expense increased $540 thousand or 7.0% from the third quarter of
2007. Salaries and benefits decreased due to the staff reduction, which occurred
during the third quarter of 2007. Loan expense increased from the prior year due
to higher collection expense and lower deferred costs on new loans. The major
cause of the increase in other expenses relates to increased FDIC insurance
premiums. The one time credit granted by the FDIC in November of 2006 was fully
utilized in the first quarter of 2008.
The effective tax rate declined to 0.0% for the third quarter of 2008 compared
to 26.7% in the third quarter of 2007. Pre-tax income was almost entirely offset
by tax-exempt interest income generated from tax-exempt loans and investments as
well as the increase in cash surrender value of officer life insurance. Also
during the current quarter, Horizon realized $47 thousand from amended returns
filed to claim additional tax benefits related to Horizon's investment
subsidiary.
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Horizon Bancorp and Subsidiaries
Management's Discussion and Analysis of Financial Condition
and Results of Operations
For the Three and Nine Month Periods Ended September 30, 2008
There have been no other material changes in the results of operations of
Horizon for the three months ending September 30, 2008 compared to the same
period of 2007.
Material Changes in Results of Operations-Nine months ended September 30, 2008
compared to the Nine months ended September 30, 2007.
For the Nine months ended September 30, 2008, net income totaled $6.850 million
or $2.11 per diluted share compared to $6.130 million or $1.89 per diluted share
for the same period of 2007. An increase in net interest margin of 34 basis
points to 3.31% for the period and a $36 million increase in average earning
assets contributed to the increase.
Non-interest income for the first nine months of 2008 increased by
$1.479 million or 16.5%. In addition to the reasons noted above for the
three-month period, during the second quarter, Horizon received death benefit
proceeds from a bank owned life insurance policy.
Non-interest expense increased $977 thousand or 4.1% from the first nine months
of 2007. The increase relates to the same reasons mentioned above for the three
months ended September 30, 2008.
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