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INBK > SEC Filings for INBK > Form 10-K on 28-Mar-2013All Recent SEC Filings

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Form 10-K for FIRST INTERNET BANCORP


28-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated and condensed financial statements and related notes appearing elsewhere in this report. This discussion and analysis includes certain forward-looking statements that involve risks, uncertainties and assumptions. You should review the "Risk Factors" section of this report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by such forward-looking statements. See "Cautionary Note Regarding Forward-Looking Statements" at the beginning of this report.

Overview

The primary drivers of our performance since January 1, 2011, have been:

our ability to capitalize on the demand for residential mortgage refinancing due to the ongoing low-rate environment and our scalable, efficient process;

our deployment of excess cash into higher-yielding assets; and

our ability to maintain high credit quality despite the ongoing difficulties affecting many other banks.

During 2011 and 2012, we reported collective net income of $8.8 million. During the same period, total assets increased by $132.5 million, or 26.3%. We increased net loans in this period by $52.8 million, or 17.6%, from December 31, 2010. Net interest income totaled $29.9 million in 2011 and 2012. During the same period, our net interest spread on an annualized basis has been relatively steady at 2.57% and 2.49% for 2011 and 2012, respectively. Securities available for sale increased by $19.8 million, or 14.4%. Our regulatory capital ratios have remained well above all required minimums. Non-performing loans as a percentage of total loans declined from 3.17% in 2010 to 2.64% and 1.23% in 2011 and 2012, respectively.

Due to our sustained record of performance, our Board of Directors declared a special cash dividend of $0.25 per share payable December 28, 2012, to holders of our common stock on December 10, 2012.

Results of Operations

Fiscal Year Ended December 31, 2012 vs. Fiscal Year Ended December 31, 2011

Interest income from loans for 2012 increased by $551,000, or 2.9%, compared to 2011 primarily due to an increase of $43.5 million in average loans outstanding.

Interest expense from deposits for 2012 decreased by $1.1 million, or 13.2%, compared to 2011 primarily due to the low rate environment. Despite an increase of $62.9 million in the average balance of interest bearing deposits, the average cost of funds decreased by 0.46%.

Provision for loan losses increased by $412,000, or 16.9%, from 2011 to 2012 as a result of management's ongoing evaluation of the adequacy of the allowance for loan losses which includes an analysis of the overall size and composition of the portfolio as well as a review of all loans for which full collectability may not be reasonably assured which considers, among other matters, the estimated net realizable value of the underlying collateral, economic conditions, loan loss experience and other factors that are particularly susceptible to changes that could result in a material change to the borrower's ability to pay the loan upon maturity. Provision expense improvements in 2012 occurred due to reduced delinquencies and charge-off activity which offset the impact of the growth within loans on the balance sheet.

Gain on loans sold during 2012 increased by $7.0 million, or 188.5%, compared to 2011, primarily due to increased loan origination for refinancing within the residential mortgage department. The ongoing low rate environment has made refinancing existing mortgages an attractive option for consumers.

Other-than-temporary impairment ("OTTI") charges in our securities portfolio decreased by $374,000, or 59.7%, compared to 2011. Management's evaluation of the securities portfolio in 2012 indicated OTTI losses on three securities. The amortized cost remaining on securities with OTTI losses totaled $2.0 million as of December 31, 2012.

Loss on asset disposals decreased by $959,000, or 91.2%, in 2012, primarily as the result of the write off in the fourth quarter of 2011 of $368,000 representing the full value of our investment in an Indiana financial institution which disclosed that it may be unable to continue as a going concern. The Bank also wrote down a commercial property held as Other Real Estate Owned ("OREO") by $288,000 in the fourth quarter of 2011. In addition, the Bank recognized a $189,000 gain on liquidation of a commercial property in OREO in the third quarter of 2012.

Salaries and employee benefits increased $3.2 million, or 60.6%, reflecting the addition of 23 full time employees during 2012 compared to 2011. We added staff within the residential mortgage and C&I departments to address increased origination volumes. In addition, the Bank recognized an additional $1.1 million of expense in 2012 related to performance bonuses.

Marketing, advertising and promotion expenses increased by $426,000, or 45.5%, as the result of the increased usage of third party lead sources to attract potential borrowers to our mortgage website. We acquire mortgage leads from third party sources to drive loan applications.

Consulting and professional fees increased by $645,000, or 83.0%, to accommodate increased legal fees of approximately $497,000 during 2012 incurred through the normal course of operations such as credit collection efforts and public company filing activities.

Loan expenses increased by $571,000, or 108.6%, due primarily to $285,000 of expenses related to a non performing commercial real estate credit which was moved to OREO in October 2012. In addition, expenses related to loan underwriting activities increased $261,000 as a result of the increase in the level of mortgage originations.

Premises and equipment expenses increased by $294,000, or 19.9%, due primarily to $191,000 of expenses related to a non performing commercial real estate credit which was moved to OREO in October 2012.

Deposit insurance premiums decreased by $272,000, or 37.4%, due to a 0.015% decrease in the Bank's FDIC assessment rates.

Average Balance Sheets, Net Interest Earnings

For the periods presented, the following table provides the total dollar amount of interest income from average interest-earning assets and the resulting yields, and the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes. Balances are based on the average of daily balances. Non-accrual loans are included in average loan balances.

Average Balance Sheets
(dollars in thousands)



                                                                                      Year ended December 31,
                                               2012                                              2011                                             2010
                                                                                                                                              Interest
                            Average       Interest and                        Average       Interest and                        Average          and
                            Balance        Dividends         Yield/Cost       Balance        Dividends         Yield/Cost       Balance       Dividends       Yield/Cost
Assets:
Interest-earning assets:
Loans                      $ 390,058     $       19,303             4.95 %   $ 346,589     $       18,752             5.41 %   $ 309,655     $    19,868             6.42 %
Investment securities        172,887              4,645             2.69 %     145,823              5,045             3.46 %     133,943           5,294             3.95 %
FHLB stock                     2,943                100             3.40 %       3,080                 83             2.69 %       3,592              68             1.89 %
Other interest-earning
assets                        27,363                 69             0.25 %      25,383                 64             0.25 %      27,447              66             0.24 %
Total interest-earning
assets                       593,251             24,117                        520,875             23,944                        474,637          25,296

Noninterest-earning
assets                        21,289                                            19,938                                            17,896
Total assets               $ 614,540                                         $ 540,813                                         $ 492,533

Liabilities and equity:
Interest-bearing
liabilities
Regular savings accounts   $   9,999     $           58             0.58 %   $   7,417     $           48             0.65 %   $   6,760     $        50             0.74 %
Interest-bearing demand
deposits                      62,154                351             0.56 %      55,708                386             0.69 %      50,963             403             0.79 %
Money market accounts        187,029              1,448             0.77 %     151,134              1,444             0.96 %     125,223           1,408             1.12 %
Certificates and
brokered deposits            238,575              5,315             2.23 %     220,601              6,388             2.90 %     212,553           7,393             3.48 %
Total interest-bearing
deposits                     497,757              7,172                        434,860              8,266                        395,499           9,254

FHLB advances                 40,625              1,360             3.35 %      38,539              1,355             3.52 %      36,427           1,531             4.20 %
Other borrowings                   -                  -             0.00 %          20                  -             0.51 %           -               -             0.00 %
Total interest-bearing
liabilities                  538,382              8,532                        473,419              9,621                        431,926          10,785

Noninterest-bearing
liabilities                   13,939                                             8,218                                             7,069
Other non-interest
bearing liabilities            3,285                                             6,863                                             4,502
Total liabilities            555,606                                           488,500                                           443,497

Stockholders' equity          58,934                                            52,313                                            49,036
Total liabilities and
equity                     $ 614,540                                         $ 540,813                                         $ 492,533

Net interest income                      $       15,585                                    $       14,323                                    $    14,511

Interest rate spread                                                2.49 %                                            2.57 %                                         2.83 %
Net interest margin                                                 2.63 %                                            2.75 %                                         3.06 %
Average interest-earning
assets to average
interest-bearing
liabilities                                                       110.19 %                                          110.02 %                                       109.89 %

Rate/Volume Analysis

(dollars in thousands)

The following table sets forth certain information regarding changes in our interest income and interest expense for the periods indicated. For each category of earning assets and interest bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in average volume multiplied by old rate) and (ii) changes in rates (change in rate multiplied by old average volume). Changes in rate/volume (change in rate multiplied by the change in volume) have been allocated to the changes due to volume and rate in proportion to the absolute value of the changes due to volume and rate prior to the allocation.

                                                      Rate/Volume Analysis of Net Interest Income
                                                            Fiscal Years ended December 31,
                               2012 vs. 2011                         2011 vs. 2010                         2010 vs. 2009
                             Due to Changes in                     Due to Changes in                     Due to Changes in
                     Volume        Rate         Net        Volume        Rate         Net         Volume        Rate         Net
Interest income
Loans receivable     $ 2,233     $ (1,683 )   $    550     $ 2,209     $ (3,325 )   $ (1,116 )   $ (1,234 )   $   (331 )   $ (1,565 )
Investment
securities               776       (1,176 )       (400 )       416         (665 )       (249 )       (957 )       (784 )     (1,741 )
FHLB stock                (4 )         22           18         (11 )         26           15           (1 )        (10 )        (11 )
Other
interest-earning
assets                     5            -            5          (5 )          3           (2 )          5            1            6
Total                  3,010       (2,837 )        173       2,609       (3,961 )     (1,352 )     (2,187 )     (1,124 )     (3,311 )

Interest expense
Deposits                 852       (1,946 )     (1,094 )       578       (1,566 )       (988 )     (1,740 )     (1,782 )     (3,522 )
FHLB advances             71          (66 )          5          85         (261 )       (176 )       (557 )          5         (552 )
Total                    923       (2,012 )     (1,089 )       663       (1,827 )     (1,164 )     (2,297 )     (1,777 )     (4,074 )

Increase
(decrease) in net
interest income      $ 2,087     $   (825 )   $  1,262     $ 1,946     $ (2,134 )   $   (188 )   $    110     $    653     $    763

Liquidity and Capital Resources

The Company's primary source of funds is dividends from the Bank, the declaration of which is subject to regulatory limits. Historically, the Company has not had significant demands for the use of its cash. However, we declared a special dividend of $0.25 per share of common stock in the fourth quarter of 2012. At December 31, 2012, the Company, on an unconsolidated basis, had $782,000 in cash generally available for its cash needs.

On March 18, 2013, the Board of Directors declared a cash dividend for the first quarter of 2013 of $0.06 per share payable April 15, 2013 to shareholders on April 1, 2013. We expect to continue to pay dividends on a quarterly basis; however, the declaration and amount of future dividends will be determined by the Board of Directors on the basis of our financial condition, earnings, regulatory constraints and other factors.

At December 31, 2012, we had $189.2 million in cash and investment securities available for sale and $63.2 million in loans held for sale that were generally available for our cash needs. At December 31, 2012, we had the ability to borrow an additional $23.1 million in FHLB advances and correspondent bank fed funds line of credit draws.

At December 31, 2012, approved outstanding loan commitments, including unused lines of credit, amounted to $33.6 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2012, totaled $78.9 million; however, due to our competitive rates, we believe that a majority of maturing deposits will remain with the Bank.

Bank-owned life insurance increased 41.4% from the end of 2011 as a result of a $3.0 million purchase completed in the first quarter of 2012.

OREO which is included in other assets increased by 142.6% during 2012, primarily as the result of the transition of a single commercial real estate loan into OREO during the fourth quarter of 2012 representing $2.6 million. The balance of OREO as of December 31, 2012 was $3.7 million.

Other assets, excluding OREO, decreased by 10.0% since the end of 2011 reflecting a decrease in deferred tax assets due to continued positive earnings and increases in unrealized gains and losses on securities available for sale impacting mark-to-market adjustments within deferred taxes.

Total deposits increased 9.0% from the end of 2011. Due to recent economic conditions, consumers have maintained higher cash balances in bank deposit accounts such as money market savings and short term time deposits.

Total shareholders' equity increased $5.9 million during 2012, as a result of net income of $5.6 million and an increase of $598,000 in accumulated other comprehensive income due to increased unrealized gains on available-for-sale securities.

At December 31, 2012, the Company and the Bank exceeded all applicable regulatory capital minimum requirements, and the Bank was considered "well-capitalized" under applicable regulations. We believe our capital resources are sufficient to meet our current and expected needs, including any cash dividends we may pay; however, if we continue to experience significant growth, we may require additional capital resources. Although we have limited experience in raising additional capital, we believe the listing of our common stock on the NASDAQ Capital Market will improve our ability to access capital markets when necessary by enhancing the marketability of our common stock.

Investing Activities

Investment Securities Portfolio

In managing our investment securities portfolio we focus on providing an adequate level of liquidity and establishing an interest rate-sensitive position, while earning an adequate level of investment income without taking undue risk. Investment securities that we intend to hold until maturity are classified as held-to-maturity securities, and all other investment securities are classified as available-for-sale. Currently, all of our investment securities are classified as available-for-sale. The carrying values of available-for-sale investment securities are adjusted for unrealized gains or losses as a valuation allowance and any gain or loss is reported on an after-tax basis as a component of other comprehensive income. Purchases during 2012 focused primarily on mortgage-backed securities issued by U.S. government sponsored enterprises.

The following table summarizes the book value and approximate fair value and distribution of our investment securities as of the dates indicated.

(dollars in thousands)                                                      December 31,
                                               2012                             2011                             2010
                                   Amortized       Approximate      Amortized       Approximate      Amortized       Approximate
                                      Cost         Fair Value          Cost         Fair Value          Cost         Fair Value
Securities available for sale:
U.S. government-sponsored
enterprises                        $   18,666     $      19,618     $   24,685     $      25,502     $   43,444     $      43,393
U.S. government treasuries                  -                 -              -                 -          2,369             2,332
Municipals                             39,999            42,540         40,849            42,761         42,463            40,764
Mortgage- and asset-backed
securities -
government-sponsored enterprises       75,782            77,489         67,354            69,790         37,850            39,981
Mortgage- and asset-backed
securities - private labeled            2,696             2,453          5,850             5,445          9,720             9,000
Other securities                       16,753            14,593          8,648             5,772          4,279             1,466
Total securities available for
sale                               $  153,896     $     156,693     $  147,386     $     149,270     $  140,125     $     136,936

Our trust preferred securities consist of the two securities identified in the following table, which contains information regarding these securities as of December 31, 2012 (amounts in thousands):

Deal name                                                I-PreTSL I           ALESCO IV
Class                                                     B-2 Notes           B-2 Notes
Book value                                           $        2,000      $        1,036
Fair value                                           $          812      $           28
Unrealized loss                                      $       (1,188 )    $       (1,008 )
Other-than-temporary impairment recorded in
earnings                                             $            -      $          964

Lowest credit rating assigned                                  CCC-                   C
Number of performing institutions                                14                  31
Number of issuers in default                                      0                   1
Number of issuers in deferral                                     2                   7

Original collateral                                  $      351,000      $      400,000
Actual defaults & deferrals as a % of original
collateral                                                     4.27 %             12.13 %
Remaining collateral                                 $      188,500      $      258,397
Actual defaults & deferrals as a % of remaining
collateral                                                     7.96 %             18.77 %
Expected defaults & deferrals as a % of remaining
collateral                                                    21.17 %             14.00 %
Performing collateral                                $      173,500      $      209,897

Current balance of class                             $       33,200      $       55,550
Subordination                                        $       16,000      $            0
Excess subordination                                 $       27,200      $     (111,276 )
Excess subordination as a % of performing
collateral                                                     15.7 %             -53.0 %

Cash Flow Analysis Assumptions:
Discount margin (1)                                            7.00 %             14.25 %
Cumulative Default % Range                              4.9% - 100%         2.2% - 100%
 (Weighted Average)                                           (29.1 )%            (16.5 )%
Loss Given Default % Range                                85% - 85%          90% - 100%
 (Weighted Average)                                             (85 )%            (90.1 )%
Cumulative Prepayment % Range                                                 0% - 100%
 (Weighted Average)                                             n/a               (15.6 )%

(1) The discount rate for floating rate bonds is a compound interest formula based on the LIBOR forward curve for each payment date

These two securities are Collateralized Debt Obligations ("CDOs") that are backed by pools of debt securities issued by financial institutions. The collateral of the ALESCO CDO consists of trust-preferred securities ("TruPS") and subordinated debt securities issued by banks and bank holding companies. The collateral of the PreTSL CDO consists of TruPS and subordinated debt securities of insurance companies. Performing collateral is the amount of remaining collateral less the balances of collateral in deferral or default. Subordination is the amount of performing collateral in excess of the current balance of a specified class of notes and all classes senior to the specified class. Excess subordination is the amount that the performing collateral balance exceeds the outstanding bonds in the current class, plus all senior classes. It is a static measure of credit enhancement, but does not incorporate all of the structural elements of the security deal. This amount can also be impacted by future defaults and deferrals, deferring balances that cure or redemptions of securities by issuers. A negative excess subordination indicates that the current performing collateral of the security would be insufficient to pay the current principal balance of the class notes after all of the senior classes notes were paid.

However, the performing collateral balance excludes the collateral of issuers currently deferring their interest payments. Because these issuers are expected to resume payment in the future (within five years of the first deferred interest period), a negative excess subordination does not necessarily mean a class note holder in the CDO will not receive a greater than projected or even full payment of cash flow at maturity.

At December 31, 2012 and 2011 the Company was receiving "payment in kind" ("PIK"), in lieu of cash interest on the ALESCO trust preferred securities investment. The Company's use of "PIK" does not indicate that additional securities have been issued in satisfaction of any outstanding obligation; rather, it indicates that a coverage test of a class or tranche directly senior to the class in question has failed and interest received on the PIK note is being capitalized, which means the principal balance is being increased. Once the coverage test is met, the capitalized interest will be paid in cash and current cash interest payments will resume.

The Company's CDOs both allow, under the terms of the issue, for issuers to defer interest for up to five consecutive years. After five years, if not cured, the securities are considered to be in default and the trustee may demand payment in full of principal and accrued interest. Issuers of the securities in the collateral pool are also considered to be in default in the event of the failure of the issuer or a subsidiary. The structuring of these CDOs provides for a waterfall approach to absorbing losses whereby lower classes or tranches are initially impacted and more senior tranches are only impacted after lower tranches can no longer absorb losses. Likewise, the waterfall approach also applies to principal and interest payments received, as senior tranches have priority over lower tranches in the receipt of payments. Both deferred and defaulted issuers are considered non-performing, and the trustee calculates, on a quarterly or semi-annual basis, certain coverage tests prior to the payment of cash interest to owners of the various tranches of the securities. The coverage tests are compared to an over-collateralization target that states the balance of performing collateral as a percentage of the tranche balance plus the balance of all senior tranches. The tests must show that performing collateral is sufficient to meet requirements for the senior tranches, both in terms of cash flow and collateral value, before cash interest can be paid to subordinate tranches. As a result of the cash flow waterfall provisions within the structure of these securities, when a senior tranche fails its coverage test, all of the cash flows that would have been paid to lower tranches are paid to the senior tranche and recorded as a reduction of the senior tranches' principal. This principal reduction in the senior tranche continues until the coverage test of the senior tranche is passed or the principal of the tranche is paid in full. For so long as the cash flows are being diverted to the senior tranches, the amount of interest due and payable to the subordinate tranches is capitalized and recorded as an increase in the principal value of the tranche. The Company's CDO investments are in the mezzanine tranches or classes which are subordinate to one of more senior tranches of their respective issues. The Company is receiving PIK for the ALESCO CDO due to failure of the required senior tranche coverage tests described. This security is currently projected to remain in full or partial PIK status for a period of three years.

The impact of payment of PIK to subordinate tranches is to strengthen the position of the senior tranches by reducing the senior tranches' principal balances relative to available collateral and cash flow. The impact to the subordinate tranches is to increase principal balances, decrease cash flow, and . . .

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