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| CHFC > SEC Filings for CHFC > Form 10-Q on 7-May-2009 | All Recent SEC Filings |
7-May-2009
Quarterly Report
The following is management's discussion and analysis of certain significant factors that have affected the Corporation's financial condition and results of operations during the periods included in the consolidated financial statements included in this filing.
Critical Accounting Policies
The Corporation's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and follow general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. 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 has identified the determination of the allowance for loan losses, pension plan accounting, income and other taxes, and the evaluation of goodwill impairment to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Therefore, management considers them to be critical accounting policies and discusses them directly with the Audit Committee of the board of directors. The Corporation's significant accounting policies are more fully described in Note 1 to the audited consolidated financial statements contained in the Corporation's 2008 Annual Report on Form 10-K and the more significant assumptions and estimates made by management are more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in the Corporation's 2008 Annual Report on Form 10-K. There have been no material changes to those policies or the estimates made pursuant to those policies during the most recent quarter.
Summary
The Corporation's net income was $2.7 million in the first quarter of 2009, compared to net income of $9.7 million in the first quarter of 2008. Diluted earnings per share was $0.11 in the first quarter of 2009, down from $0.41 in the first quarter of 2008. The decreases in net income and earnings per share were primarily the result of an increase in the provision for loan losses.
Return on average assets in the first quarter of 2009 was 0.28%, compared to 1.03% in the first quarter of 2008 on an annualized basis. Return on average equity in the first quarter of 2009 was 2.3%, compared to 7.7% in the first quarter of 2008 on an annualized basis.
Total assets were $3.98 billion as of March 31, 2009, up $176.5 million, or 4.6%, from March 31, 2008, and up $101.4 million, or 2.6%, from $3.87 billion at December 31, 2008.
Total loans were $2.95 billion as of March 31, 2009, an increase of $166.6 million, or 6.0%, from March 31, 2008, and a decrease of $30.1 million, or 1.0%, from December 31, 2008. The increase in total loans from March 31, 2008 was attributable to increases in commercial, real estate commercial and consumer loans being only partially offset by lower real estate residential loans and real estate construction loans. The decrease in total loans from December 31, 2008 was due to decreases in commercial, real estate commercial, real estate construction and real estate residential loans being only partially offset by higher consumer loans.
At March 31, 2009, shareholders' equity was 12.3% of total assets and $20.40 per outstanding common share. Shareholders' equity of $487.4 million as of March 31, 2009 decreased $4.2 million, or 0.8%, from December 31, 2008. The decrease in shareholders' equity during the three months ended March 31, 2009 was primarily attributable to cash dividends paid to shareholders exceeding net income during the three months ended March 31, 2009.
Balance Sheet Changes
Total Assets
Total assets were $3.98 billion as of March 31, 2009, an increase of $101.4 million, or 2.6%, from total assets of $3.87 billion as of December 31, 2008 and an increase of $176.5 million, or 4.6%, from total assets of $3.80 billion as of March 31, 2008. The increase in total assets from December 31, 2008 was primarily attributable to increases in investment securities and short-term investments that were funded by increased deposits, including some seasonal deposits. The increase in total assets from March 31, 2008 was primarily attributable to an increase in total loans that was funded by increased deposits.
Interest-earning assets were $3.75 billion at March 31, 2009, an increase of $190.1 million, or 5.3%, from December 31, 2008. The increase in interest-earning assets between December 31, 2008 and March 31, 2009 was primarily attributable to the increases in investment securities and short-term investments that were funded by increased deposits, including some seasonal deposits.
Investment Securities
The Corporation accounts for all investment securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), under which the Corporation is required to assess debt securities that have fair values below amortized cost basis to determine whether the decline (impairment) is other-than-temporary. Impairment is other-than-temporary if the assessment concludes that it is probable that the holder will be unable to collect all amounts due according to the contractual terms of the debt instrument. SFAS 115 permits the use of reasonable management judgment of the probability that the holder will or will not be able to collect all amounts due. In addition, SFAS 115 also requires that the holder must have the intent and ability to hold the security to recovery for an impairment to be deemed temporary and not require a charge to earnings. In addition, FASB Staff Position (FSP) 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," clarified that an investor should recognize an impairment loss in the period that the impairment is deemed other-than-temporary.
The accounting guidance does not provide for an automatic conclusion that a security does not have other-than-temporary impairment (OTTI) because all of the scheduled payments to date have been received. Further analysis and judgment are required to assess whether a decline in fair value is temporary and that it is probable that the holder will collect all of the contractual or estimated cash flows from the investment security. Further, the Securities and Exchange Commission (SEC) Staff Accounting Bulletin Topic 5M, "Other-than-Temporary Impairment of Certain Investments in Debt and Equity Securities," states that the length of time and extent to which the fair value has been less than cost can indicate a decline is other-than-temporary. The longer and/or the more severe the decline in fair value, the more persuasive the evidence that is needed to overcome the premise that the holder will not collect all of the contractual or estimated cash flows from the investment security. Accordingly, in making an OTTI assessment, the holder is to consider all available information relevant to the collectibility of the investment security, including information about past events, current conditions and reasonable and supportable forecasts, when developing the estimate of future cash flows. The accounting literature also recommends the holder consider industry analyst reports and forecasts, sector credit ratings and other market data that are relevant to the collectibility of the investment security.
The Corporation's investment securities portfolio had a carrying value of $610.2 million at March 31, 2009, with gross impairment of $11.9 million as of that date. The Corporation concluded that at March 31, 2009 the impairment was temporary. A further discussion of the impairment and the Corporation's process that resulted in the conclusion that the impairment was temporary follows.
At March 31, 2009, the Corporation's investment securities portfolio included government sponsored agency securities that had gross impairment of $0.09 million, state and political subdivisions securities with gross impairment of $0.98 million, mortgage-backed securities and collateralized mortgage obligations, combined, with gross impairment of $0.80 million, corporate bonds with gross impairment of $2.1 million and trust preferred securities with gross impairment of $7.9 million.
The state and political subdivisions investment securities in the held-to-maturity portfolio totaling $96.6 million at March 31, 2009 were recorded at amortized cost. The majority of these investment securities are from issuers primarily located in the state of Michigan and are primarily general obligations of the issuer, meaning that the Corporation has the first claim on taxes collected for the repayment of the investment securities. Of the total
$96.6 million, investment securities totaling $21.7 million had gross impairment of $0.98 million at March 31, 2009. The majority of the investment securities with impairment mature beyond 2016 and, due to the steepness of the interest yield curve at March 31, 2009, the Corporation determined that the impairment of $0.98 million at March 31, 2009 was attributable to the change in market interest rates and that the impairment was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.
The mortgage-backed securities and collateralized mortgage obligations, combined, are included in the available-for-sale investment securities portfolio, with an amortized cost of $246.4 million and gross impairment of $0.80 million at March 31, 2009. Virtually all of the impaired investment securities in these two categories are backed by an explicit guarantee of the U.S. government. The Corporation assessed the impairment on these investment securities at March 31, 2009 and determined the impairment was attributable to the general decline in market interest rates and the impairment on these investment securities at that date was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.
At March 31, 2009, the Corporation's corporate bond portfolio had an amortized cost of $53.2 million, with gross impairment of $2.1 million. Fair values of all of the corporate bonds were below amortized cost at March 31, 2009. All of the corporate bonds held at March 31, 2009 were of an investment grade, except one single issue investment security, Lehman Brothers Holdings Inc. The Corporation's remaining amortized cost of the Lehman Brothers Holdings Inc. bond was less than $0.1 million at March 31, 2009. The investment grade ratings obtained for the balance of the corporate bond portfolio indicated that the obligors' capacities to meet their financial commitments was "strong." The majority of the impairment existing at March 31, 2009 was attributable to two corporate bonds from one issuer with a combined amortized cost/par value of $2.7 million that had impairment of $1.7 million, or 81%, of the total impairment on corporate bonds at that date. Both corporate bonds are senior unsecured obligations of American General Finance Corporation (AGFC), a wholly-owned subsidiary of American General Finance Inc. (AGFI), which is wholly-owned indirectly by American International Group (AIG). The amortized cost/par value amounts of the bonds were $0.2 million and $2.5 million with maturity dates of September 1, 2010 and December 15, 2011, respectively.
The Corporation performed an assessment of the probability that it would collect all of the contractual amounts due under the two AGFC corporate bonds at March 31, 2009. Ratings from Moody's, Standard & Poor's and Fitch were Baa2, BB+ and BBB, respectively, at March 31, 2009. AGFC was downgraded by each of these rating services twice during 2008 and by Moody's on March 17, 2009 to a ratio which is just below investment grade and by Standard & Poor's on February 9, 2009 to a lower investment grade rating. Both Standard and Poor's and Fitch indicated, through the assignment of their ratings, that the issuer appeared to have a strong ability to pay its financial obligations in the intermediate term.
The public filing of AGFC's Form 10-K with the SEC for the period ended December 31, 2008 indicated AGFC had suffered a financial loss of $1.3 billion in 2008; however, AGFC's total equity at December 31, 2008 was $2.1 billion, or 8% of total assets. AGFC's own assessment of its financial condition at December 31, 2008 indicated that, after consideration of many factors, although primarily due to its ability to obtain funding from its parent company and its ability to severely reduce originations of finance receivables, AGFC believed it would have adequate liquidity to finance and operate its businesses and repay its obligations for at least the next twelve months. However, it is possible that the actual outcome of one or more of AGFC's significant judgments or estimates could prove to be materially incorrect and AGFC may not have sufficient cash to meet its obligations in the future. A $0.1 million AGFC bond owned by the Corporation that matured on October 15, 2008 was paid in full on that date as was a March 2009 interest payment on AGFC's variable rate bond issue owned by the Corporation.
At March 31, 2009, the Corporation believed it was probable, as defined by SFAS 115, that it would receive all contractual cash flows of its corporate bond portfolio and determined that the impairment on the corporate bond portfolio at that date was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.
At March 31, 2009, the Corporation owned $10.5 million of trust preferred securities that had gross impairment of $7.9 million. Of the $10.5 million balance, $10 million represented a 100% interest in a trust preferred security (TRUP) of a small non-public bank holding company in Michigan (issuer) that was purchased in the second quarter of 2008. At March 31, 2009, the Corporation determined the fair value of the TRUP was $2.5 million. The fair value measurement was developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair value of the TRUP was based on a calculation of discounted cash flows, based upon both observable inputs and appropriate risk adjustments that market participants would make for performance, liquidity and issuer specifics. See the additional discussion of the development of the fair value of the TRUP in Note 5 to the consolidated financial statements.
Management reviewed financial information of the issuer of the TRUP at March 31, 2009. Based on this review, the Corporation concluded that the significant decline in fair value of the TRUP, compared to its amortized cost, was not attributable to adverse conditions specifically related to the issuer. At March 31, 2009, it was the Corporation's opinion that the issuer appeared well positioned to continue to realize positive net income in 2009. The issuer had consistent earnings in 2007 and 2008 and reported a 25% increase in earnings during the first quarter of 2009 compared to the first quarter of 2008. At March 31, 2009, the issuer had equity capital of $57.9 million and a liquidity position which included $120 million in investment securities held as available-for-sale. Based on the Corporation's analysis at March 31, 2009, it was the Corporation's opinion that the issuer appeared to be a financially sound institution with ample liquidity to meet all of its financial obligations in 2009. This TRUP is not independently rated. Industry bank ratings for 2008, obtained from the issuer, indicated the issuer was defined as "sound." Common stock cash dividends were paid throughout 2008 and the first quarter of 2009 by the issuer and the issuer's management anticipates cash dividends to continue to be paid in 2009 and beyond. All scheduled interest payments on the TRUP were made on a timely basis in 2008 and the first quarter of 2009. The principal of $10 million of the TRUP matures in 2038, with interest payments due quarterly.
Based on the information provided by the issuer, as of March 31, 2009, it was the Corporation's opinion that there had been no adverse changes in the issuer's financial performance since the TRUP was issued and purchased by the Corporation and no indication that any adverse trends were developing that would suggest that the TRUP would be unable to make all future principal and interest payments. Further, based on the information provided, the issuer appeared to be a financially viable financial institution with both the credit quality and liquidity necessary to meet all financial obligations in 2009. At March 31, 2009, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer or its subsidiaries. In reviewing all available information regarding the issuer reflecting past performance and its financial and liquidity position, it was the Corporation's opinion that the future cash flows of the issuer supported the carrying value of the TRUP at its original cost of $10 million at March 31, 2009. There can be no assurance that other-than-temporary impairment losses will not be recognized on TRUPs or any other investment security in the future. While the fair value of the TRUP was $7.5 million below the Corporation's carrying value (original cost) at March 31, 2009 and the TRUP was impaired, it was the Corporation's assessment that the overall financial condition of the issuer did not indicate other-than-temporary impairment of the TRUP and that the unrealized loss was temporary at March 31, 2009. The Corporation has the intent and ability to hold this impaired investment security to maturity.
Loans
The Corporation's subsidiary bank is a full-service commercial bank and, therefore, the acceptance and management of credit risk is an integral part of the Corporation's business. At March 31, 2009, the Corporation's loan portfolio was $2.95 billion and consisted of loans to commercial borrowers (commercial, real estate commercial and real estate construction-commercial) totaling $1.44 billion, or 49% of total loans, loans to consumer borrowers for the purpose of acquiring residential real estate (real estate construction-residential and real estate residential) totaling $828 million, or 28% of total loans, and loans to consumer borrowers secured by various types of collateral totaling $683 million, or 23% of total loans, at that date. Loans at fixed interest rates comprised 82% of the Corporation's loan portfolio at March 31, 2009, compared to 79% at December 31, 2008. The Corporation maintains loan policies and credit underwriting standards as part of the process to manage credit risk. Underwriting standards are designed to promote relationship banking rather than transactional banking. These standards include providing loans generally only within the Corporation's market areas. The Corporation's lending markets generally consist of small communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation's lending market areas do not include the southeastern portion of Michigan. The average size of commercial loan transactions is generally relatively small, which decreases the risk of loss within the commercial loan portfolio due to the lack of loan concentration. The Corporation's commercial loan portfolio, defined as commercial, real estate commercial and real estate construction-commercial loans, is well diversified across business lines and has no concentration in any one industry. The total commercial loan portfolio of $1.44 billion at March 31, 2009 included 60 loan relationships of $2.5 million and greater. These 60 borrowing relationships totaled $313.3 million and represented 21.8% of the total commercial loan portfolio at March 31, 2009. Further, at March 31, 2009, only four of these borrowing relationships were $10 million or higher, totaling $52.8 million, or 3.7%, of the commercial loan portfolio as of that date. These four loans were all performing at March 31, 2009. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation's lending philosophy is implemented through strong administrative and reporting controls at the subsidiary bank level, with additional oversight at the corporate level. The Corporation maintains a centralized independent loan review function, which monitors asset quality of the loan portfolio.
Total loans at March 31, 2009 of $2.95 billion were down $30.1 million, or 1.0%, from total loans at December 31, 2008, and up $166.6 million, or 6.0%, from total loans at March 31, 2008. A summary of the changes in the loan portfolio by category follows.
Commercial loans decreased $24.4 million, or 4.2%, from December 31, 2008 to $563.1 million at March 31, 2009. The decrease in commercial loans was attributable to both seasonal reductions of short-term lines of credit, particularly with the Corporation's agricultural customers, and less customer demand for new financing. Commercial loans represented 19.1% of the Corporation's loan portfolio at March 31, 2009 and 19.7% at December 31, 2008.
Real estate loans include real estate commercial loans, real estate construction loans and real estate residential loans. At March 31, 2009, real estate loans were $1.71 billion, a decrease of $39.1 million, or 2.2%, from December 31, 2008. Real estate loans as a percentage of total loans were 57.8% at March 31, 2009 and 58.5% at December 31, 2008.
Real estate commercial loans decreased $1.9 million, or 0.2%, from December 31, 2008 to $784.5 million at March 31, 2009. Real estate commercial loans represented 26.6% of the Corporation's loan portfolio at March 31, 2009 and 26.4% at December 31, 2008.
Commercial lending and real estate commercial lending are generally considered to involve a higher degree of risk than one- to four-family residential lending. Real estate commercial loans are loans secured by real estate occupied by the borrower for ongoing operations and non-owner occupied real estate leased to one or more tenants. At March 31, 2009, approximately 75% of the outstanding balance of the Corporation's real estate commercial loans were secured by owner-occupied properties. Real estate commercial lending also includes loans to residential and commercial developers for the purchase of vacant land that is intended to be developed and land development loans. Land development loans are loans made to residential and commercial developers for infrastructure improvements to create finished marketable lots for residential or commercial construction. Vacant land loans are also made to borrowers for investment purposes. Commercial and real estate commercial lending typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties, vacant land and land development loans are typically dependent on the success of the operation of the related project and are typically affected by adverse conditions in the real estate market and in the economy. The Corporation generally attempts to mitigate the risks associated with commercial lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using prudent loan-to-value ratios in the underwriting process.
Real estate construction loans are originated for both business and residential properties, including development. These loans often convert to a real estate commercial or real estate residential loan at the completion of the construction period; however, most development loans are originated with the intention that the loans will be paid through the sale of finished properties by the developers within twelve months of the completion date. The severe recession in Michigan has resulted in the inability of most developers to sell their finished developed lots and units within their original expected time frames. Further, few of the Corporation's development borrowers sold developed lots or units during 2008 and the first quarter of 2009 due to the poor economic environment. Real estate construction loans made to consumers are for the construction of single family residences and are secured by these properties. Real estate construction loans to consumers at March 31, 2009 were $19.2 million, a decrease of $10.1 million, or 34.4%, from December 31, 2008. Total real estate construction loans were $112.1 million at March 31, 2009, a decrease of $6.9 million, or 5.8%, from December 31, 2008. The decrease in real estate construction loans was partially attributable to the lack of residential housing development lending during the first quarter of 2009, as it has been well publicized nationwide that this industry over expanded during the last few years. Business expansion and development continued at a historically low rate during 2008 and into 2009 across all of the Corporation's market areas due to the recessionary economic environment within the state of Michigan. Real estate construction loans represented 3.8% and 4.0% of the Corporation's loan portfolio as of March 31, 2009 and December 31, 2008, respectively.
Real estate construction lending involves a higher degree of risk than one- to four-family residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates and the need to obtain a tenant or purchaser of the property if it will not be owner-occupied. The Corporation generally attempts to mitigate the risks associated with construction lending by, among other things, lending primarily in its market areas, using prudent underwriting guidelines and closely monitoring the construction process. The Corporation's risk in
this area increased during 2008 and the first three months of 2009 as both the sale of units in residential real estate development projects slowed significantly, as customer demand significantly decreased, and the inventory of unsold housing units increased across the state of Michigan.
Real estate residential loans decreased $30.3 million, or 3.6%, from December 31, 2008 to $809.3 million as of March 31, 2009. The decrease in real estate residential loans was attributable to both a significant decline in Michigan's housing market due to the overall economic environment and customers refinancing adjustable rate and balloon mortgages to long-term fixed interest rate loans that the Corporation sold in the secondary mortgage market. Residential real estate loans represented 27.4% of the Corporation's loan portfolio as of March 31, 2009 and 28.1% as of December 31, 2008. The Corporation's real estate residential loans primarily consist of one- to four-family residential loans with fixed interest rates of fifteen years or less. The Corporation's current general practice is to sell fixed-rate real estate residential loan originations with maturities of over ten years in the secondary market. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance. The Corporation originated $141 million of real estate residential loans during the three months ended March 31, 2009, of . . .
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