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| HBNC > SEC Filings for HBNC > Form 10-K on 20-Mar-2009 | All Recent SEC Filings |
20-Mar-2009
Annual Report
Allowance for Loan Losses
An allowance for loan losses is maintained to absorb probable incurred loan
losses inherent in the loan portfolio. The determination of the allowance for
loan losses is a critical accounting policy that involves management's ongoing
quarterly assessments of the probable incurred losses inherent in the loan
portfolio. The identification of loans that have probable incurred losses is
subjective, therefore, a general reserve is maintained to cover all probable
losses within the entire loan portfolio. Horizon utilizes a loan grading system
that helps identify, monitor and address asset quality problems in an adequate
and timely manner. Each quarter, various factors affecting the quality of the
loan portfolio are reviewed. Large credits are reviewed on an individual basis
for loss potential. Other loans are reviewed as a group based upon previous
trends of loss experience. Horizon also reviews the current and anticipated
economic conditions of its lending market as well as transaction risk to
determine the effect they may have on the loss experience of the loan portfolio.
Goodwill and Intangible Assets
Management believes that the accounting for goodwill and other intangible assets
also involves a higher degree of judgment than most other significant accounting
policies. Statement of Financial Accounting Standard (SFAS) No. 142, Accounting
for Goodwill and Other Intangible Assets,establishes standards for the
amortization of acquired intangible assets and impairment assessment of
goodwill. At December 31, 2008, Horizon had core deposit intangibles of
$1.751 million subject to amortization and $5.787 million of goodwill, which is
not subject to amortization. Goodwill arising from business combinations
represents the value attributable to unidentifiable intangible assets in the
business acquired. Horizon's goodwill relates to the value inherent in the
banking industry and that value is dependent upon the ability of Horizon to
provide quality, cost effective banking services in a competitive marketplace.
The goodwill value is supported by revenue that is in part driven by the volume
of business transacted. A decrease in earnings resulting from a decline in the
customer base or the inability to deliver cost effective services over sustained
periods can lead to impairment of goodwill that could adversely impact earnings
in future periods. SFAS No. 142 requires an annual evaluation of goodwill for
impairment. The evaluation of goodwill for impairment requires the use of
estimates and assumptions. For the first time in Horizon's history, the market
value for Horizon's stock dropped below the book value during the fourth quarter
of 2008. Market price at the close of business on December 31, 2008 was $12.50
per share compared to a book value of $24.46 per common share. Horizon reported
record earnings for the ninth consecutive year in 2008 and believes the decline
in market price relates to an overall decline in the financial industry sector
and are not specific to Horizon. Horizon engaged a third party to perform an
impairment test of its goodwill. The evaluation included three approaches: 1)
income approach using a discounted cash flow based on earnings capacity, 2)
price to earnings multiples and 3) price to book value ratios. Approaches 2 & 3
use median results from 17 bank sale transactions that occurred during 2007 and
2008. The selling banks ranged in size from $763 million to $2.1 billion. The
impairment test was performed as of November 30, 2008 and yielded an implied
fair value for the Bank well above the book value.
Financial results for December 2008 (and for the full year of 2008) were as
anticipated by the analysis. An additional $20 million of capital was injected
into Horizon Bank by the holding company but the calculated fair value of
Horizon Bank is still well above its book value. Horizon has concluded that,
based on its own internal evaluation and the independent impairment test
conducted by a third party, the recorded value of goodwill is not impaired.
Mortgage Servicing Rights
Servicing assets are recognized as separate assets when rights are acquired
through purchase or through the sale of financial assets on a servicing-retained
basis. Capitalized servicing rights are amortized into non-interest income in
proportion to, and over the period of, the estimated future net servicing income
of the underlying financial assets. Servicing assets are evaluated regularly for
impairment based upon the fair value of the rights as compared to amortized
cost. Impairment is determined by stratifying servicing rights by predominant
characteristics, such as interest rates, original loan terms and whether the
loans are fixed or adjustable rate mortgages. Fair value is determined using
prices for similar assets with similar characteristics, when available, or based
upon discounted cash flows using market-based assumptions. When the book value
of an individual stratum exceeds its fair value, an impairment reserve is
recognized so that each individual stratum is carried at the lower of its
amortized book value or fair value. In periods of falling market interest rates,
accelerated loan prepayment speeds can adversely impact the fair value of these
mortgage-servicing rights relative to their book value. In the event that the
fair value of these assets was to increase in the future, Horizon can recognize
the increased fair value to the extent of the impairment allowance but cannot
recognize an asset in excess of its amortized book value. Future changes in
management's assessment of the impairment of these servicing assets, as a result
of changes in observable market data relating to market interest rates, loan
prepayment speeds, and other factors, could impact Horizon's financial condition
and results of operations either positively or adversely.
Generally, when market interest rates decline and other factors favorable to
prepayments occur, there is a corresponding increase in prepayments as customers
refinance existing mortgages under more favorable interest rate terms. When a
mortgage loan is prepaid, the anticipated cash flows associated with servicing
that loan are terminated, resulting in a reduction of the fair value of the
capitalized mortgage servicing rights. To the extent that actual borrower
prepayments do not react as anticipated by the prepayment model (i.e., the
historical data observed in the model does not correspond to actual market
activity), it is possible that the prepayment model could fail to accurately
predict mortgage prepayments and could result in significant earnings
volatility. To estimate prepayment speeds, Horizon utilizes a third-party
prepayment model, which is based upon statistically derived data linked to
certain key principal indicators involving historical borrower prepayment
activity associated with mortgage loans in the secondary market, current market
interest rates and other factors, including Horizon's own historical prepayment
experience. For purposes of model valuation, estimates are made for each product
type within the mortgage servicing rights portfolio on a monthly basis.
Derivative Instruments
As part of our asset/liability management program, Horizon utilizes, from
time-to-time, interest rate floors, caps or swaps to reduce our sensitivity to
interest rate fluctuations. These are derivative instruments, which are recorded
as assets or liabilities in the consolidated balance sheets at fair value.
Changes in the fair values of derivatives are reported in the consolidated
income statements or other comprehensive income (OCI) depending on the use of
the derivative and whether the instrument qualifies for hedge accounting. The
key criterion for the hedge accounting is that the hedged relationship must be
highly effective in achieving offsetting changes in those cash flows that are
attributable to the hedged risk, both at inception of the hedge and on an
ongoing basis.
Horizon's accounting policies related to derivatives reflect the guidance in
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as
revised and further interpreted by SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities, ("SFAS 133") and other related
accounting guidance. Derivatives that qualify for the hedge accounting treatment
are designated as either: a hedge of the fair value of the recognized asset or
liability or of an unrecognized firm commitment (a fair value hedge) or a hedge
of a forecasted transaction or the variability of cash flows to be received or
paid related to a recognized asset or liability (a cash flow hedge). For fair
value hedges, the cumulative change in fair value of both the hedge instruments
and the underlying loans is recorded in non-interest income. For cash flow
hedges, changes in the fair values of the derivative instruments are reported in
OCI to the extent the hedge is effective. The gains and losses on derivative
instruments that are reported in OCI are reflected in the consolidated income
statement in the periods in which the results of operations are impacted by the
variability of the cash flows of the hedged item. Generally, net interest income
is increased or decreased by amounts receivable or payable with respect to the
derivatives, which qualify for hedge accounting. At inception of the hedge,
Horizon establishes the method it uses for assessing the effectiveness of the
hedging derivative and the measurement approach for determining the ineffective
aspect of the hedge. The ineffective portion of the hedge, if any, is recognized
currently in the consolidated statements of income. Horizon excludes the time
value expiration of the hedge when measuring ineffectiveness.
Valuation Measurements
Valuation methodologies often involve a significant degree of judgment,
particularly when there are no observable active markets for the items being
valued. Investment securities, residential mortgage loans held for sale and
derivatives are carried at fair value, as defined in SFAS No. 157 Fair Value
Measurement ("SFAS 157"), which requires key judgments affecting how fair value
for such assets and liabilities is determined. In addition, the outcomes of
valuations have a direct bearing on the carrying amounts of goodwill, mortgage
servicing rights, and pension and other post-retirement benefit obligations. To
determine the values of these assets and liabilities, as well as the extent to
which related assets may be impaired, management makes assumptions and estimates
related to discount rates, asset returns, prepayment rates and other factors.
The use of different discount rates or other valuation assumptions could produce
significantly different results, which could affect Horizon's results of
operations.
Analysis of Financial Condition
Investment Securities
Investment securities totaled $303.268 million at December 31, 2008, and
consisted of U.S. Treasury and Government Agency securities of $24.914 million
(8.2%); Municipal securities of $88.619 million ($86.985 million are available
for sale and $1.634 million are held to maturity)(29.2%); Mortgage-backed
securities of $176.389 million (58.2%); collateralized mortgage obligations of
$12.951 million (4.3%); and corporate securities of $399 thousand (.1%).
As indicated above, 62.5% of the investment portfolio consists of
mortgage-backed securities and collateralized mortgage obligations.
Approximately 1.3% of the portfolio or $4.0 million are private label
collateralized mortgage obligations, the remainder are issued by Agencies of the
Federal Government. The private label securities generally have loan to value
ratios of approximately 50% and management feels these securities are not
impaired. These instruments are secured by residential mortgages of varying
maturities. Principal and interest payments are received monthly as the
underlying mortgages are repaid. These payments also include prepayments of
mortgage balances as borrowers either sell their homes or refinance their
mortgages. Therefore, mortgage-backed securities and collateralized mortgage
obligations have maturities that are stated in terms of average life. The
average life is the average amount of time that each dollar of principal is
expected to be outstanding. As of December 31, 2008, the mortgage-backed
securities and collateralized mortgage obligations in the investment portfolio
had an average life of 7.47 years. Securities that have interest rates above
current market rates are purchased at a premium. These securities may experience
a significant increase in prepayments when lower market interest rates create an
incentive for the borrower to refinance the underlying mortgage. This may result
in a decrease of current income, however, this risk is mitigated by a shorter
average life. Management currently believes that prepayments on these securities
could increase during 2009.
Available-for-sale municipal securities are priced by a third party using a
pricing grid which estimates prices based on recent sales of similar securities.
All municipal securities are investment grade or local non-rated issues and
management does not believe there is permanent deterioration in market value.
At December 31, 2008, 99.5% of investment securities, and at December 31, 2007,
all investment securities were classified as available for sale. Securities
classified as available for sale are carried at their fair value, with both
unrealized gains and losses recorded, net of tax, directly to stockholders'
equity. Net appreciation on these securities totaled $1.818 million, which
resulted in a balance of $1.182 million , net of tax, included in stockholders'
equity at December 31, 2008. This compared to a $63 thousand, net of tax,
included in stockholders' equity at December 31, 2007.
Effective January 1, 2008, Horizon adopted Statement of Financial Accounting
Standards No. 157, Fair Value Measurements (FAS 157). FAS 157 defines fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements. The standard describes three levels of inputs
that may be used to measure fair value:
Level 1 Quoted prices in active markets for identical assets or liabilities
Level 2 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 for substantially the full
term of the assets or liabilities
Level 3 Unobservable inputs that are supported by little or no market
activity and that are significant to the fair value of the assets or
liabilities
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When quoted market prices are available in an active market, securities are
classified within Level 1 of the valuation hierarchy. Level 1 securities include
U.S. Treasury securities and corporate notes. If quoted market prices are not
available, then fair values are estimated by using pricing models, quoted prices
of securities with similar characteristics or discounted cash flows. Level 2
securities include Federal agency securities, State and municipal securities,
Federal agency collateralized mortgage obligations and Federal agency
mortgage-backed pools. For level 2 securities, Horizon uses a third party
service to determine fair value. In performing the valuations, the pricing
service relies on models that consider security-specific details as well as
relevant industry and economic factors. The most significant of these inputs are
quoted market prices, interest rate spreads on relevant benchmark securities and
certain prepayment assumptions. To verify the reasonableness of the fair value
determination by the service, Horizon has a portion of the level 2 securities
priced by an independent securities broker dealer. At December 31, 2008, 19% of
the level 2 securities were tested. The test showed a variance of 0.3% between
the two determinations so the valuation service was deemed to be accurate and
those values were used for financial reporting.
Unrealized gains and losses on available-for-sale securities, deemed temporary,
are recorded, net of income tax, in a separate component of other comprehensive
income on the balance sheet. No unrealized losses were deemed to be
"other-than-temporary".
As a member of the Federal Reserve and Federal Home Loan Bank systems, Horizon
is required to maintain an investment in the common stock of each entity. The
investment in common stock is based on a predetermined formula. At December 31,
2008 and 2007, Horizon had investments in the common stock of the Federal
Reserve and Federal Home Loan Bank totaling $12.625 million.
At December 31, 2008, Horizon does not maintain a trading account.
For more information about securities, see Note 2 (Investment Securities) to the
consolidated financial statements.
Loans Total loans, the principal earning asset of the Bank, were $881.967 million at December 31, 2008. The current level of loans is a decrease of 0.8% from the December 31, 2007, level of $888.852 million. The table below provides comparative detail on the loan categories. (dollar amounts in thousands) Dollar Percent December 31 2008 2007 Change Change Real estate loans 1 - 4 family $ 160,661 $ 206,914 $ (46,253 ) (22.35 )% Other 7,105 9,105 (2,000 ) (21.97 ) Total 167,766 216,019 (48,253 ) (22.34 ) Commercial loans Working capital and equipment 164,237 154,459 9,778 6.33 Real estate, including agriculture 137,442 141,733 (4,291 ) (3.03 ) Tax exempt 3,258 3,809 (551 ) (14.47 ) Other 5,905 7,534 (1,629 ) (21.62 ) Total 310,842 307,535 3,307 1.08 Consumer loans Auto 160,685 174,331 (13,646 ) (7.83 ) Recreation 6,985 7,074 (89 ) (1.26 ) Real estate/home improvement 34,582 41,684 (7,102 ) (17.04 ) Home equity 73,008 59,131 13,877 23.47 Unsecured 2,438 1,979 459 23.19 Other 2,374 2,874 (500 ) (17.40 ) Total 280,072 287,073 (7,001 ) (2.44 ) Mortgage warehouse loans Prime 115,939 69,894 46,045 65.88 Sub-Prime 7,348 8,331 (983 ) (11.80 ) Total 123,287 78,225 45,062 57.61 Grand total $ 881,967 $ 888,852 $ (6,885 ) (0.77 )% |
The acceptance and management of credit risk is an integral part of the Bank's
business as a financial intermediary. The Bank has established underwriting
standards including a policy that monitors the lending function through strict
administrative and reporting requirements as well as an internal loan review of
consumer and small business loans. The Bank also uses an independent third-party
loan review function that regularly reviews asset quality.
Real Estate Loans
Real estate loans totaled $167.766 million or 19.0% of total loans as of
December 31, 2008, compared to $216.019 million or 24.3% of total loans as of
December 31, 2007. This category consists of home mortgages that generally
require a loan to value of no more than 80%. Some special guaranteed or insured
real estate loan programs do permit a higher loan to collateral value ratio.
In addition to the customary real estate loans described above, the Bank also
has outstanding on December 31, 2008, $73.008 million in home equity lines of
credit compared to $59.131 million at December 31, 2007. Credit lines normally
limit the loan to collateral value to no more than 89%. These loans are
classified as consumer loans in the table above and in Note 4 of the
consolidated financial statements.
Residential real estate lending is a highly competitive business. As of
December 31, 2008, the real estate loan portfolio reflected a wide range of
interest rates and repayment patterns, but could generally be categorized as
follows:
2008 2007
Percent of Percent of
(dollar amounts in thousands) Amount Portfolio Yield Amount Portfolio Yield
Fixed rate
Monthly payment $ 36,278 21.62 % 6.29 % $ 41,491 19.21 % 6.47 %
Biweekly payment 2,276 1.36 6.45 2,663 1.23 6.49
Adjustable rate
Monthly payment 129,201 77.01 5.96 171,845 79.55 5.90
Biweekly payment 11 0.01 5.78 20 0.01 7.79
Total $ 167,766 100.00 % 6.04 % $ 216,019 100.00 % 6.03 %
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During 2008 and 2007, approximately $178 million and $135 million, respectively,
of residential mortgages were sold into the secondary market. The 2008 amount
includes approximately $38 million of loans that were transferred to held for
sale from the real estate loan portfolio and were subsequently sold during the
first quarter to reduce Horizon's reliance on non-core funding and improve
Horizon Bank's capital ratios.
In addition to the real estate loan portfolio, the Bank sells real estate loans
and retains the servicing rights. Loans serviced for others are not included in
the consolidated balance sheets. The unpaid principal balances and number of
loans serviced for others totaled approximately $79,544,000 and 706 and
$26,191,000 and 324 at December 31, 2008 and 2007, respectively.
The Bank began capitalizing mortgage servicing rights during 2000 and the
aggregate fair value of capitalized mortgage servicing rights at December 31,
2008, totaled approximately $1,208,000. Comparable market values and a valuation
model that calculates the present value of future cash flows were used to
estimate fair value. For purposes of measuring impairment, risk characteristics
including product type, investor type and interest rates, were used to stratify
the originated mortgage servicing rights.
(dollar amounts in thousands) 2008 2007 2006
Mortgage Servicing Rights
Balances, January 1 $ 276 $ 248 $ 1,278
Servicing rights capitalized 634 79 83
Amortization of servicing rights (178 ) (51 ) (251 )
Servicing rights sold - - (862 )
732 276 248
Impairment allowance (4 ) (7 ) (3 )
Balances, December 31 $ 728 $ 269 $ 245
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Commercial Loans . . . |
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