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| PNBC > SEC Filings for PNBC > Form 10-Q on 30-Oct-2009 | All Recent SEC Filings |
30-Oct-2009
Quarterly Report
The following discussion provides information about Princeton National Bancorp, Inc.'s ("PNBC" or the "Corporation") financial condition and results of operations for the three and nine-month periods ended September 30, 2009 and 2008. This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto. 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 (the "Exchange Act"), such as discussions of the Corporation's pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words "believe", "expect", "intend", "anticipate", "estimate", "project", or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the current severe disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the weakening state of the United States economy, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation's market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation's financial results, is included in the Corporation's 2008 Annual Report on Form 10-K under the headings "Item 1. Business" and "Item 1A. Risk Factors."
CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES
The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporation's financial statements. The significant accounting policies of the Corporation are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.
The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its consolidated financial statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted.
We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.
Other Real Estate Owned
Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.
Deferred Income Tax Assets/Liabilities
Our net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of our taxable income, estimates of our future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on our future profitability. If we were to experience net operating losses for tax purposes in a future period, the realization of our deferred tax assets would be evaluated for a potential valuation reserve.
Impairment of Goodwill and Intangible Assets
Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets, with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2008 and 2007, as part of the goodwill impairment test and no impairment was deemed necessary.
As a result of our acquisition activity, goodwill, an intangible asset with an indefinite life, was reflected on our balance sheet in prior periods. Goodwill is evaluated for impairment annually, unless there are factors present that indicate a potential impairment, in which case, the goodwill impairment test is performed more frequently than annually. Accordingly, as the Corporation's stock price at March 31, 2009 decreased below book value, a goodwill impairment test was performed and no impairment was deemed necessary (see Note 3 - "Goodwill and Intangible Assets" in the Notes to Consolidated Financial Statements). In the six-month period since the impairment test, the Corporation has recorded net earnings and the stock price has improved. Therefore, there were no impairment indicators which warranted a third party study of goodwill impairment during the second and third quarters. Accordingly, there was no impairment deemed necessary as of September 30, 2009.
Mortgaging Service Rights (MSRs)
MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise. For discussion regarding the impairment of MSRs, see Note 4 - "Originated Mortgage Servicing Rights" in the Notes to Consolidated Financial Statements.
Fair Value Measurements
The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Corporation estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, the Corporation estimates fair value. The Corporation's valuation methods consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded.
Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2- inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 - inputs that are unobservable and significant to the fair value measurement.
At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 8- "Fair Value of Assets and Liabilities" in the Notes to Consolidated Financial Statements.
RESULTS OF OPERATIONS
Net income for the third quarter of 2009 was $760,000, as compared to $2,187,000 in the third quarter of 2008. Net income available to common stockholders for the third quarter of 2009 was $440,000, or basic and diluted earnings per common share of $0.13, as compared to net income available to common stockholders of $2,187,000 in the third quarter of 2008, or basic and diluted earnings per common share of $0.66. This represents a decrease of $1,747,000 (or 79.9%), and $0.53 per basic and diluted common share. The lower net income figure is attributable to an increase in the provision for loan losses (as discussed below) and insurance assessments by the FDIC, despite an 8.7% improvement in net interest income, discussed in the paragraph below. Net income for the first nine months of 2009 was $3,815,000 or basic and diluted earnings per common share of $0.89, compared to net income of $6,298,000, or basic earnings per common share of $1.91 (diluted earnings per common share of $1.90) for the first nine months of 2008. This represents a decrease of $2,483,000, (39.4%) or $1.02 per basic common share and $1.01 per diluted common share. The lower net income figure is attributed to an increase in the amount of the provision for loan losses of $3.7 million and an increase in the amount of federal insurance deposit assessments of $1.8 million. The annualized return on average assets and return on average equity were 0.24% and 3.02%, respectively, for the third quarter of 2009, compared with 0.78% and 12.54% for the third quarter of 2008. For the nine-month periods, the annualized return on average assets and return on average equity were 0.41% and 5.29%, respectively for 2009, compared with 0.77% and 12.17%, respectively for 2008.
The Corporation's provision for loan loss expense recorded each quarter is determined by management's evaluation of the risk characteristics of the loan portfolio. For the third quarter of 2009, PNBC had net charge-offs of $810,000, compared to net charge-offs of $103,000 for the third quarter of 2008. For the nine-month comparable periods, PNBC had net charge-offs of $2,350,000 in 2009 and net charge-offs of $774,000 in 2008. PNBC recorded a loan loss provision of $2,410,000 in the third quarter of 2009 and $5,045,000 in the first nine months of 2009 compared to a provision of $550,000 in the third quarter of 2008 and $1,368,000 in the first nine months of 2008. The increase in provision expense is due to the increase in non-performing loans, particularly commercial real estate loans. The ratio of non-performing loans to total loans at September 30, 2009 is 4.99% compared to 2.15% at September 30, 2008. The Corporation has no sub-prime loans in the portfolio, nor is there any sub-prime exposure in the investment portfolio.
Non-interest income totaled $2,772,000 for the third quarter of 2009, compared to $2,851,000 in the third quarter of 2008, a decrease of $79,000 (or 2.8%). Annualized non-interest income as a percentage of average total assets decreased to 0.86% for the third quarter of 2009 from 1.02% for the same period in 2008. The lower figure was the result of a decrease in service charges on deposit income of $124,000 (or 10.6%) in the comparable quarter. Year-to-date in 2009, non-interest income totaled $9,092,000 compared to $8,755,000 for the first three quarters of 2008, an increase of $337,000 (or 3.8%). The improvement is due to additional gains on sales of available-for-sale securities of $468,000, along with an increase in mortgage banking income of $446,000 (or 50.7%) period over period. This increase in mortgage banking income is due to refinance activity and is after the recording of an impairment of mortgage servicing rights during the first quarter of 2009 of $556,000. These increases more than offset declines in the categories of service charges on deposits (-11.0%), due mainly to an 11% drop in the number of overdrafts in 2009, and trust fees (-10.4%), which have declined due to a lower market value of the assets under management. Annualized non-interest income as a percentage of average total assets decreased from 1.07% for the first nine months of 2008, to 0.98% for the same period in 2009.
Total non-interest expense for the third quarter of 2009 was $9,001,000, an increase of $1,373,000 (or 18.0%) from $7,628,000 in the third quarter of 2008. The largest increase was in federal insurance deposit assessments, specifically FDIC premiums, which went up $467,000, or 471.7%. Additionally, salaries and employee benefits increased $362,000 (or 8.1%) in the comparable quarters and the category of other real estate expenses increased by $283,000 (or 975.9%) over the past year. Annualized non-interest expense as a percentage of total average assets increased to 2.80% for the third quarter of 2009, compared to 2.72% for the same period in 2008. Year-to-date non-interest expense for the first three quarters of 2009 was $26,477,000, an increase of $3,781,000 (or 16.7%) from the $22,696,000 for the first three quarters of 2008. Again, the majority of the increase is in the categories of federal insurance assessments which rose $1,822,000 (or 682.4%), and other real estate expenses which increased $670,000 (or 443.7%). Annualized non-interest expense as a percentage of total average assets also increased to 2.86% for the first nine months of 2009, compared to 2.77% for the same period in 2008.
The income tax benefit totaled $516,000 for the third quarter of 2009, as
compared to a tax expense of $658,000 for the third quarter of 2008. The
effective tax rate was (211.5%) for the three month period ended September 30,
2009 and 23.1% for the three month period ended September 30, 2008. The income
tax benefit totaled $338,000 for the first nine months of 2009, as compared to a
tax expense of $1,836,000 for the first nine months of 2008. The effective tax
rate was (9.7%) for the nine month period ended September 30, 2009 and 22.5% for
the nine month period ended September 30, 2008. The lower income tax expense is
due to a lower pre-tax income coupled with the effect of tax-exempt investment
interest income. For more information on the Corporation's income taxes see Note
9 - "Income Taxes" in the Notes to Consolidated Financial Statements.
FDIC
On February 27, 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009, at 12 to 50 basis points and, due to extraordinary circumstances, extended the period of the Restoration Plan to seven years. The Corporation's assessment, according to the new formula is now 17 basis points. Previously, the quarterly assessment rate was 7 basis points. Accordingly, the new assessment rates increased the Corporation's quarterly federal insurance expense by approximately $266,000.
On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009, which was paid on September 30, 2009. This assessment equated to a one-time cost of $588,000 and is reflected in the Corporation's income statement for the nine months ended September 30, 2009.
On September 29, 2009 the Board of Directors of the FDIC adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimates that the total prepaid assessments collected would be approximately $45 billion. The FDIC Board also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011, and extend the restoration period from seven to eight years.
Under GAAP accounting rules, unlike special assessments, prepaid assessments would not immediately affect bank earnings. Each institution would record the entire amount of its assessment related to future periods as a prepaid expense (an asset) as of December 30, 2009, the date the payment would be made. The Corporation estimates the amount of the prepaid assessment to be approximately $6 million.
As of December 31, 2009, and each quarter thereafter, each institution would record an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted.
ANALYSIS OF FINANCIAL CONDITION
Total assets at September 30, 2009 increased to $1,287,059,000 from $1,163,130,000 at December 31, 2008 (an increase of $123.9 million or 10.7%). Total loan balances decreased by $18.6 million during the nine month period to $772.2 million due to a general slow-down in the economy and the refinancing of adjustable-rate residential real estate loans into fixed rate products which are sold in the secondary market. Investment balances totaled $335,962,000 at September 30, 2009, compared to $251,115,000 at December 31, 2008 (an increase of $84.8 million or 33.8%), as excess liquidity is invested due to declining loan demand. Total deposits increased to $1,064,813,000 at September 30, 2009 from $962,132,000 at December 31, 2008 (an increase of $102.7 million or 10.7%). Comparing categories of deposits at September 30, 2009 to December 31, 2008, interest-bearing demand deposits increased $91.1 million (or 36.9%) as customers have chosen to stay liquid during the low interest-rate environment. Additionally, time deposits increased $7.7 million (or 1.4%) and savings deposits increased $4.3 million (or 7.1%), while demand deposits decreased $443,000 (or 0.4%). Borrowings, consisting of customer repurchase agreements, federal funds purchased, notes payable, treasury, tax, and loan ("TT&L") deposits, and Federal Home Loan Bank advances, decreased from $118,016,000 at December 31, 2008 to $108,313,000 at September 30, 2009 (a decrease of $9.7 million or 8.2%). The majority of this decrease was due to the repayment of the note payable (balance of $16.05 million at December 31, 2008) with proceeds from the sale of preferred stock under the Capital Purchase Program.
CAPITAL PURCHASE PROGRAM
On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation's 5.00% Series B Fixed Rate Cumulative Perpetual Preferred Stock, no par value, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation's common stock, par value $0.01 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and common stock warrants based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation's consolidated statement of income as "Preferred shares dividends", resulting in additional dilution to the Corporation's earnings per common share. The warrants are immediately exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation's diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation's regulatory Tier 1 and total capital.
The Series B Preferred stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Any redemption requires Federal Reserve approval. The Series B Perpetual Preferred stock ranks senior to the Corporation's existing authorized Series A Junior Participating Preferred stock.
ASSET QUALITY
For the nine months ended September 30, 2009, the subsidiary bank charged off $2,507,000 of loans and had recoveries of $157,000, compared to charge-offs . . .
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