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TAYC > SEC Filings for TAYC > Form 10-K on 7-Mar-2014All Recent SEC Filings

Show all filings for TAYLOR CAPITAL GROUP INC

Form 10-K for TAYLOR CAPITAL GROUP INC


7-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Cautionary Note Regarding Forward-Looking Statements Certain of the statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this report on Form 10-K constitute forward-looking statements. These forward-looking statements within the meaning of Section 27A of the Securities Act, and
Section 21E of the Exchange Act reflect our current expectations and projections about our future results, performance, prospects and opportunities. We have tried to identify these forward-looking statements by using words including "may," "might," "contemplate," "plan," "predict," "potential," "should," "will," "expect," "anticipate," "believe," "intend," "could" and "estimate" and similar expressions. These forward-looking statements are based on information currently available to us and are subject to a number of risks, uncertainties and other factors that could cause our actual results, performance, prospects or opportunities in 2014 and beyond to differ materially from those expressed in, or implied by, these forward-looking statements.
These risks, uncertainties and other factors include, without limitation:
The Merger Agreement and Plan of Merger with MB Financial may be terminated in accordance with its terms, and the Merger contemplated thereby may not be completed.

Termination of the Merger Agreement could negatively impact us.

We may be subject to business uncertainties and contractual restrictions while the Merger is pending.

We and MB Financial have entered into a memorandum of understanding with the plaintiffs to settle two stockholder actions previously filed against us, our board of directors and MB Financial challenging the Merger. It is possible that additional suits may be filed in the future. If the settlement of these existing suits is not approved by the court or is otherwise voided, an adverse ruling in these or any similar future lawsuits may prevent the Merger from being completed or from being completed within the expected timeframe.

The Merger Agreement limits our ability to pursue an alternative acquisition proposal and requires us to pay a termination fee of $20 million under limited circumstances relating to alternative acquisition proposals.

We may be materially and adversely affected by the highly regulated environment in which we operate.

Dependence on our mortgage business may increase volatility in our consolidated revenues and earnings and our residential mortgage lending profitability could be significantly reduced if we are not able to originate and sell mortgage loans at profitable margins.

Changes in interest rates may change the value of our MSR portfolio which may increase the volatility of our earnings.

Certain hedging strategies that we use to manage investment in MSRs, mortgage loans held for sale and interest rate lock commitments may be ineffective to offset any adverse changes in the fair value of these assets due to changes in interest rates and market liquidity.

Our mortgage loan repurchase reserve for losses could be insufficient.

A significant increase in certain loan balances associated with our mortgage business may result in liquidity risk related to the funding of these loans.

We are subject to certain operational risks, including, but not limited to, data processing system failures and errors and customer or employee fraud. Our controls and procedures may fail or be circumvented.

We are dependent on outside third parties for processing and handling of our records and data.

System failure or breaches of our network security, including with respect to our internet banking activities, could subject us to increased operating costs as well as litigation and other liabilities.

We may not be able to access sufficient and cost-effective sources of liquidity.

We are subject to liquidity risk, including unanticipated deposit volatility.

Changes in certain credit ratings related to us or our credit could increase our financing costs or make it more difficult for us to obtain funding or capital on commercially acceptable terms.

As a bank holding company, our sources of funds are limited.


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We are subject to interest rate risk, including interest rate fluctuations, that could have a material adverse effect on us.

Competition from financial institutions and other financial services providers may adversely affect our growth and profitability and have a material adverse effect on us.

Our business is subject to the conditions of the economies in which we operate and continued weakness in those economies and the real estate markets may materially and adversely affect us.

Our business is subject to domestic and to a lesser extent, international economic conditions and other factors, many of which are beyond our control and could materially and adversely affect us.

The preparation of our consolidated financial statements requires us to make estimates and judgments, including the use of models, which are subject to an inherent degree of uncertainty and which may differ from actual results.

We must manage credit risk and if we are unable to do so, our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio, which could have a material adverse effect on us.

We have counterparty risk and therefore we may be materially and adversely affected by the soundness of other financial institutions.

We are subject to lending concentration risks.

We are subject to mortgage asset concentration risks.

Our business strategy is dependent on our continued ability to attract, develop and retain highly qualified and experienced personnel in senior management and customer relationship positions.

Our reputation could be damaged by negative publicity.

New and less mature lines of business, new products and services or new customer relationships may subject us to certain additional risks.

We may experience difficulties in managing our future growth.

We and our subsidiaries are subject to changes in federal and state tax laws and changes in interpretation of existing laws.

Regulatory requirements recently adopted by the U.S. federal bank regulatory agencies to implement Basel III, growth plans or operating results may require us to raise additional capital, which may not be available on favorable terms or at all.

We have not paid a dividend on our common stock since the second quarter of 2008. In addition, regulatory restrictions and liquidity constraints at the holding company level could impair our ability to make distributions on our outstanding securities.

For further information about these and other risks, uncertainties and factors, please review the disclosure included in Item 1A. Risk Factors of this report. You should not place undue reliance on any forward-looking statements. Except as otherwise required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements or risk factors, whether as a result of new information, future events, changed circumstances or any other reason after the date of this filing. Introduction
We are the holding company of the Bank, a commercial bank headquartered in Chicago. The Bank specializes in serving the banking needs of closely held businesses and the people who manage them. Through its national businesses, the Bank also provides asset-based lending, residential mortgage lending and commercial equipment leasing through a growing network of offices throughout the United States. At December 31, 2013, we had assets of $5.7 billion, deposits of $3.7 billion and stockholders' equity of $464.6 million.
As noted above in Item 1. Business, on July 15, 2013, we announced that we had entered into a merger agreement with MB Financial, Inc. ("MB Financial"). The agreement provides that, subject to the conditions set forth in the merger agreement, we will merge with and into MB Financial, with MB Financial as the surviving corporation. Immediately following the merger, our wholly owned subsidiary bank will merge with MB Financial's wholly owned subsidiary bank, MB Financial Bank, N.A. The merger is expected to be completed in the first half of 2014.
The following discussion and analysis presents the more significant factors affecting our consolidated financial condition at December 31, 2013 and December 31, 2012 and results of operations for the years ended December 31, 2013, December 31, 2012, and December 31, 2011. This discussion should be read together with the "Selected Financial Data," our audited consolidated financial statements and the notes thereto and other financial data contained elsewhere in this report. In addition


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to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and forward-looking statements as a result of certain factors, including those discussed in the section captioned "Risk Factors" and elsewhere in this report.

Current Developments
We have been notified by our primary banking regulators that the Bank may be cited with a violation of Section 5 of the Federal Trade Commission Act. The potential violation relates to the checking account opening process associated with our former deposit program relationship with an organization that provides electronic financial disbursements and payment services to the higher education industry (the "Former Counterparty"). We exited this relationship in the third quarter of 2013. A violation of Section 5 of the Federal Trade Commission Act could result in the imposition of civil money penalties against the Bank, and may possibly impose a secondary obligation to make restitution to account holders affected by the violation. To the extent we ultimately would be required to make any financial restitution as a result of the potential violation, the Former Counterparty is obligated to reimburse us pursuant to a contractual indemnification agreement. If any civil money penalties are imposed upon us they would not be reimbursed to us through indemnification or otherwise. Given the preliminary status of the notification, we are unable to reasonably estimate a range of potential financial impact from this matter, if any. However, we do not currently expect that the impact of this potential regulatory violation will have a material impact on our financial position or results of operations.
Application of Critical Accounting Policies Our accounting and reporting policies conform, in all material respects, to U.S. generally accepted accounting principles ("U.S. GAAP") and general reporting practices within the financial services industry. For additional details, see "Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting and Reporting Policies" from our audited financial statements contained elsewhere in this report.
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available to us as of the date of the consolidated financial statements and, accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. The estimates, assumptions and judgments made by us are based on historical experience, current information and other factors that we believe to be reasonable under the circumstances. Certain accounting policies inherently have 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 actual outcomes. We consider our policies for the allowance for loan losses, income taxes, the valuation of derivative financial instruments, the valuation of investment securities and the valuation of mortgage servicing rights to be critical accounting policies.
The following accounting policies materially affect our reported earnings and financial condition and require significant estimates, assumptions and judgments.
Allowance for Loan Losses
We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in our loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include a general allowance computed by applying loss factors to categories of loans outstanding in the portfolio and specific allowances for identified problem loans and portfolio categories. We maintain our allowance for loan losses at a level that we consider sufficient to absorb probable losses inherent in our portfolio as of the balance sheet date. In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors including: historical charge-off experience; changes in the size of our loan portfolio; changes in the composition of our loan portfolio and the volume of delinquent, criticized and impaired loans. In addition, we use information about specific borrower situations, including their financial position, work-out plans and estimated collateral values under various liquidation scenarios to estimate the risk and amount of loss on loans to those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of risk of loss and amount of loss on any loan are complicated by the uncertainties surrounding not only our borrowers' probability of default, but also the fair value of the underlying collateral. Continuing illiquidity in the Chicago area real estate market has maintained the recent relative uncertainty with respect to real estate values. Because of the


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degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding holding periods until sale and the collateral liquidation method, our actual losses may materially vary from our current estimates. Our non-consumer loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have the potential for higher losses for each loan. Due to their size, larger loans can cause greater volatility in our reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate for any one loan may have a material impact on our reported impaired loans and related loss estimates. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of any one or a few of these loans could cause an increase in uncollectible loans and our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, our allowance for loan losses is adjusted through the recording of a provision for loan losses. Income Taxes
We are subject to the income tax laws of the United States and the states and other jurisdictions in which we operate. The determination of income tax expense or benefit and the amounts of current and deferred income tax assets and liabilities involve the use of estimates, assumptions, interpretations, and judgment. Factors considered include interpretations of federal and state income tax laws, current financial accounting standards, the difference between the tax and financial reporting basis of assets and liabilities (temporary differences), assessment of the likelihood that the reversal of deferred deductible temporary difference will yield tax benefits, and estimates of reserves required for tax uncertainties. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management's current assessment, the impact of which could be significant to future results.
Deferred tax assets and liabilities are recorded for temporary differences between the pre-tax income reported on our consolidated financial statements and taxable income. Deferred tax assets and liabilities are measured using currently enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized as an income tax benefit or income tax expense in the period that includes the enactment date. The determination of the realizability of the net deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, forecasts of future taxable income, applicable tax planning strategies, and assessments of current and future economic and business conditions. We currently do not maintain a valuation allowance against our net deferred tax assets because management has determined that it is more-likely-than-not that these net deferred tax assets will be realized.
Derivative Financial Instruments
We use derivative financial instruments ("derivatives"), including interest rate swaps and corridor agreements, interest rate swap options ("swaptions"), callable interest rate swap agreements, agreements to purchase mortgage-backed securities, or mortgage TBAs for which we do not intend to take delivery, as well as interest rate lock and forward loan sale commitments, to either accommodate individual customer needs or to assist in our interest rate risk management. All derivatives are measured and reported at fair value on our Consolidated Balance Sheets as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the effective portion of the hedged risk, is recognized in current earnings during the period of the change in the fair value. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of Other Comprehensive Income ("OCI") and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value. Similarly, the changes in the fair value of derivatives that are not designated as an accounting hedge are also reported currently in earnings. At the inception of a formally designated hedge and quarterly thereafter, an assessment is made to determine whether changes in the fair value or cash flows of the derivatives have been highly effective in offsetting the changes in the fair value or cash flows of the hedged item and whether they are expected to be highly effective in the future. If it is determined that derivatives are not highly effective as a hedge, hedge accounting is discontinued for the period. Once hedge accounting is terminated, all changes in fair value of the derivatives are reported currently in the Consolidated Statements of Income in other noninterest income, which could result in greater volatility in our earnings.
The estimates of fair values of certain of our derivative instruments, such as interest rate swaps and corridors, are calculated by an independent pricing service which uses valuation models to estimate market-based valuations. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow


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of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both us and our counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in volatility in our earnings.
The fair value of forward loan sale commitments is based on quoted prices for similar assets in active markets that we have the ability to access. We use an external valuation model that relies on internally developed inputs to estimate the fair value of our interest rate lock commitments. Valuation of Investment Securities
The fair value of our investment securities portfolio is determined in accordance with U.S. GAAP, which requires that we classify financial assets and liabilities measured at fair value into a three-level fair value hierarchy. The determination of fair value is highly subjective and requires management to rely on estimates, assumptions, and judgments that can affect amounts reported in our consolidated financial statements. We obtain the fair value of investment securities from an independent pricing service. We periodically review the pricing methodology for each significant class of assets used by this third party pricing service to assess the compliance with accounting standards for fair value measurement and classification in the fair value measurement hierarchy. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury bond yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current rating from credit rating agencies, and the bond's terms and conditions, among other things. While we use an independent pricing service to obtain the fair values of our investment portfolio, we employ certain control procedures to determine the reasonableness of the valuations. We validate the overall reasonableness of the fair values by comparing information obtained from our independent pricing service to other third party valuation sources for selected assets and review the valuations and any significant differences in valuations with members of management who have the relevant technical expertise to assess the results. In addition, we review the third party valuation methodology on a periodic basis. Each quarter we review our investment securities portfolio to determine whether unrealized losses are temporary or other-than-temporary, based on an evaluation of the creditworthiness of the issuers/guarantors, as well as the underlying collateral, if applicable. Our analysis includes an evaluation of the type of security, the length of time and extent to which the fair value has been less than the security's carrying value, the characteristics of the underlying collateral, the degree of credit support provided by subordinate tranches within the total issuance, independent credit ratings, changes in credit ratings and a cash flow analysis, considering default rates, loss severities based upon the location of the collateral, and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We use other independent pricing sources to obtain fair value estimates and perform discounted cash flow analysis for selected securities. When the discounted cash flow analysis obtained from those independent pricing sources indicates that we expect all future principal and interest payments will be received in accordance with their original contractual terms, we do not intend to sell the security, and we more likely than not will not be required to sell the security before recovery, the unrealized loss is deemed temporary. If such analysis shows that we do not expect to be able to recover our entire investment, an other-than-temporary impairment charge will be recorded in current earnings for the amount of the credit loss component. The amount of impairment related to factors other than the credit loss is recognized in OCI. Our assessments of creditworthiness and the resultant expected cash flows are complicated by the uncertainties surrounding not only the specific security and its underlying collateral but also the current economic environment. Our cash flow estimates for mortgage related securities are based on estimates of mortgage default rates, severity of loss and prepayments. Changes in assumptions can result in material changes in expected cash flows. Therefore, unrealized losses that we have determined to be temporary may at a later date be determined to be other-than-temporary and may have a material impact on our Consolidated Statements of Income.

Valuation of Mortgage Servicing Rights
The Company originates and sells residential mortgage loans in the secondary market and may retain the right to service the loans sold. Servicing involves the collection of payments from individual borrowers and the distribution of those payments to the investors or master servicer. Upon a sale of mortgage loans for which servicing rights are retained, the retained mortgage servicing rights asset is capitalized at the fair value of future net cash flows expected to be realized for performing servicing activities. Purchased mortgage servicing rights are recorded at the purchase price at the date of purchase and at fair value thereafter.


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Mortgage servicing rights do not trade in an active market with readily observable prices. The Company determines the fair value of mortgage servicing rights by estimating the fair value of the future cash flows associated with the mortgage loans being serviced. Key economic assumptions used in measuring the fair value of mortgage servicing rights include, but are not limited to, prepayment speeds, discount rates, delinquencies and cost to service. The assumptions used in the model are validated on a periodic basis. The fair value is validated on a quarterly basis with an independent third party. Material discrepancies between the internal valuation and the third party valuation are analyzed and an internal committee determines whether or not an adjustment is required.
The Company has elected to account for mortgage servicing rights using the fair value option. Changes in the fair value are recognized in mortgage banking revenue on the Company's Consolidated Statement of Income.

Outlook

We believe our 2013 results have reinforced the effectiveness of our strategy of . . .

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