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

Show all filings for MBT FINANCIAL CORP

Form 10-K for MBT FINANCIAL CORP


14-Mar-2014

Annual Report


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

Introduction - The Company is a bank holding company with one subsidiary, Monroe Bank & Trust ("Bank"). The Bank is a commercial bank that operates 17 branch offices in Monroe country, Michigan and 7 branches in Wayne County, Michigan. The Bank's primary source of income is interest income on its loans and investments and its primary expense is interest expense on its deposits and borrowings. This discussion and analysis should be read in conjunction with the accompanying consolidated statements and footnotes.

Executive Overview - The Bank is operated as a community bank, primarily providing loan, deposit, and wealth management services to the people, businesses, and communities in its market area. In addition to our commitment to our mission of serving the needs of our local communities, we are focused on improving our asset quality, profitability, and capital.

The national economic recovery is continuing slowly, and the pace of improvement in economic conditions in southeast Michigan is improving. Local unemployment rates improved during 2013, and are now comparable to the state and national averages, but remain above the historical norms. Commercial and residential development property values continue to show some stability with some areas improving slightly. Our total problem assets, which include nonperforming loans, other real estate owned, non-accrual investments, and performing loans that are internally classified as potential problems, decreased $30.7 million, or 24.5% during 2013. The improvement in our asset quality over the past year, the decrease in our net charge offs from $10.9 million in 2012 to $3.3 million in 2013, and the decrease in our total loans outstanding allowed us to decrease our Allowance for Loan and Lease Losses (ALLL) from $17.3 million to $16.2 million in 2013. The portfolio of loans held for investment decreased $29.7 million during the year, and the ALLL as a percent of loans decreased from 2.75% to 2.71%. Local property values and the unemployment rate have stabilized over the past two years and the pace of the recovery in our local markets improved in 2013. Although the recovery is continuing, it is still tenuous, and we will continue to focus our efforts on improving asset quality and strengthening capital in 2014. We also plan to focus on growing our loan portfolio and increasing revenue.

Net Interest Income decreased $1,448,000 in 2013 compared 2012 as the average earning assets decreased $32.6 million, or 2.8% and the net interest margin decreased from 3.02% to 2.98%. The provision for loan losses decreased from $7.35 million in 2012 to $2.2 million in 2013. Decreases in the historical loss rates, the size of the loan portfolio, and the amount of specific allocations during 2013 decreased the amount of ALLL required. As a result, we were able to record a provision that was smaller than the net charge offs for the year. Non-interest income decreased $0.5 million or 3.1%, primarily due to a decrease in gains on securities transactions. Non-interest expenses increased $0.8 million, or 2.1% primarily due to higher salary and benefits costs in 2013, partially offset by lower credit related costs. We expect credit related expenses to continue to improve in 2014. In addition, in 2013 the Company recorded a tax benefit of $18.8 million to eliminate the remaining valuation allowance on our deferred tax asset and we recorded a tax expense of $0.7 million for the tax expense on our fourth quarter 2013 income.

Critical Accounting Policies - The Bank's Allowance for Loan Losses is a "critical accounting estimate" because it is an estimate that is based on assumptions that are highly uncertain, and if different assumptions were used or if any of the assumptions used were to change, there could be a material impact on the presentation of the Corporation's financial condition. These assumptions include, but are not limited to, collateral values and the effect of economic conditions on the financial condition of the Bank's borrowers. To determine the Allowance for Loan Losses, the Bank estimates losses on all loans that are not classified as non-accrual or renegotiated by applying historical loss rates, adjusted for environmental factors, to those loans. This portion of the analysis utilizes the loss history for the most recent twelve quarters, adjusted for qualitative factors including recent delinquency rates, real estate values, and economic conditions. In addition, all loans over $250,000 that are nonaccrual and all loans that are renegotiated are individually tested for impairment. Impairment exists when the carrying value of a loan is greater than the realizable value of the collateral pledged to secure the loan or the present value of the cash flow of the loan. Any amount of monetary impairment is included in the Allowance for Loan Losses. Management is of the opinion that the Allowance for Loan Losses of $16,209,000 as of December 31, 2013 was adequate.

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of fair value less costs to sell or the loan carrying amount at the date of foreclosure. Subsequent to foreclosure, appraisals or other independent valuations are periodically obtained by Management and the assets are carried at the lower of carrying amount or fair value less costs to sell.

Income tax accounting standards require companies to assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all evidence using a "more likely than not" standard. We reviewed our deferred tax asset, considering both positive and negative evidence and analyzing changes in near term market conditions as well as other factors that may impact future operating results. Significant negative evidence is our net operating losses for 2008 through 2011, combined with a challenging economic environment consisting of slowly improving unemployment and a fragile economic recovery in southeast Michigan. Positive evidence includes our history of strong earnings prior to 2008, our strong capital position, our steady net interest margin, our non interest expense control initiatives, our ten consecutive quarterly profits, and our forecasted profits for the foreseeable future. As of December 31, 2011, we maintained a valuation allowance equal to the full amount of our $24.2 million deferred tax asset. Our analysis of the evidence in December 2012 indicated that we would be able to utilize a portion of our deferred tax asset and we recorded a tax benefit of $5.0 million in 2012 to reduce the valuation allowance. Based on our most recent analysis of all evidence available, both positive and negative, we believe that it is more likely than not that we will be able to utilize the entire deferred tax asset. Accordingly, we reversed our valuation allowance and recorded a tax benefit of $18.8 million in the third quarter of 2013.

The Bank holds three pooled Trust Preferred Collateralized Debt Obligation (CDO) securities in its investment securities portfolio. Due to the lack of an active market for securities of this type, the Bank utilizes an independent third party valuation firm to calculate fair values. This valuation analysis includes a determination of the portion of the fair value impairment that is the result of credit losses. The portion of the impairment that is the result of credit losses is recognized in earnings as Other Than Temporary Impairment and the impairment related to all other factors is recognized in Other Comprehensive Income.

The other-than-temporary-impairment analysis of each of the CDO securities owned by the Company is conducted by projecting the expected cash flows from the security, discounting the cash flows to determine the present value of the cash flows, and comparing the present value to the amortized cost to determine if there is impairment. The cash flow projection for each security is developed using estimated prepayment speeds, estimated rates at which payments will be deferred, estimated rates at which issuers will default, and the severity of the losses on the securities which default. Prepayment estimates are negatively impacted by the lack of an active market for issuers to refinance their trust preferred securities; however, prepayment of trust preferred securities is expected to increase due to recent restrictions on the treatment of trust preferred debt as regulatory capital. The size and creditworthiness of each institution in the CDO pool are the most significant pieces of evidence in estimating prepayment speeds. Deferral and default rates are the key drivers of the cash flow projections for each of the securities. Deferral of interest payments is allowed for up to five years, and estimates of deferral rates are determined by examining the current deferral status of the issuers, the current financial condition of the issuers, and the historical deferral levels of the issuers in each CDO pool. Key evidence examined includes whether or not an issuer has received TARP funding, the most recent credit ratings from outside services, stock price information, capitalization, asset quality, profitability, and liquidity. The most significant evidence in estimating deferrals is the comparison of key financial ratios to industry benchmarks. Near term (next 12 months) deferral rates are estimated for each security by analyzing the credit characteristics of each individual issuer in the pool. When an issuer is expected to defer interest payments, the analysis assumes that the deferral will continue for the entire five year period allowed and then, depending on the individual credit characteristics of that issuer, begin performing or move to default. Longer term annual default rates for each CDO are estimated using the credit analysis of each individual issuer compared to industry benchmarks to modify the historical default rates of financial companies. Finally, loss severity is estimated using analytical research provided by Standard and Poor's and Moody's, which supports the assumption that a small percentage of defaulted trust preferred securities recover without loss. The projected cash flows are discounted using the contractual rate of each security.

Recent Accounting Pronouncements - No recent accounting pronouncements are expected to have a significant impact on the Corporation's financial statements. Accounting Standards Update 2013-02 (ASU 2013-02), "Comprehensive Income:
Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income" was issued in February 2013. ASU 2013-02 requires an entity to provide information about the amounts reclassified out of Accumulated Other Comprehensive Income (AOCI) by component. In addition, an entity is required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of AOCI by the respective line items of net income, but only if the amount reclassified is required to be reclassified in its entirety in the same reporting period. For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures that provide additional details about those amounts. ASU 2013-02 does not change the current requirements for reporting net income or other comprehensive income in the financial statements. ASU 2013-02 is effective for interim and annual periods beginning on or after December 15, 2012. The Company adopted ASU 2013-02 on January 31, 2013.

Accounting Standards Update 2014-04 (ASU 2014-04), "Receivables - Troubled Debt Restructurings by Creditors - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure." was issued in January 2014. ASU 2014-04 clarifies that an in substance foreclosure repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either: (a) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure; or (b) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additional disclosures are required. ASU 2014-04 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2014. The adoption of ASU 2014-04 by the Company is not expected to have a material impact.

Results of Operations

Comparison of 2013 to 2012 - The Company reported a Net Profit of $25.5 million in 2013, compared to the Net Profit of $8.5 million in 2012 mainly due to the increase of $14.6 million in the Benefit From Income Taxes caused by the elimination of the remaining deferred tax asset valuation allowance in 2013. The Income Before Provision for Taxes increased $2.4 million, or 47.2%, primarily due to the reduction in the Provision for Loan Losses, which exceeded the reductions in net interest income and non-interest income and the increase in non-interest expenses. The primary source of earnings for the Bank is its net interest income, which decreased $1.4 million, or 4.2% compared to 2012. Net interest income decreased as the net interest margin decreased from 3.02% to 2.98% and the average earning assets decreased 2.8%. The historically low interest rate environment inhibits the Company's ability to further reduce rates paid on deposits and reduce funding costs on pace with the yields on interest earning assets. Earning assets decreased during 2013 as the Company decreased its use of non-deposit funding by paying off $95 million of maturing Federal Home Loan Bank borrowings in the second quarter. Interest income decreased $5.3 million during 2013 as the yield on earnings assets decreased from 3.89% to 3.53%, the amount of average earning assets was decreased from $1.14 billion to $1.11 billion. Interest expense decreased $3.8 million compared to 2012 as the average amount of interest bearing liabilities decreased $57.9 million and the cost of the interest bearing liabilities decreased from 1.01% in 2012 to 0.65% in 2013. The decrease in the average interest bearing liabilities and the average cost of funds was due to the repayment of $95 million in Federal Home Loan Bank borrowings in the second quarter of 2013. The average cost of the borrowings that were repaid was 2.57%.

The Provision for Loan Losses decreased 70.1% from $7.35 million in 2012 to $2.2 million in 2013 as the amount of net charge offs decreased from $10.9 million in 2012 to $3.3 million in 2013. The improving economic conditions and continued high credit standards and collection efforts contributed to the decrease in charge offs. The net charge offs exceeded the provision by $1.1 million, causing a decrease of that amount in our Allowance for Loan Losses. The Allowance as a percent of loans decreased from 2.75% as of December 31, 2012 to 2.71% as of December 31, 2013 as the Allowance decreased by 6.3% while the loan portfolio decreased by 4.7%.

Other Income decreased 3.1% from $16.4 million in 2012 to $15.9 million in 2013. Wealth Management income increased $323,000, or 8.0% as improvement in market values of financial assets led to an increase in assets under management. Security gains decreased $856,000 as the Bank realized less gains on sales of securities in 2013 as market interest rates moved higher. Mortgage loan origination income decreased 22.2% from 2012 to 2013 as refinance activity decreased due to the increase in interest rates. Other non-interest income increased $424,000 from 2012 to 2013 mainly due to increases of $291,000 in rental income on OREO properties and $114,000 in investment services commissions.

Other expenses increased $814,000, or 2.1% in 2013 compared to 2012. Salaries and benefits expense increased $1.2 million, or 5.9% as salaries increased $0.4 million due to increases in salary rates and the number of employees, the resumption of the officers' incentive plan in 2013 caused an increase of $0.9 million, and benefits expense decreased $0.1 million. Occupancy expense increased $376,000 or 14.0% mainly due to an increase in maintenance costs due to an increase in the environmental cleanup costs at our Temperance branch location. Completion of this project was delayed by wetter than normal weather in the summer of 2013, and we accrued additional expense for the estimated costs to complete the work in 2014. Professional fees decreased 13.2% from $2.3 million in 2012 to $2.0 million in 2013 as a decrease in legal fees due to reduced collection activity and lower accounting and legal fees related to the ongoing IRS audit. Losses on Other Real Estate Owned increased $364,000, or 33.8% as several properties were liquidated at auctions. Maintenance, insurance, and property tax costs on OREO properties decreased $495,000 or 33.1% due to the reduction in properties owned.

The Company's net income for 2013, before provision for income taxes, was $7.4 million, an increase of $2.4 million compared to the pretax income of $5.0 million in 2012. In 2013 we recorded a tax benefit of $18.8 million to eliminate the remaining valuation allowance on our deferred tax asset and we recorded a tax expense of $0.7 million for the tax expense on our fourth quarter 2013 income. In 2012 we recorded a tax benefit of $5.0 million to reverse a portion of the valuation allowance on our deferred tax asset and a tax expense of $1.5 million to accrue for an estimated adjustment to our 2009 tax return resulting from the ongoing IRS audit of the Company's tax returns filed for its 2004, 2005, 2007, 2008, 2009, and 2010 tax years. The total tax recorded in 2013 was a benefit of $18.1 million, for an effective tax rate of (244%). The total tax recorded in 2012 was a benefit of $3.5 million, for an effective rate of (69.5%). The net income in 2013 was $25.5 million, an improvement of $17.0 million compared to the net income of $8.5 million in 2012.

Comparison of 2012 to 2011 - The Company recorded a Net Profit of $8.5 million in 2012, compared to the Net Loss of $3.8 million in 2011 mainly due to the decrease of $6.45 million in the Provision for Loan Losses, a $5.0 million reduction in the valuation allowance on our deferred tax asset (which net of our current provisions resulted in a decrease of $4.0 million in federal income tax expense), and the decrease of $4.1 million in non-interest expenses. The primary source of earnings for the Bank is its net interest income, which decreased $0.5 million, or 1.4% compared to 2011. Net interest income decreased as the net interest margin decreased from 3.07% to 3.02% and the average earning assets increased less than 0.1%. Earning assets were little changed during 2012 as loan demand remained weak and Management continued its efforts to improve the Bank's capital ratios by restricting asset growth. Interest income decreased $5.0 million during 2012 as the yield on earnings assets decreased from 4.33% to 3.89%, while the amount of earning assets was essentially unchanged at $1.14 billion. Interest expense decreased $4.5 million compared to 2011 as the average amount of interest bearing liabilities decreased $29.4 million and the cost of the interest bearing liabilities decreased from 1.43% in 2011 to 1.01% in 2012. The decrease in the average cost of funds was due to the historically low level of market interest rates throughout the year and because the outstanding balances of interest bearing liabilities shifted from higher cost borrowed funds, certificates of deposit, and money market deposits to lower cost savings and interest bearing demand deposits.

The Provision for Loan Losses decreased 46.7% from $13.8 million in 2011 to $7.35 million in 2012 as the amount of net charge offs decreased from $14.2 million in 2011 to $10.9 million in 2012. The slowly improving economic conditions and continued high credit standards and collection efforts contributed to the decrease in charge offs. The net charge offs exceeded the provision by $3.6 million, causing a decrease of that amount in our Allowance for Loan Losses. The Allowance as a percent of loans decreased from 3.07% as of December 31, 2011 to 2.75% as of December 31, 2012 as the Allowance decreased by 17.1% while the loan portfolio decreased by 7.7%.

Other Income decreased 9.8% from $18.2 million in 2011 to $16.4 million in 2012. Security gains increased $0.2 million as the Bank realized more gains on sales of securities in 2012 as interest rates moved lower. Mortgage loan origination income increased 87.1% from 2011 to 2012 as the real estate market conditions improved slightly and refinance activity increased sharply. Income from Bank Owned Life Insurance decreased $2.1 million, or 59.6%, due to the proceeds of a death claim for one of our directors in 2011.

Other expenses decreased $4.1 million, or 9.6% in 2012 compared to 2011. Salaries and benefits expense increased $838,000, or 4.3% as salaries increased due to increases in salary rates and the number of employees, and retirement benefits, health care, and payroll taxes all increased. Occupancy expense decreased 13.7% mainly due to a reduction in maintenance costs due to an accrual of $340,000 in 2011 for additional environmental cleanup costs at our Temperance branch location. Depreciation and property tax expenses also decreased. Professional fees decreased 8.6% from $2.5 million in 2011 to $2.3 million in 2012 as a decrease in legal fees due to reduced collection activity was partially offset by higher accounting and legal fees due to an ongoing IRS audit. Expenses and losses on Other Real Estate Owned decreased $3.1 million, or 54.6% as real estate values began to recover, decreasing the need to write down our properties. Maintenance, insurance, and property tax costs on OREO properties also decreased. Death benefit obligation expense decreased $1.6 million due to the accrual of a death benefit payable to the beneficiary of one of our board members in 2011. Other expenses increased $783,000, or 22.5% due to an interest accrual on the proposed IRS audit settlement, an excise tax paid on a retirement plan ERISA violation, various legal settlements, and increased employee training expenses.

The Company's net income for 2012, before provision for income taxes, was $5.0 million, an increase of $8.3 million compared to the pretax loss of $3.3 million in 2011. In 2011 we recorded a tax expense to accrue $500,000 for an estimated adjustment to our 2009 tax return resulting from the ongoing IRS audit of the Company's tax returns filed for its 2004, 2005, 2007, 2008, 2009, and 2010 tax years. The ultimate resolution of the audit is still uncertain. The issues being challenged mainly involve the timing of income recognition and would normally result in an increase in the deferred tax asset. In 2012 we proposed a settlement to the IRS and recorded an additional tax expense accrual of $1.5 million to reflect the amount of that proposed settlement. Based on current knowledge, the Company believes that the accrued tax liability is adequate to absorb the effect relating to the ultimate resolution of the uncertain tax positions challenged by the IRS. In 2012, we also recorded a tax benefit of $5.0 million to reduce the valuation allowance on our deferred tax asset. The total tax recorded in 2012 was a benefit of $3.5 million, for an effective tax rate of (69.5%). The net income in 2012 was $8.5 million, an improvement of $12.3 million compared to the loss of $3.8 million in 2011.

Earnings for the Bank are usually highly reflective of the Net Interest Income. In 2008, during the economic crisis, the Federal Open Market Committee (FOMC) of the Federal Reserve lowered the fed funds rate target to 0-0.25%, where it remained through 2013 and into 2014. The yield curve shape became steeply, positively sloped in 2009 and through 2010. Due to continued high unemployment and the absence of inflation, the Fed extended its quantitative easing program through 2012 in an attempt to keep longer term market rates low and encourage borrowing, which reduced the slope from the yield curve. Labor markets began to gain strength in 2012 and into 2013, and the fed began to taper its securities purchases in 2013, which caused an increase in longer term market interest rates and an increase in the slope of the yield curve in the second half of 2013. Loan and investment yields follow long term market yields, and the yield on our loans decreased from 5.53% in 2011 to 5.30% in 2012 and 4.96% in 2013. The yields on our investment securities also decreased each year, from 2.31% in 2011 to 1.96% in 2012 and 1.76% in 2013. In the current environment of low interest rates and low, but increasing, loan demand, we have been maintaining our investment portfolio in shorter duration securities and cash reserves. This liquidity will help us fund loan growth and benefit from increases in interest rates, but it currently is contributing to the low investment yields. Funding costs are more closely tied to the short term rates, and the average cost of our deposits decreased from 1.04% in 2011 to 0.62% in 2012 and to 0.41% in 2013. Borrowed funds costs are primarily based on the 3 month LIBOR, which increased late in 2011 before decreasing slightly in 2012 and 2013. As a result our average cost of borrowed funds increased from 2.76% in 2011 to 2.85% in 2012 and decreased to 2.73% in 2013. This caused our net interest margin to decrease from 3.07% in 2011 to 3.02% in 2012 and to 2.98% in 2013. The average cost of interest bearing deposits was 0.50%, 0.74%, and 1.22%, for 2013, 2012, and 2011, respectively. The following table shows selected financial ratios for the same three years.

                                   2013    2012    2011
Return on Average Assets            2.12 %  0.69 % -0.30 %
Return on Average Equity           28.78 % 11.03 % -5.11 %
Dividend Payout Ratio               0.00 %  0.00 %  0.00 %
Average Equity to Average Assets    7.36 %  6.27 %  5.84 %

Balance Sheet Activity - Compared to 2012, the total assets of the Company decreased $45.9 million, or 3.6%. The decrease was the result of repayment of non-deposit funding, which decreased $95 million. The decrease in borrowed funds was offset by increases of $20.9 million in deposits and 27.0 million in stockholders' equity. We continued to reduce our non-core funding, and in 2013 $7.6 million in brokered certificates of deposit and $95.0 million in Federal Home Loan Bank advances matured and were not replaced. We reduced our total brokered CDs from $16.3 million at December 31, 2012 to $8.7 million at December 31, 2013. Loan demand improved in 2013, but it was not sufficient to replace the amount of principal payments received and charge offs during the year. As a result, total loans held for investment decreased $29.7 million, or 4.7%. We expect the loan portfolio to continue to stabilize in the first quarter of 2014 before beginning to increase before the end of the year. Although deposit funding increased and loans decreased, the decrease in borrowed funds led to a decrease of $37.5 million in our cash and investment securities. The investment portfolio primarily consists of mortgage backed securities issued by GNMA, and debt securities issued by U.S government agencies and states and political subdivisions. Due to the low interest rate environment and our anticipated cash needs for 2014, we are holding a large amount of our excess funds in cash and cash equivalents instead of investing it in securities. Capital increased $27.0 million, due to the earnings of $25.5 million and stock issuance of $12.3 million; partially offset by a reduction of $10.8 million in accumulated other comprehensive income that was caused by an increase in the unrealized losses on our available for sale investment securities.

Asset Quality - The Corporation uses an internal loan classification system as a means of tracking and reporting problem and potential problem credit assets. Loans that are rated one to four are considered "pass" or high quality credits, loans rated five are "watch" credits, and loans rated six and higher are "problem assets", which includes non performing loans. Nonperforming assets include all loans that are 90 days or more past due, non-accrual loans, Other Real Estate Owned (OREO), and Troubled Debt Restructurings (TDRs). Asset quality began to weaken in 2007 and problem assets increased to $157.8 million, or 12.5% of total assets at December 31, 2010. From 2011 through 2013, economic conditions nationally and in southeast Michigan improved moderately. Although unemployment remains elevated, property values are recovering, economic activity is increasing, and problem assets decreased to $125.2 million, or 9.9% of total . . .

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