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| CTZN > SEC Filings for CTZN > Form 10-K on 15-Apr-2009 | All Recent SEC Filings |
15-Apr-2009
Annual Report
GENERAL. Management's discussion and analysis of financial condition and results
of operations is intended to assist in understanding the financial condition and
results of operations of the Company. The information contained in this section
should be read in conjunction with the Company's Consolidated Financial
Statements and accompanying Notes under Item 8 of this Report.
OVERVIEW
The Company currently operates as a community-oriented financial institution
that accepts deposits from the general public in the communities surrounding its
24 full-service banking centers and 1 loan production office. The deposited
funds, together with funds generated from operations and borrowings, are used by
the Company to originate loans. The Company's principal lending activity is the
origination of mortgage loans for the purchase or refinancing of one-to-four
family residential properties. The Company also originates commercial and
multi-family real estate loans, construction loans, commercial loans, automobile
loans, home equity loans and lines of credit and a variety of other consumer
loans.
The combined effects of the critical issues involving the mortgage market
nationally, Michigan's economic conditions including a decline in Michigan's
residential real estate values along with the highest rate of unemployment in
the nation, are some of the many the reasons the Bank saw continued increases in
nonperforming loans during 2008. Michigan's unemployment is currently 12.0% as
of February 28, 2009, St. Clair County's unemployment stands at 18.1% and local
unemployment in Port Huron is 24.6%. As a result, the Company substantially
increased its provision for loan losses to $36.2 million in 2008, compared to
$12.3 million in 2007 and $2.8 million in 2006.
As discussed in more detail later in this section, the Company recorded (1)
other-than-temporary impairment losses totaling $44.8 million on its investment
securities, (2) a $23.9 million increase in the provision for loan losses
compared to 2007, (3) a $9.8 million, or 100%, impairment loss on its goodwill
and (4) a $5.2 million valuation allowance on its deferred tax assets.
The combination of the above charges contributed to a 2008 net loss of
$58.9 million compared to net income of $1.9 million in 2007 and $9.1 million in
2006.
CRITICAL ACCOUNTING POLICIES
Management has established various accounting policies that govern how
accounting principles generally accepted in the United States of America are
used to prepare the Company's financial statements. The Company's significant
accounting policies are described in the Notes to the Consolidated Financial
Statements under Item 8 of this Report. Certain accounting policies require
management to make estimates and assumptions about matters that are highly
uncertain and as to which different estimates and assumptions would have a
material impact on the carrying value of certain of the Company's assets and
liabilities, on the Company's
net income and on the Company's overall financial condition and results of
operations. The estimates and assumptions management uses are based on
historical experience and other factors, which management believes to be
reasonable under the circumstances. Actual results could differ significantly as
a result of these estimates and assumptions. Management believes that the
Company's "critical accounting policies" relate to the Company's valuation of
securities, allowance for loan losses, valuation of its mortgage servicing
rights, goodwill and intangibles and accounting for income taxes. These policies
are described in more detail below.
VALUATION OF INVESTMENT SECURITIES. Securities are evaluated to determine
whether a decline in their value below amortized cost is other-than-temporary.
Management and the Asset/Liability Committee systematically evaluate securities
for other-than-temporary declines in market value on a quarterly basis.
Management utilizes criteria such as the magnitude and duration of the decline,
trends of the respective indices, historical rate patterns and their relation to
the expected rates, in addition to the reasons underlying the decline, and, for
debt securities, external credit ratings and recent downgrades, to determine
whether the loss in value is other-than-temporary. The term
"other-than-temporary" is not intended to indicate that the decline is
permanent. It indicates that the prospects for a near term recovery of value are
not necessarily favorable. Once a decline in value is determined to be
other-than-temporary, the value of the security is reduced to its fair value,
forming a new cost basis for the investment, and a corresponding charge to
earnings is recognized through noninterest income. For additional information
about the valuation of securities, see Note 1 to the Company's Consolidated
Financial Statements under Item 8 of this Report.
ALLOWANCE FOR LOAN LOSSES. The Company recognizes that losses will be
experienced from originating loans and that the risk of loss will vary with,
among other factors, the type of loan being made, the creditworthiness of the
borrower over the term of the loan, general economic conditions and, in the case
of a secured loan, the quality of the security for the loan. To reflect the
perceived risk associated with the Company's loan portfolio, the Company
maintains an allowance for loan losses to absorb potential losses from loans in
its loan portfolio. As losses are estimated to have occurred, management
establishes a provision for loan losses, which is charged directly against
earnings. Loan losses are charged against the allowance when management believes
the uncollectibility of a loan balance is assured. Subsequent recoveries, if
any, are credited to the allowance. In general, the Company reviews the
allowance for loan losses on a monthly basis and establishes a provision based
on actual and estimated losses inherent in the portfolio.
Potential Significant Impact on Financial Statements and Condition. The level
of the allowance for loan losses is important to the portrayal of the Company's
financial condition and results of operations. Although management believes that
it uses the best information available to establish the allowance for loan
losses, the determination of what the allowance should be requires management to
make difficult and subjective judgments about which estimates and assumptions to
use, and no assurances can be given that the Company's level of allowance for
loan losses will be sufficient to cover future loan losses incurred by the
Company. Actual results may differ materially from these estimates and
assumptions, resulting in a direct impact on the Company's allowance for loan
losses and requiring changes in the allowance. Nevertheless, management believes
that, based on information currently available, the Company's allowance for loan
losses is sufficient to cover losses inherent in its loan portfolio at this
time. However, because the estimates and assumptions underlying the Company's
allowance for loan losses are inherently uncertain, different estimates and
assumptions could require a material increase in the allowance for loan losses.
Any material increase in the allowance for loan losses could have a material
adverse effect on the Company's net income, its financial condition and results
of operations. For additional information about the allowance for loan losses,
see Note 1 to the Company's Consolidated Financial Statements under Item 8 of
this Report.
VALUATION OF MORTGAGE SERVICING RIGHTS. The Company routinely sells its
originated residential mortgage loans to investors, mainly Freddie Mac and
Fannie Mae. Although the Company sells the mortgage loans, it frequently retains
the servicing rights, or the rights to collect payments and otherwise service
these loans, for an administrative or servicing fee. The mortgage loans that the
Company services for others are not included as assets in the Company's
consolidated balance sheet. Loans serviced for others were approximately
$824.8 million and $759.7 million at December 31, 2008 and December 31, 2007,
respectively.
The Company's mortgage servicing rights relating to loans serviced for others
represent an asset of the Company. This asset is initially capitalized and
included in other assets on the Company's consolidated balance sheet. The
mortgage servicing rights are then amortized against noninterest income in
proportion to, and over the period of, the estimated future net servicing income
of the underlying mortgage servicing rights. There are a number of factors,
however, that can affect the ultimate value of the mortgage servicing rights to
the Company, including the estimated prepayment speed of the loan and the
discount rate used to present value the servicing right. For example, if the
mortgage loan is prepaid, the Company will receive fewer servicing fees, meaning
that the present value of the mortgage servicing rights is less than the
carrying value of those rights on the Company's balance sheet. Therefore, in an
attempt to reflect an accurate expected value to the Company of the mortgage
servicing rights, the Company performs a valuation of its mortgage servicing
rights with the assistance of an independent third party. The valuation of the
mortgage servicing rights is based on relevant characteristics of the Company's
loan servicing portfolio, such as loan terms, interest rates and recent
prepayment experience, as well as current market interest rate levels, market
forecasts and other economic conditions. Based upon the valuation of the
Company's mortgage servicing rights, management then establishes a valuation
allowance by each strata, if necessary, to quantify the likely impairment of the
value of the mortgage servicing rights to the Company. The estimates of
prepayment speeds and discount
rates are inherently uncertain, and different estimates could have a material
impact on the Company's net income and results of operations. The valuation
allowance is evaluated and adjusted quarterly by management to reflect changes
in the fair value of the underlying mortgage servicing rights based on market
conditions.
The balances of the Company 's capitalized mortgage servicing rights, net of
valuation allowance, included in the Company's other assets at December 31, 2008
and December 31, 2007 were $5.4 million and $4.7 million, respectively. The fair
values of the Company's mortgage servicing rights were determined using annual
constant prepayment speeds of 14.14% and 14.11%, and discount rates of 8.00% and
9.00%, at December 31, 2008 and December 31, 2007, respectively. (Constant
prepayment speeds are a statistical measure of the historical or expected
prepayment of principal on a mortgage.) Different estimates of the prepayment
speeds and discount rates or different assumptions could have a material impact
on the value of the mortgage servicing rights and, therefore, on the Company's
valuation allowance. For further discussion of the Company's valuation allowance
and valuation of mortgage servicing rights, including a table setting forth the
valuation allowances established by management with regard to the Company 's
mortgage servicing rights for the most recent three years, see Note 6 to the
Company's Consolidated Financial Statements under Item 8 of this Report.
GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill arising from business
combinations represents the value attributable to unidentifiable intangible
elements in the business acquired. The Company's goodwill relates to value
inherent in the banking business and the value is dependent upon the Company's
ability to provide quality, cost-effective services in a competitive market
place. As such, goodwill value is supported ultimately by revenue that is
generated by the volume of business transacted. A decline in earnings as a
result of a lack of growth 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. Goodwill is subject to ongoing periodic
impairment tests and is evaluated using a two step impairment approach. Step 1
compares the fair value of the reporting unit (the Company is deemed to be
comprised of a single reporting unit for financial reporting purpose) with its
carrying value, including goodwill. If the fair value of the reporting unit
exceeds its carrying amount, goodwill of the reporting unit is considered not
impaired; however, if the carrying amount of the reporting unit exceeds its fair
value, an additional procedure (step 2) must be performed. Step 2 compares the
implied fair value of the reporting unit's goodwill with the carrying amount of
that goodwill. An impairment loss is recorded to the extent that the carrying
amount of goodwill exceeds its fair value. For other intangible assets, an
impairment analysis is performed whenever events or changes in circumstances
indicate that the carrying amount of the asset may not be recoverable. The
carrying amount of an intangible asset is not recoverable if it exceeds the sum
of the undiscounted cash flows expected to result from the use and eventual
disposition of the asset. An impairment loss is recognized if the carrying
amount of the asset is not recoverable and its carrying amount exceeds its fair
value. The tests for impairment of goodwill and other intangible assets require
the Company to make several estimates about fair value, most of which are based
on projected future cash flows. The estimates associated with the goodwill and
other intangible asset impairment tests are considered critical due to the
judgments required in determining fair value amounts, including projected future
cash flows. For a further discussion of the Company's goodwill and intangibles,
please refer to Notes 1 and 2 to the Company's Consolidated Financial Statements
under Item 8 of this Report.
ACCOUNTING FOR INCOME TAXES. The Company accounts for income taxes in accordance
with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for
Income Taxes, as interpreted by FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes (FIN 48), resulting in two components of income tax
expense, current and deferred. Income taxes are discussed in more detail in Note
9 to the Company's Consolidated Financial Statements under Item 8 of this
Report. Accrued income taxes represent the net estimated amount currently due to
or to be received from taxing authorities. In estimating accrued income taxes,
management assesses the relative merits and risks of the appropriate tax
treatment of transactions taking into account statutory, judicial and regulatory
guidance in the context of our tax position. Deferred tax assets and liabilities
represent differences between when a tax benefit or expense is recognized for
financial reporting purposes and on our tax return. Deferred tax assets are
periodically assessed for recoverability. The Company records a valuation
allowance if it believes, based on available evidence, that it is "more likely
than not" that the future tax assets recognized will not be realized before
their expiration. The amount of the deferred tax asset recognized and considered
realizable could be reduced if projected taxable income is not achieved due to
various factors such as unfavorable business conditions. If projected taxable
income is not expected to be achieved, the Company records a valuation allowance
to reduce its deferred tax assets to the amount that it believes can be realized
in its future tax returns.
It is the Company's policy to evaluate the realizability of deferred tax
assets related to unrealized losses on held to maturity and available for sale
debt securities separately from its other deferred tax assets when it has the
intent and ability to hold the security to maturity, in the case of a held to
maturity security, or the intent and ability to hold the security to recovery
(maturity, if necessary), in the case of an available for sale security. Because
the future taxable income implicit in the recovery of the basis of these debt
securities for financial reporting purposes will offset the deductions
underlying the deferred tax asset, a valuation allowance would generally not be
necessary, even in cases where a valuation allowance might be necessary related
to the Company's other deferred tax assets. Should an other-than-temporary
impairment of a debt security be incurred, current accounting guidance requires
that the related charge be recorded in earnings for the difference between the
security's amortized cost and its fair value, which could exceed the Company's
estimate of the actual credit loss based on its assumptions regarding future
cash flows related to the security. In that
case, the Company's policy is to record a deferred tax asset, without a
valuation allowance, for the tax effects of the difference between the estimated
credit loss and the fair value of the security.
Deferred tax assets and liabilities are calculated based on tax rates
expected to be in effect in future periods. Previously recorded tax assets and
liabilities are adjusted when the expected date of the future event is revised
based upon current information. The Company may record a liability for
unrecognized tax benefits related to uncertain tax positions taken on its tax
returns for which there is less than a 50% likelihood of being recognized upon a
tax examination. Interest and penalties, to the extent applicable, are recorded
in income tax expense.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2008 AND 2007
TOTAL ASSETS. Total assets increased $156.1 million, or 8.7%, to $1.961 billion
at December 31, 2008 from $1.804 billion at December 31, 2007, primarily due to
purchases of held to maturity non-agency CMOs of $301.9 million, using borrowed
funds, and an increase in cash and cash equivalents of $43.0 million as the
Company increased cash on hand and liquidity. These increases were partially
offset by decreases in the following areas:
• a $63.2 million net decrease in securities available for sale and securities
held to maturity, due primarily to maturities and sales from the portfolio
as well as a $44.8 million write down in value due to other than temporary
impairments in the securities portfolio, and
• a $114.8 million, or 7.6%, decrease in loans as the current economic conditions have resulted in a smaller pool of qualified borrowers, and the Bank has continued to sell seasoned mortgages in its portfolio to Fannie Mae and Freddie Mac. As noted in the below section titled "Quality of Assets" the Bank charged off loan balances totaling $31.2 million in 2008.
The increase in investments held to maturity during 2008 was entirely made up
of 'AAA' rated non-agency collateralized mortgage obligations which were
purchased at a discount, diversified geographically throughout the country,
carried an average coupon of 5.85%, with weighted average credit scores in
excess of 700. Given the Company's concentration of lending in the State of
Michigan and specifically in southeastern Michigan, the Asset/Liability
Committee determined these investments provide valuable diversification and a
premium return as compared to retail lending rates. However, since acquisition
date and up to December 31, 2008, $68.9 million, or 27.5%, of the carrying
amount of the securities held to maturity portfolio had been downgraded by the
major rating agencies to levels still considered investment grade. In addition,
another $170.2 million, or 68.1%, of the carrying amount of the securities held
to maturity portfolio had been downgraded to sub-investment grade levels though
December 31, 2008. As of March 26, 2009, all $250.0 million of the Company's
held to maturity investments have been downgraded to below 'AAA', of which
$226.4 million, or 90.6%, have been downgraded to sub-investment grade levels.
Similar security types within the available for sale securities portfolio have
also experienced major rating agency downgrades. Since acquisition date and up
to December 31, 2008, $8.5 million, or 16.4%, of the carrying amount of the
Company's available for sale non-agency collateralized mortgage obligations
portfolio had been downgraded to levels still considered investment grade, while
$32.1 million, or 61.7%, had been downgraded to sub-investment grade levels. As
of March 26, 2009, $49.1 million of the carrying amount of the Company's
available for sale investments in this asset class have been downgraded to below
'AAA', of which $37.6 million, or 72.3%, have been downgraded to sub-investment
grade levels. These downgrades have occurred as a result of the continued
increase in delinquency levels impacting the residential real estate markets
nationally and, more specifically as delinquency levels are impacting the
underlying collateral of the specific securities receiving downgrades. The major
rating agencies will continue to review these residential real estate
collateralized investment types and could possibly apply further downgrades to
these and other investments within the Company's investment portfolio. Reference
is made to the "Other-Than-Temporary Impairments" (OTTI) section that follows as
well as Note 3 to the Company's Consolidated Financial Statements under Item 8
of this Report for additional information regarding the Company's analysis and
review for possible other than temporary impairment (OTTI) relating to these
securities. This OTTI analysis will continue to be performed on a quarterly
basis. Considering the above described downgrades and the sensitivity of the
various assumptions used in the Company's OTTI analysis model, there is a
continued risk that more of the Company's collateralized mortgage obligations
will experience an OTTI charge in future periods.
OTHER-THAN-TEMPORARY IMPAIRMENTS. The Company assesses its ability to hold any
fixed maturity security in an unrealized loss position to its recovery,
including fixed maturity securities classified as available for sale, at each
balance sheet date. The decision to sell any such fixed maturity security
classified as available for sale reflects management judgment that the security
sold is unlikely to provide, on a relative value basis, as attractive a return
in the future as alternative investments carrying comparable risks. With respect
to distressed securities, the sale decision reflects management's assessment
that the risk-discounted eventual recovery is less than the value achievable on
sale.
Management evaluates its investments for impairments in valuation as well as
credit. Determination that a security has incurred an other-than-temporary
decline in value requires the judgment of management and consideration of the
fundamental condition of the issuer, its near term prospects and all relevant
facts and circumstances. However, there are inherent weaknesses in any
calculation
technique, and changes in the underlying assumptions used, including discount
rates and estimates of future cash flows, could significantly affect the results
of current or future values in determination of impairment.
Once an investment security has been determined to be other-than-temporarily
impaired, the amount of such impairment is determined by reference to that
security's contemporaneous fair value and recorded as a charge to earnings.
Freddie Mac Preferred Stock Impairment. At September 30, 2008, the Bancorp,
parent company of the Bank, recognized an other-than temporary impairment charge
of $4.8 million on its holding of a Freddie Mac preferred equity security
position included in securities available for sale. As of June 30, 2008, the
Freddie Mac preferred equity security holding represented $5.0 million, or 1.3%,
of the total amortized cost of the Company's investment securities portfolio and
$2.9 million, or 0.8%, of the fair value of the Company's investment securities
portfolio. Subsequent to June 30, 2008, Freddie Mac, along with Fannie Mae,
recognized substantial mortgage related losses in connection with their primary
business activities. As a result of these occurrences, the fair value of Fannie
Mae and Freddie Mac preferred equity securities experienced significant losses,
including the position held by the Bancorp.
On September 7, 2008, in response to these adverse occurrences, the United
States Treasury Department announced that Fannie Mae and Freddie Mac were placed
into conservatorship by their independent regulator, the Federal Housing Finance
Agency (FHFA). Determination to place Fannie Mae and Freddie Mac into
conservatorship was made in collaboration with the Treasury Department and the
Federal Reserve. The two government sponsored enterprises will remain under
conservatorship, with the FHFA acting as conservator, until they become
stabilized.
In order to stabilize the government sponsored enterprises, the Treasury has
established Preferred Stock Purchase Agreements with Fannie Mae and Freddie Mac,
obligating the Treasury to infuse capital, as needed, to maintain the
enterprises' positive net worth. According to terms of the Preferred Stock
Purchase Agreements, existing common and preferred shareholders will bear losses
ahead of the new senior preferred stock holdings by the Treasury. Additionally,
all dividends on common and preferred shares have been discontinued
prospectively.
Results of the above actions, along with uncertainty in the market place
regarding the future value of the preferred stock of Fannie Mae and Freddie Mac,
resulted in materially significant decreases in market values of these
securities. The prospect for future fair value improvements of Fannie Mae and
Freddie Mac preferred equity securities remains unclear today.
At September 30, 2008, as a result of the above noted occurrences, the
Company recorded a an OTTI charge on its holding of the Freddie Mac preferred
stock equity position, in a pre-tax amount of $4.8 million. Under a provision of
the Emergency Economic Stabilization Act (EESA), signed into law on October 3,
2008, banks that experienced losses on their investments in Fannie Mae or
Freddie Mac preferred shares are allowed to deduct their losses as ordinary
losses for tax purposes. The bill provides that for purposes of the Internal
Revenue Code of 1986, gain or loss from the sale or exchange of any "applicable
preferred stock" will be treated as ordinary income or loss. "Applicable
preferred stock" means preferred stock in Fannie Mae or Freddie Mac that was
held on September 6, 2008, or was sold or exchanged on or after January 1, 2008,
and before September 7, 2008. The Company had held its Freddie Mac preferred
security position since March 2001 and had held it continuously, without
interruption, through the reporting period ended September 30, 2008. However, as
EESA was not signed into law until October 3, 2008, the resulting $1.6 million
tax benefit to result from the Freddie Mac preferred security impairment charge
was not reflected in the third quarter 2008 financial statements. Instead, the
$1.6 million tax loss benefit was reflected in the fourth quarter 2008. The
Company subsequently sold this security in the fourth quarter and recorded an
additional loss of $173,000.
Non-Agency Collateralized Mortgage Obligations. During the quarter ended
September 30, 2008, the Company performed OTTI testing on $114.9 million, or
46%, of the carrying amount of its non-agency collateralized mortgage
obligations within the available for sale and held to maturity portfolios. The
holdings tested were identified as a result of increased delinquency and
foreclosure levels, as well as deteriorating liquidation values on the
repossessed collateral of the underlying mortgage loans collateralizing these
holdings. As a result of the depressed credit and collateral value conditions,
the major rating agencies applied investment rating downgrades to the identified
holdings to levels below 'AAA', bringing into question full recovery of the
Company's invested principal in the identified holdings. Testing for principal
impairment involved utilization of Intex, a market-standard cash flow model, to
detail the specific cash flow structure and collateral make-up of each position.
Relevant inputs to the model include market spread data in consideration of
. . .
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