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CUBI > SEC Filings for CUBI > Form 10-K on 12-Mar-2014All Recent SEC Filings

Show all filings for CUSTOMERS BANCORP, INC.

Form 10-K for CUSTOMERS BANCORP, INC.


12-Mar-2014

Annual Report


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

You should read this Management Discussion and Analysis in conjunction with "Business - Executive Summary" and the Bancorp's consolidated financial statements and related notes for the year ended December 31, 2013. Certain amounts reported in the 2012 and 2011 financial statements have been reclassified to conform to the 2013 presentation. These reclassifications did not significantly impact the Bancorp's financial position or results of operations.

Critical Accounting Policies

Customers Bancorp has adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America (US GAAP) and that are consistent with general practices within the banking industry in the preparation of its financial statements. The Bancorp's significant accounting policies are described in" NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES AND BASIS OF PRESENTATION" to its audited financial statements.

Certain accounting policies involve significant judgments and assumptions by Customers Bancorp that have a material impact on the carrying value of certain assets and liabilities. Customers Bancorp considers these accounting policies to be critical accounting policies. The judgment and assumptions used 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 management makes, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of the Bancorp's assets and liabilities and results of operations.

The following is a summary of the policies Customers Bancorp recognizes as involving critical accounting estimates: Allowance for Loan Losses, Stock-Based Compensation, Unrealized Gains and Losses on Available for Sale Securities, Fair Value Accounting, Accounting for Purchased-Credit-Impaired (PCI) Loans, FDIC Receivable for Loss, and Deferred Income Taxes.

Allowance for Loan Losses. Customers Bancorp maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated credit losses incurred as of the report date. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including historical losses, current and anticipated economic conditions, the size and composition of the loan portfolio, delinquency statistics, criticized and classified assets and impaired loans, results of internal loan reviews, borrowers' perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Bancorp's results of operations in the future.

Estimates of cash flows expected to be collected for purchased-credit-impaired loans are updated each reporting period. If the Bank has probable decreases in expected cash flows to be collected after acquisition, the Bank charges the provision for loan losses and establishes an allowance for loan losses.

Stock-Based Compensation. Customers Bancorp recognizes compensation expense for share-based awards in accordance with FASB Accounting Standards Codification ("ASC") 718 Compensation - Stock Compensation. Expense related to stock option awards is based on the fair value of the option at the grant date, with compensation expense recognized over the service period, which is usually the vesting period. Customers Bancorp utilizes the Black-Scholes option-pricing model to estimate the fair value of each option on the date of grant. The Black-Scholes model takes into consideration the exercise price of the option, the expected life of the option, the current price of the underlying stock and its expected volatility, expected dividends on our stock, and the current risk-free interest rate for the expected life of the option. The Bancorp's estimate of the fair value of a stock option is based on expectations derived from its limited historical experience and may not necessarily equate to market value when fully vested.

Unrealized Gains and Losses on Securities Available for Sale. Customers Bancorp receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage backed securities and U.S. government agency securities. Customers Bancorp uses various indicators in determining whether a security is other-than-temporarily impaired including, for debt securities, when it is probable that the contractual interest and principal will not be collected, or for equity securities, whether the market value is below its cost for an extended period of time with low expectation of recovery. The debt securities are monitored for changes in credit ratings because adverse changes in credit ratings could indicate a change in the estimated cash flows of the underlying collateral or issuer. The unrealized losses associated with securities that management does not intend to sell, and more likely than not that we will not be required to sell prior to maturity or market price recovery, were not considered to be other-than-temporarily impaired as of December 31, 2013 and December 31, 2012, because the unrealized losses were related to changes in interest rates and did not affect


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the expected cash flows of the underlying collateral or issuer. The unrealized losses associated with the equity investments that management does not intend to sell, and more likely than not we will not be required to sell, were not considered other-than- temporarily impaired as of December 31, 2013 or 2012 because the decrease in market price or foreign currency exchange rates was estimated to be temporary.

Fair Value. 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. Management 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, Customers Bancorp estimates fair value. The valuation methods and inputs consider factors such as types of underlying assets or liabilities, rates of estimated credit losses, interest rate or discount rate and collateral. The best estimate of fair value involves assumptions including, but not limited to, various performance indicators, such as historical and projected default and recovery rates, credit ratings, current delinquency rates, loan-to-value ratios and the possibility of obligor refinancing. US GAAP requires the use of fair values in determining the carrying values of certain assets and liabilities, as well as for specific disclosures. The most significant uses of fair values include residential mortgage loans acquired subject to an agreement to resell, residential mortgage loans originated with an intent to sell, impaired loans and foreclosed property and the net assets acquired in business combinations. For additional information, refer to "NOTE 19 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS."

Purchased Credit-Impaired Loans

For certain acquired loans that have experienced a deterioration of credit quality, Customers Bancorp follows the guidance contained in ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Purchased credit-impaired ("PCI") loans are loans that were acquired in business combinations or asset purchases with evidence of credit deterioration since origination to the date acquired and for which it is probable that all contractually required payments will not be collected are considered to be credit impaired. Evidence of credit quality deterioration as of purchase dates may include information such as past-due and non-accrual status, borrower credit scores and recent loan to value percentages. Loans acquired through business combinations that do not meet the specific criteria of ASC 310-30, but for which a discount is attributable at least in part to credit quality, are also accounted for under this guidance unless the loan type is excluded from its scope.

The fair value of loans with evidence of credit deterioration is recorded net of a nonaccretable difference and, if appropriate, an accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is the nonaccretable difference, which is not included in the carrying amount of acquired loans. Subsequent decreases in the estimated cash flows of the loan will generally result in a provision for loan losses. Subsequent to acquisition, estimates of cash flows expected to be collected are updated each reporting period based on updated assumptions regarding default rates, loss severities, and other factors that are reflective of current market conditions. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges, or a reclassification of the difference from nonaccretable to accretable with a positive impact on accretion of interest income in future periods. Further, any excess of cash flows expected at the time of acquisition over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of those cash flows.

Purchased-credit-impaired loans acquired in the same fiscal quarter may be aggregated into one or more pools, provided that the loans have common risk characteristics. A pool is then accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. On a quarterly basis, the Bank re-estimates the total cash flows (both principal and interest) expected to be collected over the remaining life of each pool. These estimates incorporate assumptions regarding default rates, loss severities, the amounts and timing of prepayments and other factors that reflect then-current market conditions. If the timing and/or amounts of expected cash flows on purchased-credit-impaired loans were determined not to be reasonably estimable, no interest would be accreted and the loans would be reported as non-accrual loans; however, when the timing and amounts of expected cash flows for purchased-credit-impaired loans are reasonably estimable, interest is being accreted and the loans are being reported as performing loans. Charge-offs are not recorded on purchased-credit-impaired loans until actual losses exceed the estimated losses that were recorded as purchase accounting adjustments at acquisition date.

FDIC Receivable for Loss Share Agreements. The majority of the loans and other real estate assets acquired in an FDIC-assisted acquisition is covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Bank for 80% of all losses incurred in connection with those assets. Management estimated the amount that the Bank will receive from the FDIC under the loss share agreements that will result from losses incurred as the Bank disposes of covered loans and other real estate assets and records the estimate as a receivable from the FDIC.

The FDIC loss sharing receivable is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if the assets are sold. Management estimated the fair value of the FDIC loss sharing receivable using the present value of cash flows related to the loss share agreements based on the expected reimbursements for losses and the applicable loss share percentages. Management reviews and updates the fair value of the FDIC receivable prospectively as loss


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estimates related to covered loans and other real estate owned change. The ultimate realization of the FDIC loss sharing receivable depends on the performance of the underlying covered assets, the passage of time, and claims paid by the FDIC. Changes in estimated cash flows of the covered assets likewise result in changes in the estimated cash flows to be received pursuant to the reimbursement agreement between the Bank and the FDIC. An increase in a cash flow estimate for a covered loan will result in a decrease in the indemnification asset, and a decrease in a cash flow estimate for a covered loan will result in an increase in the indemnification asset. Increases to the indemnification asset are recorded as a reduction to the provision for loan losses and decreases to the indemnification asset are recorded either as an increase to the provision for loan losses (to the extent an increase in the FDIC receivable balance was previously recorded as a reduction to the provision for loan losses) or recognized over the life of the loss share agreements.

Deferred Income Taxes. The Bancorp provides for deferred income taxes on the liability method whereby tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities in the financial statements and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Accounting Changes

The Fair Value Option

The Bank elected the fair value option for mortgage warehouse lending transactions documented under a Master Repurchase Agreement originated after July 1, 2012 in order to more accurately represent the short-term nature of the transaction and its inherent credit risk. The Bank also elected the fair value option for mortgage loans originated with the intent to sell effective October 1, 2013. These adoptions are in accordance with the parameters established by Accounting Standards Codification ("ASC") 825-10-25, Financial Instruments-Overall-Recognition: The Fair Value Option. The interest income from the warehouse lending transactions and mortgage loans originated with the intent to sell are classified in "Interest Income - Loans held for sale" on the income statement. The unrealized fair value changes related to these loans are classified in "Mortgage banking income" on the consolidated statements of income. An allowance for loan losses is not recorded for loans measured at fair value since under ASC 825 as the exit price (the repurchase price or sales price) used as the fair value measure considers estimated credit losses.

Change in Accounting Estimates

Estimates of cash flows from purchased-credit-impaired loans were revised during the third quarter of 2012 due to a conversion to a more sophisticated and precise loan valuation system. In accordance with the guidance in ASC 310-30, interest income is based on an acquired loan's expected cash flows. Complex models are needed to calculate loan-level and/or pool level expected cash flows in accordance with ASC 310-30. The loan data analysis provided by the new software is a more precise quantification of future cash flows than the analysis that was previously calculated manually. Upon conversion to the new software, acquisition date loan values were loaded into the system, and the new software calculated their fair values using its complex valuation model. Conversion to the new system was completed in September 2012. To adjust the acquisition date loan balances recorded on Customers Bank's books to the amounts calculated by the new software, approximately $4.5 million was recognized in other non-interest income in the third quarter of 2012. The revised valuation for the purchased-credit-impaired acquisition date loan balances due to the conversion to the new software was accounted for prospectively as a change in accounting estimate.

When converting to the new software system, the Bank was required to calculate the estimated cash flows from the various acquisition dates of the purchased-credit-impaired loans through the date the software was implemented as it was impracticable to perform these calculations on a monthly or quarterly basis. In the third quarter of 2012, approximately $4.5 million was recognized in interest income related to this change. The impact of the revised valuation of cash flows for the purchased-credit-impaired loan activity due to the conversion to the new software was accounted for prospectively as a change in accounting estimate.

Also during the third quarter of 2012, the Bank re-estimated the cash flows for the purchased-credit-impaired loans using current data. The re-estimated expected cash flows decreased from prior estimated cash flows. Consistent with ASC 310-10's fundamental premise that a decrease in expected cash flows results in accrual of a loss contingency and should not result in a change in yield, the Bank evaluated the adequacy of the allowance for loan losses for purchased-credit-impaired loans and determined that an additional provision for loan losses of $7.5 million was appropriate. As a result of the changes in estimates, net income for the year ended December 31, 2012 increased by $900,000, net of tax, and basic and diluted earnings increased by $0.07 per share.

Background and Reorganization

Customers Bancorp was formed in April 2010 to facilitate a reorganization into a bank holding company structure pursuant to which Customers Bank became a wholly owned subsidiary of Customers Bancorp (the "Reorganization") on September 17, 2011. Pursuant to the Reorganization, all of the issued and outstanding shares of Voting Common Stock and Class B Non-Voting Common Stock of


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Customers Bank were exchanged on a one-for-three basis for shares of Voting Common Stock and Class B Non-Voting Common Stock, respectively, of Customers Bancorp. The Bancorp is authorized to issue up to 100,000,000 shares of Voting Common Stock, 100,000,000 shares of Class B Non-Voting Common Stock and 100,000,000 shares of preferred stock. All share and per share information for periods prior to the reorganization has been restated to reflect the Reorganization, including the one-for-three consideration used in the Reorganization.

In the Reorganization, the Bank's issued and outstanding shares of Voting Common Stock of 22,525,825 shares and Class B Non-Voting Common Stock of 6,834,895 shares converted into 7,508,473 shares of the Bancorp's Voting Common Stock and 2,278,294 shares of the Bancorp's Class B Non-Voting Common Stock. Cash was paid in lieu of fractional shares. Outstanding warrants to purchase 1,410,732 shares of the Bank's Voting Common Stock with a weighted-average exercise price of $3.55 per share and 243,102 shares of the Bank's Class B Non-Voting Common Stock with a weighted-average exercise price of $3.50 per share were converted into warrants to purchase 470,260 shares of the Bancorp's Voting Common Stock with a weighted-average exercise price of $10.64 per share and warrants to purchase 81,036 shares of the Bancorp's Class B Non-Voting Common Stock with a weighted-average exercise price of $10.50 per share. Outstanding stock options to purchase 2,572,404 shares of the Bank's Voting Common Stock with a weighted- average exercise price of $3.50 per share and stock options to purchase 231,500 shares of the Bank's Class B Non-Voting Common Stock with a weighted-average exercise price of $4.00 per share were converted into stock options to purchase 855,774 shares of the Bancorp's Voting Common Stock with a weighted-average exercise price of $10.49 per share and stock options to purchase 77,166 shares of the Bancorp's Class B Non-Voting Common Stock with a weighted-average exercise price of $12.00 per share.

Accordingly, descriptions of balance sheet and income statement items prior to September 17, 2011 represent those of Customers Bank, and descriptions of balance sheet and income statement items after September 17, 2011 represent the consolidated results of Customers Bancorp. The consolidated results of operations and financial condition presented for those periods after the Reorganization Date, September 17, 2011, include combined results for Customers Bancorp and Customers Bank. All share and per share information has been retrospectively restated to reflect the Reorganization, including the one-for-three consideration used in the Reorganization.

Overview

The following discussion and analysis presents material factors affecting the financial condition of Customers Bancorp as of December 31, 2013 and December 31, 2012 and results of operations for the years ended December 31, 2013, 2012, and 2011. This discussion and analysis should be read in conjunction with the financial statements, notes thereto and other financial information of Customers Bancorp appearing elsewhere in this Form 10-K.

Like most financial institutions, Customers Bancorp derives the majority of its income from interest it receives on its interest-earning assets, such as loans and investments. The Bancorp's primary source of funds for making these loans and investments is its deposits, on which it pays interest. Consequently, one of the key measures of the Bancorp's success is its amount of net interest income, or the difference between the income on its interest-earning assets and the expense on its interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield earned on these interest-earning assets and the rate paid on these interest-bearing liabilities, which is called net interest spread.

There is credit risk inherent in all loans, so Customers Bancorp maintains an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. The Bancorp maintains this allowance by charging a provision for loan losses against its operating earnings. Customers Bancorp has included a detailed discussion of this process, as well as several tables describing its allowance for loan losses.

2014 Economic Outlook

The growth outlook over the next twelve months looks moderate as the US economy continues to recover from the 2008-2009 recession. The economy has overcome many headwinds since the recession officially ended in 2009. Growth is likely to be restrained in 2014 because the consumer remains under pressure from a lack of true income growth. However, there are several positive developments. There is less uncertainty facing businesses in 2014 due to the two year budget agreement and a more certain political landscape. Unemployment rates continue to be moderate in the geographic regions in which Customers competes. The Federal Reserve has begun reducing its historic quantitative easing economic intervention, indicating its views of a more stable economy. Furthermore, the Federal Reserve has indicated short-term interest rates are not expected to increase until 2015, and the Federal Reserve has indicated it will tolerate some inflation over increasing short-term rates. Additionally, there is a more robust manufacturing base and balanced housing market which should all contribute to growth in the 2.00% to 2.50% range for 2014.

While the outlook in the US remains optimistic, fears of a slowing China could have a negative impact on the US economy as well as the global economy. While many feel that a Chinese slowdown is expected, a deeper than expected slowdown could cause ripple


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effects across the globe. In the Bancorp's market area, management sees continued moderate (2%-3%) growth in 2014. The housing market appears to have stabilized with modest increases in value in selected areas. Unemployment should remain at current rates or slightly improve during the year. Management is seeing improvement in loan demand in the Bancorp's commercial and industrial, multi-family and commercial real estate loan portfolios and expects to significantly improve mortgage lending in the coming year. There continues to be some uncertainty in the political and external environments in 2014, and it is likely that these challenging conditions will continue in the next few years. Overall, the Bancorp's management is optimistic that 2014 will show a continuation of the improving environment that was seen in 2013.

Results of Operations

The following discussion of Customers Bancorp's consolidated results of operations should be read in conjunction with its consolidated financial statements, including the accompanying notes. Also see "CRITICAL ACCOUNTING POLICIES" and "NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES AND BASIS OF PRESENTATION" for information concerning certain significant accounting policies and estimates applied in determining reported results of operations.

For the years ended December 31, 2013 and 2012

Net income available to common shareholders increased $8.9 million (37.3%) to $32.7 million for the year ended December 31, 2013, compared to $23.8 million for the year ended December 31, 2012. The increased net income resulted from a $31.4 million increase in net interest income and a $12.0 million decrease in the provision for loan losses, offset by decreases in non-interest income of $5.9 million, an increase in non-interest expense of $23.4 million and a $5.3 million increase in income tax expense.

The increased net interest income of $31.4 million (43.8%) for the year ended December 31, 2013 to $103.2 million compared to $71.8 million for the year ended December 31, 2012 resulted principally from an increase in average loan balances (loans held for sale and loans receivable) of $964.7 million to $2.8 billion, offset in part by a 39 basis point decrease in average yields on loans to 4.26% net with a 22 basis point decrease in the cost of funding. The growth in average loans was principally in loans to mortgage bankers to fund warehouse lines and multi-family and other commercial real estate loans. The decrease in yield results from a combination of changed market conditions, including increased competition for loans, and product mix, as secured multi-family loans yield less than other commercial products and was our primary growth area.

During 2013, the provision for loan losses was $2.2 million, a decrease of $12.0 million from a provision of $14.3 million during 2012. The decrease in the provision for loan losses in 2013 resulted primarily from (i) $7.5 million increase in the provision recorded in 2012 due to the re-estimation of cash flows related to purchased-credit-impaired loans, (ii) $2.6 million reduction in the provision during 2013 due to better sustained performance of the Bancorp's commercial (including multi-family) and residential mortgage loan portfolios,
(iii) $0.3 million net reduction in the provision, including the effect of a write-down of the FDIC receivable balance, in 2013 upon final payoff of covered loans which previously had a specific allowance, and (iv) approximately $1.6 . . .

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