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LSBI > SEC Filings for LSBI > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for LSB FINANCIAL CORP



Annual Report

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

Executive Summary

LSB Financial Corp., an Indiana corporation ("LSB Financial" or the "Company"), is the holding company of Lafayette Savings Bank, FSB ("Lafayette Savings" or the "Bank"). LSB Financial has no separate operations and its business consists only of the business of Lafayette Savings. References in this Annual Report to "we," "us" and "our" refer to LSB Financial and/or Lafayette Savings as the context requires.

Lafayette Savings is, and intends to continue to be, an independent, community-oriented financial institution. The Bank has been in business for 144 years and differs from many of our competitors by having a local board and local decision-making in all areas of business. In general, our business consists of attracting or acquiring deposits and lending that money out primarily as real estate loans to construct and purchase single-family residential properties, multi-family and commercial properties and to fund land development projects. We also make a limited number of commercial business and consumer loans.

We have an experienced and committed staff and enjoy a good reputation for serving the people of the community, for understanding their financial needs and for finding a way to meet those needs. We contribute time and money to improve the quality of life in our market area and many of our employees volunteer for local non-profit agencies. We believe this sets us apart from the other 22 banks and credit unions that compete with us. We also believe that operating independently under the same name for over 144 years is a benefit to us - especially as local offices of large banks often have less local authority as their companies strive to consolidate. Focusing time and resources on acquiring customers who may be feeling disenfranchised by their no-longer-local or very large bank has proved to be a successful strategy.

Tippecanoe County and the eight surrounding counties comprise Lafayette Savings' primary market area. Lafayette is the county seat of Tippecanoe County and West Lafayette is the home of Purdue University. There are three things that set Greater Lafayette apart from other urban areas of the country - the presence of a world class university, Purdue University; a government sector due to the presence of the county seat; and the mix of heavy industry and high-tech innovative start-up companies tied to Purdue University. In addition, Greater Lafayette is a regional health care center serving nine counties and has a large campus of Ivy Tech Community College.

Tippecanoe County typically shows better growth and lower unemployment rates than Indiana or the national economy because of the diverse employment base. The Tippecanoe County unemployment rate peaked at 10.6% in July 2009 and ended 2013 at 5.4% compared to 6.9% for Indiana and 6.7% nationally. The local housing market has remained fairly stable for the last several years with no price bubble and no resulting price swings. As of the most recent third quarter results provided by the Federal Housing Finance Agency, the five year percent change in house prices for the Lafayette Metropolitan Statistical Area ("MSA") was a 1.00% increase with the one-year change a 1.02% increase. For the third quarter of 2013, the most recent report available, housing prices in the MSA increased 0.67%. Existing home sales increased 13% in Tippecanoe County in 2013, while the average price of a home sold in 2013 was 1% higher than in 2012. New home starts decreased to 457 in 2013 from 496 in 2012.

The area's diversity did not make us immune to the ongoing effects of the recession; however, growth continues, although not at the same rate as before the recession. Current signs of recovery, based on a report from Greater Lafayette Commerce, include increasing manufacturing employment, a continuing commitment to new facilities and renovations at Purdue University, and signs of renewed activity in residential development projects. Capital investments announced and/or made in 2013 are expected to total over $1 billion compared to $605 million in 2012 and $444 million in 2011. Purdue, the area's largest employer, announced enrollment of almost 39,000 in the fall 2013 semester.

Subaru, the area's largest industrial employer and producer of the Subaru Legacy, Outback and Tribeca, recently announced addition of more production capacity for a new model to be built there. They expect to hire 900 additional employees by 2016. Wabash National, the area's second largest industrial employer, continues to secure contracts to maintain its production level. Nanshan America began operating its new aluminum extrusion plant in Lafayette in 2012 and expects to employ 200 people. Alcoa will be adding a 115,000 square foot aluminum lithium plant to begin production in 2014 and employ 75 people. While the developments noted above lead us to believe the most serious problems are behind us as increased hiring and new industry moving to town have continued, we expect the recovery to be long term.

We have seen progress in our problem loans as more borrowers who had fallen behind on their loan payments are qualifying for troubled debt restructures, or have resumed payments or, less often, we have acquired control of their properties. The majority of our delinquent loans are secured by real estate and we believe we have sufficient reserves to cover incurred losses. The challenge is to get delinquent borrowers back on a workable payment schedule or if that is not feasible, to get control of their properties through an overburdened court system. In 2013, we acquired one property through foreclosure. We sold two OREO properties in 2013.

The funds we use to make loans come primarily from deposits from customers in our market area, from brokered deposits and from Federal Home Loan Bank ("FHLB") advances. In addition we maintain an investment portfolio of available-for-sale securities to provide liquidity as needed. Our preference is to rely on local deposits unless the cost is not competitive, but if the need is immediate we will acquire pre-payable FHLB advances which are immediately available for member banks within their borrowing tolerance and can then be replaced with local or brokered deposits as they become available. We will also consider purchasing fixed term FHLB advances or brokered deposits as needed. We generally prefer brokered deposits over FHLB advances when the cost of raising money locally is not competitive. The deposits are available with a range of terms, there is no collateral requirement and the money is predictable as it cannot be withdrawn early except in the case of the death of a depositor and there is no option to have the money rollover at maturity. In 2013, total deposits remained fairly flat, increasing by only $6.0 million, from $308.6 million to $314.6 million. This increase consisted of a $17.4 million increase in our core deposits offset by an $11.4 million decrease in our higher rate time accounts. The movement was primarily because of depositors' preference for having immediate access to their accounts if needed. Our reliance on brokered funds as a percentage of total deposits decreased slightly in 2013 from 4.44% of deposits to 4.35% with the actual dollar amount unchanged at $13.7 million. While we always welcome local deposits, the cost and convenience of brokered funds make them a useful alternative. We will also continue to rely on FHLB advances to provide immediate liquidity and help manage interest rate risk.

Our primary source of income is net interest income, which is the difference between the interest income earned on our loan and investment portfolio and the interest expense incurred on deposits and borrowings. Our net interest income depends on the balance of our loan and investment portfolios and the size of our net interest margin - the difference between the income generated from loans and the cost of funding. Our net interest income also depends on the shape of the yield curve. The Federal Reserve has held short-term rates at almost zero for the last four years while long-term rates have stayed in the 3.0% range. Because deposits are generally tied to shorter-term market rates and loans are generally tied to longer-term rates this would typically be viewed as a positive step and in fact our net interest margin increased to a record high of 4.12% before falling to 3.36% at year end. The decrease was generally due to the continued decline in loan rates while deposit rates have started to level out. Our expectation for 2014 is that deposit rates will remain at these low levels as the Federal Reserve continues to focus on strengthening the economy. Overall loan rates are expected to remain low.

Rate changes can typically be expected to have an impact on interest income. Because the Federal Reserve has stated it intends to keep rates low, we expect to see little change in the money supply or market rates in 2014. Low rates generally increase borrower preference for fixed rate products which we typically sell on the secondary market. Some existing adjustable rate loans can be expected to reprice to lower rates which could be expected to have a negative impact on our interest income, although many of our loans have already reached their interest rate floors. While we would expect to sell the majority of our fixed rate loans on the secondary market, we expect to book some higher quality loans to replace runoff in the portfolio. Although new loans put on the books in 2013 will be at comparatively low rates we expect they will provide a return above any other opportunities for investment.

Our primary expense is interest on deposits and FHLB advances which are used to fund loan growth. We offer customers in our market area time deposits for terms ranging from three months to 66 months, checking accounts and savings accounts. We also purchase brokered deposits and FHLB advances as needed to provide funding or improve our interest rate risk position. Generally when interest rates are low, depositors will choose shorter-term products and conversely when rates are high, depositors will choose longer-term products.

We consider expected changes in interest rates when structuring our interest-earning assets and our interest-bearing liabilities. When rates are expected to increase we try to book shorter-term assets that will reprice relatively quickly to higher rates over time, and book longer-term liabilities that will remain for a longer time at lower rates. Conversely, when rates are expected to fall, we would like our balance sheet to be structured such that loans will reprice more slowly to lower rates and deposits will reprice more quickly. We currently offer a three-year and a five-year certificate of deposit that allows depositors one opportunity to have their rate adjusted to the market rate at a

future date to encourage them to choose longer-term deposit products. However, since we are not able to predict market interest rate fluctuations, our asset/liability management strategy may not prevent interest rate changes from having an adverse effect on our results of operations and financial condition.

Our results of operations may also be affected by general and local competitive conditions, particularly those with respect to changes in market rates, government policies and actions of regulatory authorities.

2013 Summary

Our strategy in 2013 was to focus on improving credit quality by enhancing credit analysis, working to manage non-performing loans and dispose of other real estate owned (OREO), control the cost of funds and other expenses, and focus on growth in other income. New lending was focused on selectively extending credit to stronger borrowers to improve credit quality and on increasing our secondary market lending, including VA and FHA lending to qualified borrowers. Our credit department is fully staffed with a department manager experienced in credit analysis and debt restructuring, an experienced credit analyst and two collectors.

Although the local economy fared somewhat better in 2013, the opportunity for loan production was generally lower than expected despite low market interest rates. Local unit residential real estate sales in 2013 increased from 2012, from 1,922 properties to 1,829 through September 2013, and building permits for single family homes were up slightly. Commercial real estate activity was more often due to existing properties changing hands or being refinanced rather than new projects being started. New commercial building activity was minimal. Our residential loan originators originated and sold $45.3 million of residential loans on the secondary market for a gain of $1.3 million. In 2013, we sold $347,000 of OREO properties, consisting of 2 properties.

In 2013 we allocated $650,000 to loan loss reserves. The allocation generally covered the charge off of $244,000 of loans where we no longer expected payment, and $273,000 to charge down the balance on loans to be restructured. We had recoveries of $315,000 in 2013 and added $162,000 of foreclosed properties to OREO. At December 31, 2013, our allowance for loan losses to total loans was 2.43%, compared to 2.06% at December 2012. Our non-performing loans decreased from $6.4 million at December 31, 2012 to $2.6 million at December 31, 2013, including $1.2 million of loans that were less than 90 days past due but must remain as non-performing loans until they show they can continue to perform, typically by paying as agreed for six months. At December 31, 2013, our allowance for loan losses compared to non-performing loans was 246.81% compared to 91.57% at December 31, 2012. Non-performing loans compared to total loans decreased from 2.29% at December 31, 2012 to 1.01% at December 31, 2013. Despite improvements in our loan quality, the slow economic recovery has had a noticeable effect on debt service coverage, which can be seen in the increase in Watch loans from $13.1 million at December 2012 to $22.4 million at December 2013 as we have added several new relationships, including loans on various rental properties. The rental situation is generally improving as more people are interested in renting than owning. However, the possibility of problems while these markets stabilize warrants monitoring. Our OREO properties at December 31, 2013 were $18,000 compared to $256,000 at December 31, 2012. In 2013, we wrote off losses of $53,000 on the sale of OREO properties generally due to the lack of interest in the properties at the time of sale compared to $97,000 in 2012. We believe our allowance for loan losses to be adequate to absorb estimated incurred losses inherent in our loan portfolio. While we continue to seek to lower our delinquencies, based on our analysis we believe we have sufficient reserves to cover incurred losses.

The continuing upward slope of the yield curve in 2013 had the expected effect of decreasing interest rate margins as the average deposit rates had already reached very low levels. While loans tied to prime remained at low rates and other repricing variable rate loans repriced to lower rates resulting in a 34 basis point decrease in the yield on loans, deposit rates in 2013 only decreased by 24 basis points. This was due to both the decrease in deposit rates and the fact that much of the movement of deposits from higher rate time accounts to lower rate demand and savings accounts had occurred earlier. However, our percentage of interest earning assets to interest bearing liabilities increased to 1.07% over the year as more cash was moved into interest earning assets, typically investments and interest earning deposit accounts.

Other non-interest income, excluding the gain on sale of loans and the loss on the sale of OREO, increased by $233,000 from December 31, 2012 to December 31, 2013. This was generally attributable to a $327,000 increase in Other Income due to a $147,000 increase in income from our wealth management department on the sale of non-bank investment products, a $142,000 increase in mortgage loan servicing fees due to the increase in the volume of loans serviced, a $40,000 increase in debit card fees due to increased volume, offset by a $134,000 decrease in

deposit account fees due primarily to changes in our fee structure as a result of changes mandated by the Dodd-Frank Act.

The results of our loan and deposit activity in 2013 are illustrated in the Selected Financial Condition Data on page 35 and include:

Residential mortgage loans (including loans held for sale) decreased by 1.9% from $100.6 million to $98.7 million.

All other real estate loans, net, including multi-family, land, land development, construction and commercial real estate loans decreased 13.9% from $159.4 million to $137.2 million net of undisbursed loans.

Commercial business lending decreased 13.8% from $13.3 million to $11.5 million.

At December 31, 2013, 72.9% of our gross loan portfolio had adjustable interest rates.

Total deposit accounts increased 1.9% from $308.6 million at December 31, 2012 to $314.6 million at December 31, 2013, with core deposits increasing 10.4% from $167.7 million to $185.1 million over the same period.

2014 Overview

We expect to see continued slow growth in our residential loan portfolio through 2014 with interest rates generally staying at or near historically low levels, at least through the first part of the year. While we expect to see good volume in residential mortgage loan refinance activity as long as loan rates stay at this level, especially with the opening of our new residential mortgage center on the newly renovated first floor of the LSB Building, we intend to originate most of these loans for sale on the secondary market when borrowers choose long-term fixed rate terms, while keeping some of our shorter-term fixed rate loans and adjustable rate loans in our portfolio. We expect to have the opportunity to consider some new commercial loans but will continue to evaluate them with an eye to credit quality. However, portfolio loan growth overall is expected to be modest. Money from repayment and prepayment of loans that is not immediately used for new lending opportunities will be used to purchase readily marketable investment securities to bring in a return on investment.

Because of the improvement in our loan quality, operating results will be less affected by the disposition of non-performing loans and of properties in foreclosure or held in other real estate owned. We expect to see the loss of interest income on non-performing assets and non-interest expenses incurred in obtaining, marketing and disposing of the properties in 2014 as we made significant progress in addressing these problems in 2013. Our allowance for loan losses to non-performing loans ended the year at 246.81% and the allowance for loan losses to total loans was 2.43%, both significantly improved. Despite improvements in our loan quality, the slow economic recovery has had a noticeable effect on debt service coverage which can be seen in the increase in Watch loans from $13.1 million at December 2012 to $22.4 million at December 2013 as we have added several new relationships, including loans on various rental properties. The rental situation is generally improving as more people are interested in renting than owning. However, the possibility of problems while these markets stabilize warrants monitoring. We continue to work proactively with troubled borrowers while their situation is still salvageable. We monitor these and all other loans in our portfolio carefully and perform specific impairment analyses on any loans over 90 days delinquent. Based on our analysis, we believe that our current loan loss reserve is sufficient to cover estimated incurred losses. In the event that loan growth is not as strong as expected, we will invest in securities that are readily marketable if needed.

We intend to continue to follow a strategy in 2014 that includes (1) maintaining a strong capital position, (2) managing our vulnerability to changes in interest rates by emphasizing adjustable rate and/or shorter-term loans, (3) optimizing our net interest margin by supplementing our traditional mortgage lending with prudent multi-family and commercial real estate, consumer and construction loans when feasible, (4) working to originate and sell residential mortgage loans in the secondary market for a fee, including FHA and VA loans, to access a market not previously available to us, and (5) funding our growth by using primarily local deposits but using brokered deposits and FHLB advances should loan growth warrant it.

Possible Implications of Current Events

Significant external factors impact our results of operations including the general economic environment, changes in the level of market interest rates, government policies, actions by regulatory authorities and competition. Our cost of funds is influenced by interest rates on competing investments and general market rates of interest. Lending activities are influenced by the demand for real estate loans and other types of loans, which are in turn affected by the interest rates at which such loans are made, general economic conditions affecting loan demand and the availability of funds for lending activities.

Management continues to assess the impact on the Company of the uncertain economic and regulatory environment affecting the country at large and the financial services industry in particular. The level of turmoil in the financial services industry does present unusual risks and challenges for the Company, as described below:

The Current Economic Environment Poses Challenges For Us and Could Adversely Affect Our Financial Condition and Results of Operations. We continue to operate in a challenging and uncertain economic environment, including generally uncertain national conditions and local conditions in our markets. Overall economic growth continues to be slow and national and regional unemployment rates remain at elevated levels. The risks associated with our business remain acute in periods of slow economic growth and high unemployment. Moreover, many financial institutions continue to be affected by an uncertain real estate market. While we continue to take steps to decrease and limit our exposure to problem loans, and while our local economy has remained somewhat insulated from the most severe effects of the current economic environment, we nonetheless retain direct exposure to the residential and commercial real estate markets and we are affected by these events.

Our loan portfolio includes commercial real estate loans, residential mortgage loans, and construction and land development loans. Declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition and results of operations. In addition, the current level of low economic growth on a national scale, the occurrence of another national recession or a deterioration in local economic conditions in our markets could drive losses beyond that which is provided for in our allowance for loan losses and result in the following other consequences: increases in loan delinquencies, problem assets and foreclosures may increase; demand for our products and services may decline; deposits may decrease, which would adversely impact our liquidity position; and collateral for our loans, especially real estate, may decline in value, in turn reducing customers' borrowing power, and reducing the value of assets and collateral associated with our existing loans.

Impact of Recent and Future Legislation, Including New Capital Requirements. During the last five years, Congress and the Treasury Department have adopted legislation and taken actions to address the disruptions in the financial system and declines in the housing market, and the overall regulation of financial institutions and the financial system. See Part I, Item 1 - Regulation and Supervision for a description of recent legislation and regulatory actions, including the adoption of final rules that establish new risk-based capital and leverage ratios to which we will be subject as they are phased in from 2015 to 2019. There can be no assurance regarding the specific impact that such measures may have on us and no assurance whether or to what extent we will be able to benefit from such programs.

In addition to the legislation mentioned above, federal and state governments could pass additional legislation responsive to current credit conditions. As an example, the Bank could experience higher credit losses because of federal or state legislation or regulatory action that reduces the amount the Bank's borrowers are otherwise contractually required to pay under existing loan contracts. Also, the Bank could experience higher credit losses because of federal or state legislation or regulatory action that limits its ability to foreclose on property or other collateral or makes foreclosure less economically feasible.

Difficult Market Conditions Have Adversely Affected Our Industry. We are particularly exposed to downturns in the U.S. housing market. Dramatic declines in the housing market over the past five years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage and construction loans and securities and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities, major commercial and investment banks, and regional financial institutions. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have continued to observe tight lending standards, including with respect to other financial institutions, although there have been signs that lending is increasing. These market conditions have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, and increased market volatility. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on the Company and others in the financial institutions industry. In particular, the Company may face the following risks in connection with these events:

We are experiencing, and expect to continue experiencing increased regulation of our industry, particularly as a result of the Dodd-Frank Act and the CFPB. Compliance with such regulation is expected to increase our costs and may limit our ability to pursue business opportunities.

Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage and underwrite our customers become less predictive of future behaviors.

The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic predictions might impair the ability of our borrowers to repay their loans, which may no longer be capable of accurate estimation which may, in turn, impact the reliability of the process.

Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events, including actions by rating agencies and deteriorating investor expectations.

Competition in our industry could intensify as a result of the increasing consolidation of financial services companies in connection with current market conditions.

We may be required to pay higher deposit insurance premiums because market developments have significantly depleted the insurance fund of the Federal Deposit Insurance Corporation (FDIC) and reduced the ratio of reserves to insured deposits.

Future Reduction in Liquidity in the Banking System. The Federal Reserve Bank has been injecting vast amounts of liquidity into the banking system to . . .

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