10-Q 1 c99904e10vq.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q {X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005 OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________________ to ___________________________ Commission file number 0-8679 BAYLAKE CORP. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Wisconsin 39-1268055 --------------------------------------------- -------------------- (State or other jurisdiction of incorporation (Identification No.) or organization) 217 North Fourth Avenue, Sturgeon Bay, WI 54235 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (920)-743-5551 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) None -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes {X} No { } Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes {X} No { } Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes { } No {X} Applicable Only to Corporate Issuers: Number of outstanding shares of each of common stock, par value $5.00 per share, as of November 1, 2005: 7,765,727 shares BAYLAKE CORP. AND SUBSIDIARIES INDEX
PAGE NO. -------- PART I - FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets (Unaudited) as of September 30, 2005 and December 31, 2004 3 Consolidated Statements of Income and Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2005 and 2004 4 -5 Consolidated Statements of Changes in Stockholders' Equity (Unaudited) for the nine months ended September 30, 2005 and 2004 6 Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2005 and 2004 7-8 Notes to Consolidated Unaudited Financial Statements 9-11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12-36 Item 3. Quantitative and Qualitative Disclosures About Market Risk 36-38 Item 4. Controls and Procedures 38 PART II - OTHER INFORMATION Signatures 39 EXHIBIT INDEX Exhibit 31.1 Certification pursuant to Section 302 40 Exhibit 31.2 Certification pursuant to Section 302 42 Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 44 Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 45
BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, 2005 and December 31, 2004 (Amounts in thousands of dollars)
Sept 30, 2005 December 31, (Unaudited) 2004 ------------- ------------ ASSETS Cash and due from financial institutions $ 21,980 $ 20,727 Federal funds sold 3,132 5,445 ----------- ------------ Cash and cash equivalents 25,112 26,172 Securities available for sale 211,227 197,392 Loans held for sale 544 1,349 Loans, net of allowance after $10,492 and $10,445 779,256 746,783 Cash value of life insurance 22,632 21,561 Premises and equipment, net 28,508 24,777 Federal Home Loan Bank stock 8,006 7,697 Foreclosed assets, net 2,629 2,572 Goodwill 5,723 5,723 Accrued interest receivable 5,202 4,330 Other assets 10,799 9,392 ----------- ------------ Total assets $ 1,099,638 $ 1,047,748 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest-bearing $ 119,609 $ 120,511 Interest-bearing 747,015 724,030 ----------- ------------ Total deposits 866,624 844,541 Federal Home Loan Bank advances 125,187 100,192 Federal funds purchased and repurchase agreements 1,906 1,284 Subordinated debentures 16,100 16,100 Accrued expenses and other liabilities 11,759 8,272 Dividends payable - 1,154 ----------- ------------ Total liabilities 1,021,576 971,543 Common stock, $5 par value, authorized 50,000,000; issued- 7,788,886 shares in 2005, 7,715,936 shares in 2004; outstanding- 7,765,727 shares in 2005, 7,692,777 shares in 2004 38,944 38,580 Additional paid-in capital 9,348 8,806 Retained earnings 30,653 28,275 Treasury stock (23,159 shares in 2005 and 2004) (625) (625) Accumulated other comprehensive income (loss) (258) 1,169 ----------- ------------ Total stockholders' equity 78,062 76,205 ----------- ------------ Total liabilities and stockholder equity $ 1,099,638 $ 1,047,748 =========== ============
See accompanying notes to Unaudited Consolidated Financial Statements. 3 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited) Three and Nine Months ended September 30, 2005 and 2004 (Amounts in thousands of dollars except per share data)
Three months ended Sept 30 Nine months ended Sept 30 2005 2004 2005 2004 Interest and dividend income Loans, including fees $ 13,576 $ 10,722 $ 38,183 $ 30,835 Taxable securities 1,768 1,664 5,226 4,878 Tax exempt securities 508 362 1,400 1,128 Federal funds sold and other 33 4 66 11 --------- --------- --------- -------- Total interest and dividend income 15,885 12,752 44,875 36,852 --------- --------- --------- -------- Interest expense Deposits 5,193 2,890 13,514 8,718 Federal funds purchased and repurchase agreements 215 67 706 289 Federal Home Loan Bank advances and other debt 1,224 610 2,975 1,633 Subordinated debentures 461 424 1,384 1,271 --------- --------- --------- -------- Total interest expense 7,093 3,991 18,579 11,911 --------- --------- --------- -------- NET INTEREST INCOME 8,792 8,761 26,296 24,941 Provision for loan losses 1,547 70 1,668 1,569 --------- --------- --------- -------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 7,245 8,691 24,628 23,372 --------- --------- --------- -------- Other income Fees from fiduciary activities 193 167 556 529 Fees from loan servicing 292 286 863 763 Fees for other services to customers 1,260 1,100 3,543 3,264 Gains from sales of loans 348 420 733 1,045 Increase in cash surrender value of life insurance 184 190 601 582 Other income 142 164 666 890 --------- --------- --------- -------- Total other income 2,419 2,327 6,962 7,073 --------- --------- --------- -------- Noninterest expenses Salaries and employee benefits 4,213 3,860 13,070 11,669 Occupancy expense 717 517 1,855 1,568 Equipment expense 349 332 996 1,000 Data processing and courier 285 280 861 835 Operation of other real estate 87 65 216 336 Provision for impairment of letter of credit 1,846 -- 1,846 -- Other operating expenses 1,522 1,432 4,565 4,051 --------- --------- --------- -------- Total other expenses 9,019 6,486 23,409 19,459 --------- --------- --------- -------- INCOME BEFORE INCOME TAX EXPENSE 645 4,532 8,181 10,986 Income tax expense (benefit) (62) 1,458 2,330 3,423 --------- --------- --------- -------- NET INCOME $ 707 $ 3,074 $ 5,851 $ 7,563 --------- --------- --------- -------- COMPREHENSIVE INCOME $ 220 $ 5,245 $ 4,424 $ 7,419 --------- --------- --------- -------- BASIC EARNINGS PER SHARE $ 0.09 $ 0.40 $ 0.76 $ 0.99 DILUTED EARNINGS PER SHARE $ 0.09 $ 0.40 $ 0.75 $ 0.98
See accompanying notes to Unaudited Consolidated Financial Statements. 4 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) Nine months ended September 30, (Amounts in thousands of dollars except for per share data)
Accumulated Common Stock Additional Other ------------------ Paid-in Retained Treasury Comprehensive Total Shares Amount Capital Earnings Stock Income Equity --------- -------- ---------- -------- ------------- ------- BALANCE, JANUARY 1, 2004 7,604,977 $ 38,141 $ 8,163 $ 21,864 $ (625) $ 2,085 $69,628 Net income for the year - - - 7,563 - - 7,563 Net changes in unrealized gain (loss) on securities available for sale, net of $72 deferred taxes - - - - - (144) (144) ------- Total comprehensive income 7,419 Stock options exercised 67,306 336 375 - - - 711 Tax benefit from exercise of stock options - - 107 - - - 107 Cash dividends declared ($0.42 per share) - - - (3,207) - - (3,207) --------- -------- ---------- -------- -------- ------------- ------- BALANCE, SEPTEMBER 30, 2004 7,672,283 $ 38,477 $ 8,645 $ 26,220 $ (625) $ 1,941 $74,658 ========= ======== ========== ======== ======== ============= ======= BALANCE, JANUARY 1, 2005 7,692,777 $ 38,580 $ 8,806 $ 28,275 $ (625) $ 1,169 $76,205 Net income for the year - - - 5,851 - - 5,851 Net changes in unrealized gain (loss) on securities available for sale, net of $(793) deferred taxes - - - - - (1,427) (1,427) ------- Total comprehensive income 4,424 Stock options exercised 72,950 364 299 - - - 663 Tax benefit from exercise of stock options - - 243 - - - 243 Cash dividends declared ($0.45 per share) - - - (3,473) - - (3,473) --------- -------- ---------- -------- -------- ------------- ------- BALANCE, SEPTEMBER 30, 2005 7,765,727 $ 38,944 $ 9,348 $ 30,653 $ (625) $ (258) $78,062 ========= ======== ========== ======== ======== ============= =======
See accompanying notes to Unaudited Consolidated Financial Statements. 5 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine months ended September 30, 2005 and 2004 (Amounts in thousands of dollars)
2005 2004 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Reconciliation of net income to net cash provided by operating activities: Net income $ 5,851 $ 7,563 Adjustments to reconcile net income to net cash provided to operating activities: Depreciation and amortization 1,353 1,267 Provision for losses on loans 1,668 1,569 Provision for impairment on letter of credit 1,846 - Net amortization of securities 457 398 Increase in cash surrender value of life insurance (601) (582) Federal Home Loan Bank stock dividend (309) (337) Net gain on sale of loans (733) (1,045) Proceeds from sale of loans held for sale 38,007 49,070 Origination of loans held for sale (36,469) (48,190) Net (gain) loss from disposal of other real estate 35 (178) Net (gain) loss from disposal of bank premises and equipment 224 (482) Changes in assets and liabilities: Accrued interest receivable and other assets (685) (1,496) Accrued expenses and other liabilities 873 2,123 -------- -------- Net cash provided by operating activities 11,517 9,680 CASH FLOWS FROM INVESTING ACTIVITIES: Principal payments on securities available-for-sale 14,143 15,019 Purchase of securities available-for-sale (30,654) (30,832) Proceeds from sale of other real estate owned 908 2,242 Proceeds from sale of premises and equipment 316 767 Cash paid in completion of acquisition - (754) Loan originations and payments, net (35,141) (41,907) Additions to premises and equipment (5,415) (2,691) Investment in bank-owned life insurance (470) - -------- -------- Net cash used in investing activities (56,313) (58,156)
See accompanying notes to Unaudited Consolidated Financial Statements. 6 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Nine months ended September 30, 2005 and 2004 (Amounts in thousands of dollars)
2005 2004 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net change in deposits $ 22,083 $ 19,588 Net change in federal funds purchased and repurchase agreements 622 5,008 Proceeds from Federal Home Loan Bank advances 25,000 25,101 Repayments on Federal Home Loan Bank advances (5) - Payments on other borrowings and long-term debt - (53) Proceeds from exercise of stock options 663 711 Cash dividends paid (4,627) (4,268) -------- -------- Net cash provided by financing activities 43,736 46,087 -------- -------- Net change in cash and cash equivalents (1,060) (2,389) Beginning cash and cash equivalents 26,172 24,226 -------- -------- ENDING CASH AND CASH EQUIVALENTS $ 25,112 $ 21,837 ======== ======== Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ 17,349 $ 11,997 Income taxes $ 3,099 $ 2,093
See accompanying notes to Unaudited Consolidated Financial Statements. 7 BAYLAKE CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS SEPTEMBER 30, 2005 1. The accompanying consolidated financial statements should be read in conjunction with Baylake Corp.'s 2004 annual report on Form 10-K. The accompanying consolidated financial statements are unaudited. These interim financial statements are prepared in accordance with the requirements of Form 10-Q, and accordingly do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial information included in this report reflects all adjustments, consisting of normal recurring accruals, which are necessary for a fair statement of the financial position as of September 30, 2005 and December 31, 2004. The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of results to be expected for the entire year. 2. To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, foreclosed assets, and fair values of financial instruments are particularly subject to change. 3. Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options were exercised and stock awards were fully vested and resulted in the issuance of common stock that then shared in the earnings of the Company, is computed by dividing net income by weighted average number of common shares and common stock equivalents. The following table shows the computation of the basic and diluted earnings per share for the three and nine months ended September 30 (dollars in thousands, except per share amounts):
Three months ended Nine months ended September 30, September 30, (Net income in thousands) 2005 2004 2005 2004 ----------- ------------ ----------- ----------- (NUMERATOR): Net income $ 707 $ 3,074 $ 5,851 $ 7,563 (DENOMINATOR): Weighted average number of common shares outstanding-basic 7,742,346 7,654,549 7,713,177 7,633,253 Dilutive effect of stock options 86,401 76,477 82,972 72,323 ----------- ------------ ----------- ------ Weighted average number of common shares outstanding-diluted 7,828,747 7,731,026 7,796,149 7,705,576 BASIC EPS $ 0.09 $ 0.40 $ 0.76 $ 0.99 DILUTED EPS $ 0.09 $ 0.40 $ 0.75 $ 0.98
8 BAYLAKE CORP. AND SUBSIDIARIES 4. Baylake Corp. declared a cash dividend of $0.15 per share paid on September 15, 2005 to shareholders of record as of September 1, 2005. 5. The Company has a non-qualified stock option plan, which is described more fully in the Company's December 31, 2004 Annual Report on Form 10-K. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under these plans had an exercise price at least equal to the fair market value of the underlying common stock on the grant date. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of SFAS 123 "Accounting for Stock-Based Compensation," to stock-based employee compensation.
Three months ended Nine months ended September 30, September 30, (In thousands, except per share amounts) 2005 2004 2005 2004 ------- --------- --------- --------- Net income, as reported $ 707 $ 3,074 $ 5,851 $ 7,563 Less: Total stock-based compensation cost determined under the fair value based method, net of income taxes (14) (27) (43) (82) ------- --------- --------- --------- Pro forma net income 693 3,047 5,808 7,481 Basic-as reported $ 0.09 $ 0.40 $ 0.76 $ 0.99 Basic-pro forma $ 0.09 $ 0.40 $ 0.75 $ 0.98 Diluted-as reported $ 0.09 $ 0.40 $ 0.75 $ 0.98 Diluted-pro forma $ 0.09 $ 0.39 $ 0.74 $ 0.97
The fair value of each option granted was estimated as of the date of grant using the Black-Scholes option pricing model. The resulting compensation cost was amortized over the vesting period. 6. Certain amounts reported in the September 30, 2004 Form 10-Q have been reclassified to conform to the September 30, 2005 presentation. 7. Included in the totals for Premises and Equipment is $6.1 million related to the construction project for Baylake City Center LLC. The $6.1 million relates to the purchase and remodeling costs of an existing retail building purchased by Baylake Bank's subsidiary, Baylake City Center LLC and totals 139,000 square feet. At June 2005, the completion of the project relative to a bank branch were completed and the office opened for business. Costs for this project have amounted to $2.1 million. The space occupied is 25,000 square feet. Approximately 91,000 square feet of the project are expected to be sold for office and 9 BAYLAKE CORP. AND SUBSIDIARIES condominium use. This portion of the property has been listed for sale with a commercial real estate brokerage firm. The estimated costs allocated to this portion of the project amount to $4.0 million. 8. In the process of completing loan and asset quality reviews for the third quarter ended September 30, 2005, a matter came to management's attention of potential cash flow problems for one of the Company's borrowers. As the information became available, the Company completed an impairment analysis to determine their exposure on loans to this borrower as well as a letter of credit outstanding for this borrower. This resulted in the Company allocating a reserve of 100%, or $500,000, to this borrower's loans at September 30, 2005. In addition to this, included in other operating expenses for the three-month and nine-month periods ended September 30, 2005 is a provision for impairment losses totaling $1.8 million reflecting a liability established by the Company for their exposure related to the value of a letter of credit to this borrower to its currently estimated realizable value at September 30, 2005. 9. On October 17, 2005, the banking regulators commenced a regularly scheduled examination of the Bank. There can be no assurance that the regulators will not identify items which may have an impact on the financial statements of the Company. 10. Effect of Newly Issued But Not Yet Effective Accounting Standards: FAS 123R requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options. This will apply to awards granted or modified after the first year beginning after June 15, 2005. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. The Company has ceased issuing stock options under the current plan and thus expects no further grants. However, the plan is still in existence and the Company has reserved the right to grant additional options. Existing options that will vest after the adoption date are expected to result in an immaterial amount of compensation expense during 2006 though 2008. SOP 03-3 requires that a valuation allowance for loans acquired in a transfer, including in a business combination, reflect only losses incurred after acquisition and should not be recorded at acquisition. It applies to any loan acquired in a transfer that showed evidence of credit quality deterioration since it was made. The effect of these new standards on the Company's financial position and results of operations is not expected to be material upon adoption. 10 PART 1 - FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Baylake is a full-service financial services company, providing a wide variety of loan, deposit and other banking products and services to its business, individual or retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Company is the bank holding company of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member bank of the Federal Reserve and Federal Home Loan Bank. The following sets forth management's discussion and analysis of the consolidated financial condition and results of operations of Baylake Corp. ("Baylake" or the "Company") for the three and nine months ended September 30, 2005 and 2004 which may not be otherwise apparent from the consolidated financial statements included in this report. Unless otherwise stated, the "Company" or "Baylake" refers to this entity and to its subsidiaries on a consolidated basis when the context indicates. For a more complete understanding, this discussion and analysis should be read in conjunction with the financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report. FORWARD-LOOKING INFORMATION This discussion and analysis of financial condition and results of operations, and other sections of this report, may contain forward-looking statements that are based on the current expectations of management. Such expressions of expectations are not historical in nature and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "projects," and other such words are intended to identify in such forward-looking statements. The statements contained herein and in such forward-looking statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the control of the Company, that may cause actual future results to differ materially from what may be expressed or forecasted in such forward-looking statements. Readers should not place undue expectations on any forward-looking statements. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the relationships; demand for financial products and financial services; the degree of competition by traditional and non-traditional financial services competitors; changes in banking legislation or regulations; changes in tax laws and the results of recent Wisconsin state tax developments; changes in interest rates; changes in prices; the impact of technological advances; governmental and regulatory policy changes; trends in customer behavior as well as their ability to repay loans; and changes in the general economic conditions, nationally or in the State of Wisconsin. 11 CRITICAL ACCOUNTING POLICIES In the course of the Company's normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in the consolidated financial statements of the Company. Some of these policies are more critical than others. Allowance for Loan Losses: The allowance for loan losses ("ALL") is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and the estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Goodwill: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of the acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment, and any such impairment will be recognized in the period identified. Income tax accounting: The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. 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 the consolidated results of the Company's operations and reported earnings. The Company believes that the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. Income tax expense may be affected by developments in the state of Wisconsin. Like many financial institutions that are located in Wisconsin, a subsidiary of the Bank located in the state of Nevada holds and manages various investment securities. Due to that fact that these subsidiaries are out of state, income from their operations has not been subject to Wisconsin state taxation. Although the Wisconsin Department of Revenue issued favorable tax rulings regarding Nevada subsidiaries of Wisconsin financial institutions, the Department representatives have recently stated that the Department intends to revoke those rulings and tax some or all these subsidiaries' income, even though there has been no intervening change in the law. The Department also implemented a program in 2003 for the audit of Wisconsin financial institutions who have 12 formed and contributed assets to subsidiaries located in Nevada; to date, the Company and its subsidiaries have not been audited on these matters. The Department sent letters in July 2004 to financial institutions in Wisconsin, whether or not they are undergoing an audit, reporting on settlements involving 17 banks and their out-of-state investment subsidiaries. The letter provided a summary of currently available settlement parameters. For periods before 2004, they include: restrictions on the types of subsidiary income excluded from Wisconsin taxation; assessment of certain back taxes for a limited period of time; and interest (but not penalties) on any past-due taxes. For 2004 and going forward, there are similar provisions plus limits on the amount of subsidiaries' assets as to which their income will be excluded from Wisconsin tax. Settlement on the terms outlined would result in the Department's rescission of related prior letter rulings, and would purport to be binding going forward except for future legislation or change by mutual agreement. By implication, the Department appears to accept the general proposition that some out-of-state investment subsidiary income is not subject to Wisconsin taxes. The Company continues to believe that it has reported income and paid Wisconsin taxes correctly in accordance with applicable tax laws and the Department's prior longstanding interpretations thereof, including interpretations issued specifically to it. However, in view of the Department's subsequent change in position (even if that change does not have a basis in law), the aggressive stance now being taken by the Department, the settlements by some other banks, and the potential effect that decisions by other similarly situated institutions may have on the Company's alternatives going forward, the Company has determined that it would consider a settlement proposal from the Department; however, the Company has not yet received a specific proposal nor has any assessment been made against the Company or its subsidiaries. The Company will need to review any settlement proposal in more specific detail to quantify in any definitive way the Department's view of its exposure and to evaluate alternatives. Although there will likely be challenges to the Department's actions and interpretations, the Bank's net income would be reduced if the Department succeeds in its actions and interpretations. The Bank could also incur costs in the future to address any action taken against it by the Department. 13 RESULTS OF OPERATIONS The following table sets forth the Company's net income and related summary information for the three and nine-months periods ended September 30, 2005 and 2004, as well as comparisons between the respective periods. TABLE 1 SUMMARY RESULTS OF OPERATIONS ($ in thousands, except per share data)
Three months Three months Nine months Nine months ended Sept 30, ended Sept 30, ended Sept 30, ended Sept 30, 2005 2004 2005 2004 Net income, as reported $ 707 $3,074 $5,851 $7,563 EPS-basic, as reported $ 0.09 $ 0.40 $ 0.76 $ 0.99 EPS-diluted, as reported $ 0.09 $ 0.40 $ 0.75 $ 0.98 Cash dividends declared $ 0.15 $ 0.14 $ 0.45 $ 0.42 Return on average assets, as reported 0.26% 1.21% 0.72% 1.01% Return on average equity, as reported 3.60% 17.04% 10.09% 14.14% Efficiency ratio, as reported (1) 78.11% 57.11% 68.40% 59.26%
(1) Non-interest expense divided by sum of taxable equivalent net interest income plus non-interest income, excluding investment securities gains, net The decrease in net income for the three-month and nine-month periods is primarily due to an increase in non-interest expense and an increase in the provision for loan losses. Both of these items were impacted by negative developments relating to one borrower, which resulted in a $1.8 million provision for impairment on the letter of credit, as well as a $650,000 provision for the borrower's related loans. These were partially offset by an increase in net interest income and a decrease in income tax expense. Net Interest Income Net interest income is the largest component of the Company's operating income (net interest income on a tax-equivalent basis plus other non-interest income), accounting for 79.1% of total operating income for the three months ended September 30, 2005, as compared to 79.5% for the same period in 2004. Net interest income represents the difference between interest earned on loans, investments and other interest earning assets offset by the interest expense attributable to the deposits and the borrowings that fund such assets. Interest fluctuations together with changes in the volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of earned interest income. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable. Net interest income on a tax equivalent basis for the three months ended September 30, 2005 increased $96,000, or 1.1%, to $9.1 million from $9.0 million over the comparable period a year ago. The increase results from increased loan levels offset partially by a decrease in net interest margin. During the nine months ended September 30, 2005, net interest income increased $1.5 million, or 5.8%, to $27.3 million from $25.8 million for the comparable period in 2004. The increase results for the same reasons as listed above. 14 Net interest margin is tax-equivalent net interest income expressed as a percentage of average earning assets. The net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds to fund a portion of earning assets. As a result, the level of funds available without interest cost (demand deposits and equity capital) is an important component increasing net interest margin. The net interest margin for the third quarter of 2005 was 3.58%, down 27 basis points ("bps") from 3.85% for the comparable period in 2004. This comparable period decrease was attributable to a 39 bps decrease in interest rate spread (the net result of a 81 bps increase in the yield on earning assets offset by a 120 bps increase in the cost of interest-bearing liabilities). During the nine months ended September 30, 2005, the net interest margin was 3.64% compared to 3.70% for the comparable period in 2004. Net interest margin decreased as a result of an increase in earning assets relative to interest-bearing liabilities offset partially by a 16 bps decrease in interest rate spread (the net result of a 70 bps increase in the yield on earning assets offset by a 86 bps increase in the cost of interest-bearing liabilities). As the Federal Reserve Board ("FRB") has steadily increased interest rates during the latter half of 2004 and the first nine months of 2005, average interest rates were higher in 2005 than in 2004. Interest rates rose steadily during the period with six rate increases totaling 150 bps between the comparable first nine month periods. The Company had positioned the balance sheet to be slightly asset sensitive (which means that assets will re-price faster than liabilities); thus, the rate increases impacted net interest income positively. The Company expects that in a gradually increasing interest rate environment, we would continue to anticipate that our income statement would benefit from asset sensitivity over the long term, although changes in the portfolio or the pace of increases could affect that trend. For instance, net interest margin decreased in the third quarter as a result of deposit mix which caused short-term deposits to re-price slightly higher relative to the changes occurring in the re-pricing within the loan portfolio. For the three months ended September 30, 2005, average-earning assets increased $81.5 million, or 8.7%, when compared to the same period last year. The Company recorded an increase in average loans of $53.6 million, or 7.2%, for the third quarter of 2005 compared to the same period a year ago. For the nine months ended September 30, 2005, average-earning assets increased $71.9 million, or 7.7%, when compared to the same period last year. The Company recorded an increase in average loans of $48.2 million, or 6.5%, for the first nine months of 2005 compared to the same period a year ago. Although they tend to have more risk, loans have typically resulted in higher rates of interest income to the Company than have investment securities, which further positively affected income in the quarter. Interest rate spread is the difference between the tax-equivalent rate earned on average earning assets and the rate paid on average interest-bearing liabilities. The interest rate spread decreased for the quarter ended September 30, 2005 when compared to the same period a year ago. The interest rate spread decreased 39 bps to 3.21% at September 30, 2005 from 3.60% in the same quarter in 2004. While the average yield on earning assets increased 81 bps during the period, the average rate paid on interest-bearing liabilities increased 120 bps over the same period. For the nine months ended September 30, 2005, the interest rate spread decreased 16 bps to 3.32% from 3.48% when compared to the same period a year earlier. The average yield on earning assets increased 70 bps to 6.12% from 5.42% during the nine-month period, while the average rate paid on interest-bearing liabilities increased 86 bps. The increase in the rates paid on interest-bearing liabilities occurred as a result of a higher cost of funding from deposits and other wholesale funding such as federal funds purchased and loans from the Federal Home Loan Bank. We would expect that trend to continue in light of the recent Federal Reserve Board interest rate increases. 15 TABLE 2 NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS ($ in thousands) Three months ended September 30,
2005 2004 -------------------------------- -------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance expense Rate Balance expense rate ASSETS Earning assets: Loans, net $ 798,321 $ 13,653 6.84% $ 744,714 $ 10,803 5.80% Taxable securities 172,055 1,768 4.11% 161,135 1,664 4.13% Tax exempt securities 45,630 766 6.71% 30,802 551 7.16% Federal funds sold and interest bearing due from banks 3,786 33 3.49% 1,608 4 1.00% ----------- -------- ----- ----------- -------- ----- Total earning assets 1,019,792 16,220 6.36% 938,259 13,022 5.56% ----------- -------- ----- ----------- -------- ----- Non-interest earning assets 82,507 74,860 ----------- ----------- Total assets $ 1,102,299 $ 1,013,119 ----------- ----------- LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: Total interest-bearing deposits 736,925 5,193 2.82% 686,697 2,890 1.68% Short-term borrowings 21,948 204 3.72% 14,658 64 1.75% Customer repurchase agreements 1,553 11 2.83% 1,196 3 1.00% Federal Home Loan Bank advances 122,904 1,224 3.98% 100,195 610 2.44% Subordinated debentures 16,100 461 11.45% 16,100 424 10.53% ----------- -------- ----- ----------- -------- ----- Total interest-bearing liabilities $ 899,430 $ 7,093 3.15% $ 818,846 $ 3,991 1.95% ----------- -------- ----- ----------- -------- ----- Demand deposits 115,807 114,181 Accrued expenses and other liabilities 8,573 7,932 Stockholders' equity 78,489 72,160 ----------- ------ Total liabilities and stockholders' equity $ 1,102,299 $ 1,013,119 ----------- ----------- Interest rate spread $ 9,127 3.21% $ 9,031 3.60% Net interest margin 3.58% 3.85% ----- -----
16 TABLE 3 NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS ($ in thousands) Nine months ended September 30,
2005 2004 -------------------------------- -------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance Expense Rate Balance Expense Rate ASSETS Earning assets: Loans, net $ 785,124 $ 38,433 6.53% $ 736,943 $ 31,077 5.62% Taxable securities 169,714 5,226 4.11% 156,763 4,878 4.15% Tax exempt securities 41,473 2,117 6.81% 32,123 1,711 7.10% Federal funds sold and interest bearing due from banks 3,206 66 2.74% 1,821 11 0.81% ----------- -------- ----- ----------- -------- ----- Total earning assets 999,517 45,842 6.12% 927,650 37,677 5.42% ----------- -------- ----- ----------- -------- ----- Non-interest earning assets 80,157 73,016 ----------- ----------- Total assets $ 1,079,674 $ 1,000,666 ----------- ----------- LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: Total interest-bearing deposits 727,383 13,514 2.48% 681,217 8,718 1.71% Short-term borrowings 27,636 679 3.28% 26,405 281 1.42% Customer repurchase agreements 1,421 27 2.53% 1,107 8 0.96% Federal Home Loan Bank 113,449 2,975 3.50% 93,646 1,633 2.33% advances Subordinated debentures 16,100 1,384 11.46% 16,100 1,271 10.53% ----------- -------- ----- ----------- -------- ----- Total interest-bearing liabilities $ 885,989 $ 18,579 2.80% $ 818,475 $ 11,911 1.94% ----------- -------- ----- ----------- -------- ----- Demand deposits 107,965 102,901 Accrued expenses and other liabilities 8,367 7,976
17 Stockholders' equity 77,353 71,314 ----------- ----------- Total liabilities and stockholders' equity $ 1,079,674 $ 1,000,666 ----------- ----------- Interest rate spread $ 27,263 3.32% $ 25,766 3.48% Net interest margin 3.64% 3.70% ---- ----
The ratio of average earning assets to average total assets measures management's ability to employ overall assets for the production of interest income. This ratio was 92.6% and 92.7%, respectively, for the first nine months of 2005 and 2004, respectively. Provision for Loan Losses The provision for loan losses ("PFLL") is the cost of providing an allowance for probable incurred losses. Prior to the third quarter of 2004, the Company determined the allowance by risk rating loans that were classified as substandard or doubtful thru a grading process that was predicated on various risk rating matrices and the assignment of potential loss based on those ratings. In addition, the remaining loans in the portfolio were assigned risk weightings based on their various classifications. During the third quarter of 2004, the Company further enhanced its methodologies to individually review substandard and doubtful loans for impairment and bring other factors into the process to evaluate the ALL. The Company made these enhancements to more accurately reflect the risk inherent in the loan portfolio. As previously discussed, the allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. These current factors, include loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's evaluation of loan quality, general economic factors and collateral values. As a result of this process, the PFLL for the first nine months of 2005 was $1.7 million as compared to a PFLL of $1.6 million for the first nine months in 2004. Net declines in asset quality in the loan portfolio were a factor in the level of provision for the first nine months of 2005. This was offset partially by a decrease in identified potential problem loans for the period. Net loan charge-offs in the first nine months of 2005 were $1.6 million compared with net charge-offs of $771,000 for the same period in 2004. The loans charged-off in the first nine months of 2005 had a specific reserve in the aggregate of $1.3 million which approximated the amount charged-off. Net charge-offs to average loans on an annualized basis were 0.28% for the first nine months of 2005 compared to 0.14% for the same period in 2004. For the nine months ended September 30, 2005, non-accrual loans increased $1.4 million, in part as the result of a transfer to non-accrual of a $1.0 million commercial real estate credit which already was on our watch list. There was not a material change in the amount of reserve allocated to this credit, as a result of this transfer. At the end of October 2005, this credit was still in non-accrual status. 18 TABLE 4 ALLOWANCE FOR LOAN LOSSES ($ in thousands)
For the nine For the nine months ended months ended Sept 30, 2005 Sept 30, 2004 Allowance for Loan Losses ("ALL) Balance at beginning of period $ 10,445 $ 12,159 Provision for loan losses 1,668 1,569 Charge-offs 1,913 1,689 Recoveries 292 918 Balance at end of period $ 10,492 $ 12,957 Net charge-offs ("NCOs:) $ 1,621 $ 771
As described more fully in Table 8 below, non-accrual loans increased during the period from December 31, 2004. The required allocation of the allowance for such loans increased $1.2 million. Included in this increase was the potential problem loan of $500,000 that was determined to be impaired and allocated a specific provision of $500,000 at September 30, 2005. Additional financing approved in October 2005 in the form of a line of credit for $200,000 has been afforded this borrower to meet various funding needs and Management has included this additional financing in its impairment analysis. These facts in addition to the net charge-offs for the nine months ended September were factors in the determination of a provision of $1.7 million for the nine-month period ended September 30, 2005. Management believes that the current provision conforms to the Company's loan loss reserve policy and is adequate in view of the present condition of the Company's loan portfolio. However, a decline in the quality of our loan portfolio, as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the allowance. If there are significant charge-offs against the allowance, or we otherwise determine that the allowance is inadequate, we will need to make higher provisions in the future. See "Risk Management and the Allowance for Loan Losses" and "Non-Performing Loans, Potential Problem Loans and Other Real Estate" below for more information related to non-performing loans. Non-Interest Income Total non-interest income increased $92,000, or 4.0% to $2.4 million for the third quarter of 2005 when compared to the third quarter of 2004. For the nine months ended September 30, 2005, total non-interest income was $7.0 million, a decrease of $111,000, or 1.6%, when compared to the same period in 2004. The non-interest income to average assets ratio was 0.88% for the three months ended September 30, 2005 compared to 0.92% for the same period in 2004. For the nine months ended September 30, 2005, the non-interest income to average assets ratio was 0.86% compared to 0.94% for the same period in 2004. The decrease in non-interest income for the nine-month periods is mainly due to decreases in gains on sale of bank premises. Additionally the decrease for the three-month and nine-month periods is due to decreases in gains from sales of loans offset by an increase in other services to customers. 19 Table 5 reflects the various components of non-interest income for the comparable quarters. TABLE 5 NON-INTEREST INCOME ($ in thousands)
Third Third quarter quarter Percent YTD YTD Percent 2005 2004 change 2005 2004 change Fees from fiduciary services $ 193 $ 167 15.6% $ 556 $ 529 5.1% Fees from loan servicing 292 286 2.1% 863 763 13.1% Service charges on deposit accounts 877 753 16.5% 2,447 2,206 10.9% Other fee income 199 161 23.6% 549 483 13.7% Financial services income 184 186 (1.1%) 547 575 (4.9%) Gains from sales of loans 348 420 (17.1%) 733 1,045 (29.9%) Increase in cash surrender value of life insurance 184 190 (3.2%) 601 582 3.3% Gain on sale of bank assets 3 - NM 306 482 (36.5%) Other income 139 164 (15.2%) 360 408 (11.8%) ------- ------- ------- ------- Total Other Income $ 2,419 $ 2,327 4.0% $ 6,962 $ 7,073 (1.6%)
Service charges on deposit accounts increased $124,000 for the three-month period and $241,000 for the nine-month period ended September 30, 2005 due in part to the implementation of an overdraft privilege program started in the third quarter of 2004 and other price increases implemented during the latter part of 2004. In the first nine months of 2005, gains from sales of loans were affected by a slowdown in refinancing activity throughout the industry due to higher mortgage rates. In comparison, the same period in 2004 saw slightly higher levels of loan refinancing as a result of the historically low interest rate environment. Gains from sales of loans decreased $312,000 between the comparable periods of 2005 and 2004. The decrease was driven primarily by secondary mortgage and commercial loan production (loan production to be sold to the secondary market) and resulting sales. As interest rates have increased over the nine months, the Company has seen a decrease in the number of loan applications. Secondary loan production declined 24.3% between the comparable first nine-month periods ($36.5 million in the first nine months of 2005 versus $48.2 million in the first nine months of 2004). 20 For the nine month period ended September 30, 2005, the reduction in gain on sale of bank assets was related to non-recurring gains taken in 2004 on the sale of bank land located in the Green Bay market area totaling $482,000. Gains totaling $106,000 were realized in the first nine months of 2005 on the sale of various bank premises and equipment. Partially offsetting the decrease were gains realized on the sale of stock of Pulse in 2005. Gains related to a gain on sale of stock of $200,000 ($21,000 recognized in the second quarter) in connection with a third party acquisition of Pulse. Pulse was an ATM operator/provider in which the Bank held shares. Financial service income was flat for the third quarter of 2005 with a decrease of $2,000, or 1.1%. For the nine months ended September 30, 2005, financial services income has decreased $28,000, or 4.9%, when compared to the same period in 2004 as a result of slowdown in business activity. Non-Interest Expense Impacting the three and nine-month periods ended September 30, 2005 was a $1.8 million charge for impairment related to an off-balance sheet letter of credit, as mentioned in note 8 to our consolidated financial statements. As a result, non-interest expense increased $2.5 million or 39.1%, to $9.0 million for the three months ended September 30, 2005 compared to the same period in 2004. For the nine months ended September 30, 2005, total non-interest expense increased $4.0 million, or 20.3%, to $23.4 million compared to the same period in 2004. The non-interest expense to average assets ratio was 3.27% for the three months ended September 30, 2005 compared to 2.56% for the same period in 2004. For the nine months ended September 30, 2005, non-interest expense ratio to average assets was 2.89% compared to 2.59% for the same period in 2004. Net overhead expense is total non-interest expense less total non-interest income excluding securities gains. The net overhead expenses to average assets ratio was 2.39% for the three months ended September 30, 2005 compared to 1.64% for the same period in 2004. For the nine months ended September 30, 2005, the net overhead expenses to average assets ratio was 2.03% compared to 1.65% for the same period in 2004. The efficiency ratio is total non-interest expense as a percentage of the sum of net-interest income on a fully taxable equivalent basis and total non-interest income. The efficiency ratio for the three months ended September 30, 2005 was 78.11% compared to 57.11% for the same period in 2004. For the nine months ended September 30, 2005, the efficiency ratio was 68.40% compared to 59.26% for the same period in 2004. 21 TABLE 6 NON-INTEREST EXPENSE ($ in thousands)
Third Third quarter quarter Percent YTD YTD Percent 2005 2004 change 2005 2004 change Salaries and employee benefits $ 4,213 $ 3,860 9.1% $13,070 $11,669 12.0% Occupancy 717 517 38.7% 1,855 1,568 18.3% Equipment 349 332 5.1% 996 1,000 (0.4%) Data processing and courier 285 280 1.8% 861 835 3.1% Operation of other real estate owned 87 65 33.8% 216 336 (35.7%) Business development and advertising 276 171 61.4% 764 565 35.2% Charitable contributions 36 33 9.1% 183 194 (5.7%) Stationary and supplies 139 141 (1.4%) 406 382 6.3% Director fees 134 104 28.8% 326 314 3.8% FDIC 28 28 0.0% 84 85 (1.2%) Mortgage servicing rights amortization 54 57 (5.3%) 170 189 (10.1%) Legal and professional 115 152 (24.3%) 419 346 21.1% Loss on disposal of fixed assets 76 0 NM 330 0 NM Provision for impairment of letter of credit 1,846 0 NM 1,846 0 NM Other operating 664 746 (11.0%) 1,883 1,976 (4.7%) ------- ------- ------- ------- Total non-interest expense $ 9,019 $ 6,486 39.1% $23,409 $19,459 20.3%
Salaries and employee benefits showed an increase of $353,000, or 9.2%, to $4.2 million for the third quarter of 2005 compared to the same period in 2004. The number of full-time equivalent employees was 311 as of September 30, 2005 compared to 308 at September 30, 2004. For the three months ended September 30, 2005, salary-related expenses increased $288,000, or 10.9%, due principally to merit increases between the years and related staff increases. For the nine months ended September 30, 2005, salary-related expenses increased $499,000, or 6.1%, compared to the same period in 2004 for the reasons listed previously. Contributing to the increase in salary and employee benefits were expenses related to the Baylake Bank Supplemental Executive Retirement Plan ("Plan"). In the first quarter, the Company implemented the Plan, which is intended to provide certain management and highly compensated employees of the Bank who have contributed, and are expected to continue to contribute, to the Bank's success by providing for deferred compensation in addition to that available under the Bank's other retirement programs. Costs amounted to approximately $121,000 in expenses related to the vested portion of the Plan contributions in the third quarter of 2005 and $519,000 for the nine months ended September 30, 2005. Accrued bonus expense and benefit costs, principally for health insurance and pension costs, represent the remaining increase in personnel-related costs. The increase in health insurance costs is expected to continue for the balance of 2005 and for 2006. Management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to continue in future years. 22 Expenses related to the operation of other real estate owned increased $22,000 to $87,000 for the 2005 three-month period ended September 30 compared to the same period in 2004. For the nine -- month period ended September 30, 2005, other real estate owned expenses decreased $120,000 to $216,000 compared to the same period in 2004. These expenses decreased primarily as a result of the disposal of several properties in early 2005. Included in these expenses were net losses taken on the sale of other real estate owned amounting to $35,000 for the nine months ended September 30, 2005 compared to net gains taken on sale of $178,000 for the same period in 2004. In addition, costs related to the holding of other real estate owned properties decreased $333,000 to $181,000 for the first nine months of 2005. Legal and professional expense for the first nine months in 2005 increased substantially, by $73,000, to $419,000. The increase was the result of increased costs relative to SEC compliance primarily as a result of enhanced requirements imposed by the Sarbanes-Oxley Act of 2002 and related SEC actions. The loss on disposal of fixed assets relates primarily to the sale of two buildings and land formerly used as branch offices. In addition, the bank closed one leased facility during the period, for which leasehold improvements were written off during the period. In each case, the branches had been replaced with newer facilities and had been unoccupied at date of sale or closing. The provision for impairment loss on the letter of credit relates to the establishment of a liability for the Company's exposure on a letter of credit. Subsequent to the end of the third quarter, a matter relating to potential cash flow problems affecting one of the Company's borrowers came to management's attention. This customer has a letter of credit arrangement with the Company totaling $8.8 million; the letter of credit supports secondary market financing on behalf of the borrower. The Company has completed an analysis of this off-balance sheet commitment and provided $1.8 million to establish a liability for the potential exposure. The Company now believes that the letter of credit will be drawn upon, and as such, the collateral and cash flows will not be sufficient to support the outstanding debt. The Company is monitoring the financial condition of the borrower on an ongoing basis and if it continues to deteriorate, may need to provide additional reserves with respect to the off-balance sheet commitment. Income Taxes Income tax expense for the Company for the nine months ended September 30, 2005 was $2.3 million, a decrease of $1.1 million, or 31.9%, compared to the same period in 2004. For the three months ended September 30, 2005, income tax expense resulted in a $62,000 income tax benefit compared to an income tax expense of $1.5 million for the same period in 2004. The tax benefit for the three months, and the lower tax expense reflected for the three and nine-months periods ended September 30 reflected the Company's decrease in before tax earnings. The Company's effective tax rate (income tax expense divided by income before taxes) was 28.5% for the nine months ended September 30, 2005 compared with 31.2% for the same period in 2004. The effective tax rate of 28.5% consisted of a federal effective tax rate of 23.6% and Wisconsin state effective tax rate of 4.9%. For the three and nine-month periods ended September 30, the decrease in income tax expense was primarily due to a decrease in taxable income in addition to an increase in tax-exempt interest income from municipal investments. Income tax expense recorded in the consolidated statements of income involves interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Company undergoes examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. See "Critical Accounting Policies-Income Tax Accounting" above regarding Wisconsin tax matters which may affect our income tax expense. 23 BALANCE SHEET ANALYSIS Loans At September 30, 2005, total loans increased $32.5 million, or 4.3%, to $789.7 million from $757.2 million at December 31, 2004. Growth in the Company's loan portfolio resulted primarily from an increase in real estate commercial loans to $454.6 million at September 30, 2005 compared to $424.7 million at December 31, 2004. In addition, growth in real estate construction loans increased to $89.6 million at September 30, 2005 compared to $80.4 million at December 31, 2004. Growth in commercial real estate mortgages and commercial loans occurred principally as a result of the Company's expansion efforts (primarily in the Green Bay market) and the strong economic growth in that market. The following table reflects the composition (mix) of the loan portfolio: TABLE 7 LOAN PORTFOLIO ANALYSIS ($ in thousands)
September December 31, Percent 30, 2005 2004 change Amount of loans by type Real estate-mortgage Commercial $ 454,575 $424,712 7.0% 1-4 family residential First liens 85,361 78,321 9.0% Junior liens 22,167 20,244 9.5% Home equity 34,290 35,785 (4.2%) Commercial, financial and agricultural 75,461 83,787 (9.9%) Real estate-construction 89,620 80,384 11.5% Installment Credit cards and related plans 2,073 2,152 (3.7%) Other 12,281 11,784 4.2% Obligations of states and political subdivisions 14,338 20,457 (29.9%) Less: deferred origination fees, net of costs 418 398 5.0% --------- -------- ----- Total $ 789,748 $757,228 4.3%
Risk Management and the Allowance for Loan Losses The loan portfolio is the Company's primary asset subject to credit risk. To reflect this credit risk, the Company sets aside an allowance for probable incurred credit losses through periodic charges to earnings. These charges are shown in the Company's consolidated income statement as provision for loan losses. See "Provision for Loan Losses" above. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and an on-going review of payment performance. Asset quality administration, including early identification of problem loans and timely resolution of problems, further enhances management of credit risk and minimization of loan losses. All specifically identifiable and quantifiable losses are charged off against the allowance. Charged-off loans are subject to periodic review, and specific efforts are taken to achieve maximum recovery of principal and interest. 24 As indicated in Table 4 above, the ALL at September 30, 2005 was $10.5 million compared with $10.4 million at the end of 2004. This was based on management's analysis of the loan portfolio risk at September 30, 2005. A provision expense of $1.7 million relating to a letter of credit impairment was recorded for the nine months ended September 30, 2005. See discussion above in "Results of Operations-Provision for Loan Losses." The quarter to date provision has increased by $1.5 million compared to the same period in 2004, as discussed previously. The provision for loan losses is predominately a function of management's evaluation of the loan portfolio, with particular emphasis directed toward non-performing and other potential problem loans. During these evaluations, consideration is also given to such factors as management's evaluation of specific loans, the level and composition of impaired loans, other non-performing loans, historical loan experience, results of examinations by regulatory agencies and various other factors. On a quarterly basis, management reviews the adequacy of the ALL. Commercial credits are graded by the loan officers and the loan review function validates the officers' grades. In the event that the loan review function downgrades the loan, it is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (i.e., collateral value is nominal, etc.). To establish the appropriate level of the allowance, a sample of loans (including impaired and non-performing loans) are reviewed and classified as to potential loss exposure. Based on an estimation computed pursuant to the requirements of Financial Accounting Standards Board ("FASB") Statement No. 5, "Accounting for Contingencies," and FASB Statements No. 114 and 118, "Accounting by Creditors for Impairment of a Loan," the analysis of the ALL consists of two components: (i) specific credit allocation established for expected losses resulting from analysis developed through specific credit allocations on individual loans for which the recorded investment in the loan exceeds its fair value; (ii) general portfolio allocation based on historical loan loss experience for each loan category and adjusted for economic conditions as well as specific and other factors in the markets in which the Company operates. The specific credit allocation of the ALL is based on a regular analysis of loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the market price of the loan, or, if the loan is collateral dependent, the fair value of the underlying collateral less cost of sale. The general portfolio allocation component of the ALL is determined statistically using a loss migration analysis that examines historical loan loss experience. The loss migration analysis is performed quarterly and loss factors are updated regularly based on actual experience. The general portfolio allocation element of the ALL also includes consideration of the amounts necessary for concentrations and changes in portfolio mix and volume. The ALL is based on estimates, and ultimate losses will vary from current estimates. These estimates are reviewed monthly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the provision for loan losses. The composition of the loan portfolio has not significantly changed since year-end 2004. Management remains watchful of credit quality issues and believes that issues within the portfolio are reflective of the challenging economic environment experienced over the past few years. Should the economic climate deteriorate from current levels, borrowers may experience 25 difficulty, and the level of non-performing loans, charge-offs and delinquencies could rise and require further increases in the provision. Consideration for making such allocations is consistent with the factors discussed above, and all of the factors are subject to change; thus, the allocation is not necessarily indicative of the loan categories in which future loan losses will occur. It would also be expected that the amount allocated for any particular type of loan will increase or decrease proportionately to both the changes in the loan balances and to increases or decreases in the estimated loss in loans of that type. In other words, changes in the risk profile of the various parts of the loan portfolio should be reflected in the allowance allocated. While there exists probable asset quality problems in the loan portfolio, management believes sufficient reserves have been provided in the ALL to absorb probable incurred losses in the loan portfolio at September 30, 2005. Ongoing efforts are being made to collect these loans, and the Company involves the legal process when necessary to minimize the risk of further deterioration of these loans for full collection. While management uses available information to recognize losses on loans, future adjustments to the ALL may be necessary based on changes in economic conditions and the impact of such change on the Company's borrowers. As an integral part of their examination process, various regulatory agencies also review the Company's ALL. Such agencies may require that changes in the ALL be recognized when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. Non-Performing Loans, Potential Problem Loans and Other Real Estate Management encourages early identification of non-accrual and problem loans in order to minimize the risk of loss. This is accomplished by monitoring and reviewing credit policies and procedures on a regular basis. Non-performing loans are a leading indicator of future loan loss potential. Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days or more past due but still accruing, and restructured loans. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collection of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income. 26 TABLE 8 NON-PERFORMING ASSETS ($ in thousands)
At or for the At or for the At or for the period ended period ended period ended Sept 30, 2005 Sept 30, 2004 December 31, 2004 Nonperforming Assets: Nonaccrual loans $ 7,299 $ 13,239 $ 5,920 Accruing loans past due 90 days or more 0 0 0 -------- --------- -------- Total nonperforming loans ("NPLs") $ 7,299 $ 13,239 $ 5,920 Other real estate owned 2,629 2,520 2,572 -------- --------- -------- Total nonperforming assets ("NPAs") $ 9,928 $ 15,759 $ 8,492 Ratios: ALL to NCO's (annualized) 4.85 12.60 3.15 NCO's to average loans (annualized) 0.28% 0.14% 0.45% ALL to total loans 1.33% 1.72% 1.38% NPL's to total loans 0.92% 1.76% 0.78% NPA's to total assets 0.90% 1.53% 0.81% ALL to NPL's 143.75% 97.87% 176.44%
As indicated in Table 8, non-performing loans at September 30, 2005 were $7.3 million compared to $5.9 million at December 31, 2004. This increase is due, in part to the transfer to non-accrual of a $1.0 million commercial real estate credit which already was on our watch list. There was not a material change in the amount of reserve allocated to this credit, as a result of this transfer. Non-accrual loans represented $7.3 million of the total non-performing loans. Real estate non-accrual loans accounted for $6.5 million of the total, of which $893,000 was residential real estate and $5.4 million was commercial real estate, while commercial and industrial non-accrual loans total $746,000. As a result the ratio of non-performing loans to total loans at September 30, 2005 was 0.92% compared to 0.78% at end of year 2004. The Company's ALL was 143.8% of total non-performing loans at September 30, 2005 compared to 176.4% at end of year 2004. Non-performing assets (non-performing loans plus other real estate owned assets) at September 30, 2005 were $9.9 million compared to $8.5 million at December 31, 2004. Other real estate owned, which represents property that the Company acquired through foreclosure or in satisfaction of debt, consisted of two residential and fifteen commercial properties totaling $2.6 million. Other real estate owned at December 31, 2004 totaled $2.6 million and consisted of sixteen properties. Potential problem loans are currently performing loans that management believes may incur difficulties in complying with loan repayment terms. Management's decision to place loans in this category does not necessarily mean that the Company expects to take losses on such loans, but that management needs to be more vigilant in its efforts to oversee the loans and recognize that a higher degree of risk is associated with these potential problem loans. At September 30, 2005, potential problem loans amounted to $3.8 million compared to a total of $9.3 million at December 31, 2004. As a result of impairment analysis, $6.0 million of potential problem loans were specifically allocated a portion of the loan loss provision and transferred from potential problem loans since end of year 2004. 27 As mentioned previously, an impairment loss has been provided in the amount of $1.8 million to establish a liability for potential exposure for a customer's letter of credit arrangement with the Company totaling $8.8 million. The letter of credit supports secondary market financing on behalf of the borrower. The Company is monitoring the financial condition of the borrower (in the hotel industry) on an ongoing basis, and if it continues to deteriorate, may need to provide additional reserves with respect to the off-balance sheet commitment. Investment Portfolio The investment portfolio is intended to provide the Company with adequate liquidity, flexibility in asset/liability management and, lastly, an increase in its earning potential. At September 30, 2005, the investment portfolio (which includes investment securities available for sale) increased $13.8 million, or 7.0%, to $211.2 million from $197.4 million at December 31, 2004. At September 30, 2005, the investment portfolio represented 19.2% of total assets compared with 18.8% at December 31, 2004. Securities available for sale consist of the following: TABLE 9 INVESTMENT SECURITY ANALYSIS At September 30, 2005 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. agencies 399 742 70,429 Mortgage-backed securities 12 1,277 91,229 Obligations of states & political subdivisions 1,192 70 46,806 Private placement 45 0 1,040 Other securities 0 0 1,723 ------ ------ ---------- Total securities available for sale $1,648 $2,089 $ 211,227
28 At December 31, 2004 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. Agencies $ 965 $ 214 $ 59,547 Mortgage-backed securities 190 794 99,360 Obligations of states & political subdivisions 1,556 0 33,973 Private placement 76 0 1,070 Other securities 0 0 3,442 ------ ------ ---------- Total investment securities $2,787 $1,008 $ 197,392
Federal Home Loan Bank Stock At September 30, 2005, the Company has $8 million of Federal Home Loan Bank stock. Of this amount, $1.8 million is in excess of the amount that the Company is required to hold. In late October the FHLB issued a statement that they would suspend redeeming excess or voluntary capital stock. The FHLB indicated that it would resume the voluntary redemptions as soon as possible. While the Company does believe that this will not have a financial statement impact, we are continuing to monitor the situation. Deposits Total deposits at September 30, 2005 increased $22.1 million, or 2.6%, to $866.6 million from $844.5 million at December 31, 2004. Non-interest bearing deposits at September 30, 2005 decreased $902,000, or 0.7%, to $119.6 million from $120.5 million at December 31, 2004. Interest-bearing deposits at September 30, 2005 increased $23.0 million, or 3.2%, to $747.0 million from $724.0 million at December 31, 2004. Brokered CD's totaled $179.3 million at September 30, 2005 compared to $175.4 million at December 31, 2004. Time deposits greater than $100,000 and brokered time deposits were priced within the framework of the Company's rate structure and did not materially increase the average rates on deposit liabilities. If liquidity concerns arose, the Company has alternative sources of funds such as lines with correspondent banks and borrowing arrangements with FHLB should the need present itself. Increased competition for consumer deposits and customer awareness of interest rates continues to limit the Company's core deposit growth in these types of deposits. Typically, overall deposits for the first six months tend to decline slightly as a result of the seasonality of the Company's customer base as customers draw down deposits during the early first half of the year in anticipation of the summer tourist season. 29 Emphasis has been, and will continue to be, placed on generating additional core deposits in the remainder of 2005 and 2006 through competitive pricing of deposit products and through the branch delivery systems that have already been established. The Company will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. The Company also may increase brokered time deposits during the remainder of the year 2005 and in 2006 as an additional source of funds to provide for loan growth in the event that core deposit growth goals would not be accomplished. Brokered deposits tend to be by their nature less stable than core deposits, and may also bear a higher cost structure. Under a scenario of increased brokered deposits, the Company will continue to look at other wholesale sources of funds, if the brokered CD market became illiquid or more costly in terms of interest rate. Borrowings Federal funds purchased and securities under agreements to repurchase at September 30, 2005 increased $622,000 to $1.9 million from $1.3 million at December 31, 2004. Securities under repurchase provided the increase between periods. There were no federal funds purchased at September 30, 2005 and December 31, 2004. Federal Home Loan Bank Advances totaled $125.2 million at September 30, 2005 compared to $100.2 million at December 31, 2004. Typically, borrowings increase in order to fund growth in the loan portfolio in periods when borrowings increase more rapidly than deposits. The Company will borrow monies if borrowing is a less costly form of funding loans compared to the cost of acquiring deposits or if deposit growth is not sufficient. Additionally, the availability of deposits also determines the amount of funds the Company needs to borrow in order to fund loan demand. The Company anticipates it will continue to use wholesale funding sources of this nature, if these borrowings add incrementally to overall profitability. In connection with the issuance of Trust Preferred Securities in 2001 (see "Capital Resources"), the Company issued long-term subordinated debentures to Baylake Capital Trust I, a Delaware Business Trust, formed by the Company. The aggregate principal amount of the debentures due 2031, to the trust is $16,597,940. For additional details, please make reference to the Consolidated Financial Statements and the accompanying footnotes on the Company's Form 10-K for the year 2004. CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT LIABILITIES The Company utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2004 for discussion with respect to the Company's quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in Form 10-K have not materially changed since that report was filed. 30 The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments: TABLE 10 LENDING RELATED COMMITMENTS ($ in thousands)
September 30, 2005 December 31, 2004 Commitments to fund home equity line loans $ 55,161 $ 45,101 Commitments to fund commercial real estate loans 4,726 5,314 Commitments unused on various other lines of credit loans 173,633 135,889 ---------- ---------- Total commitments to extend credit $ 233,520 $ 186,304 Financial standby letters of credit $ 24,412 $ 23,428
See "Balance Sheet Analysis - Non-Performing Loans, Potential Problem Loans and Other Real Estate" for a discussion of potential exposure relating to a $8.8 million letter of credit arrangement with a customer. The following table summarizes the Company's significant contractual obligations and commitments at September 30, 2005: TABLE 11 CONTRACTUAL OBLIGATIONS ($ in thousands)
WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL ------------- --------- --------- ------------- -------- Federal funds purchased and repurchase agreements $ 1,906 $ 0 $ 0 $ 0 $ 1,906 Federal Home Loan Bank advances 85,000 15,000 187 25,000 125,187 Subordinated debentures 0 0 0 16,100 16,100 Operating leases 128 220 112 0 460 ------- --------- ----- --------- -------- Total $87,034 $ 15,220 $ 299 $ 41,100 $143,653
LIQUIDITY Liquidity management refers to the ability of the Company to ensure that cash is available in a timely manner to meet loan demand and depositors' needs, and to service other liabilities as they become due, without undue cost or risk, and without causing a disruption to normal operating activities. The Company and the Bank have different liquidity considerations. The Company's primary sources of funds are dividends from the Bank, investment income, and net proceeds from borrowings and the offerings of junior subordinated obligations, in addition to the issuance of its common stock securities. The Company manages its liquidity position in order to provide funds necessary to pay dividends to its shareholders. Dividends received from Bank totaled $3.6 million for the first nine months of 2005 and will continue to be the Company's main source of long-term liquidity. The dividends from the Bank along with existing cash were sufficient to pay cash dividends to the Company's shareholders of $4.6 million in the first nine months of 2005. 31 The Bank meets its cash flow needs by having funding sources available to it to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity at the Bank is derived from deposit growth (including brokered deposits), maturing loans, the maturity of the investment portfolio, access to other funding sources (such as federal funds purchased), marketability of certain of its assets; the ability to use its loan and investment portfolios as collateral for secured borrowings and strong capital positions. Maturing investments have been a primary source of liquidity at the Bank. For the nine months ended September 30, 2005, principal payments totaling $14.1 million were received on investments. The Company purchased $30.7 million in investments in the first nine months of 2005. This resulted in net cash of $16.6 million used in investing activities for the first nine months of 2005. At September 30, 2005 the investment portfolio contained $161.7 million of U.S. Treasury and federal agency backed securities representing 76.5% of the total investment portfolio. These securities tend to be highly marketable. Deposit growth is typically another source of liquidity for the Bank in the latter half of each year, although deposits typically shrink in the first half resulting in a use of cash. As a financing activity reflected in the September 30, 2005 Consolidated Statements of Cash Flows, deposits increased and resulted in $22.1 million of cash flow during the first nine months of 2005. The Company's overall deposit base increased 2.6% for the nine months ended September 30, 2005. Deposit growth is generally the most stable source of liquidity for the Bank. Although brokered deposits are inherently less stable than locally generated core deposits, we use them when we believe it is appropriate as a result of market conditions in our markets as compared to the brokered markets and/or when we need to supplement local deposit generation to fund loans. Affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause the Bank to develop alternative sources of funds which may not be as liquid and potentially a more costly alternative. The scheduled maturity of loans can provide a source of additional liquidity. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing loans. The Bank's liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand as a need for liquidity will cause the Company to acquire other sources of funding which could be harder to find; therefore more costly to acquire. Within the classification of short-term borrowings at September 30, 2005, federal funds purchased and securities sold under agreements to repurchase totaled $1.9 million compared to $1.3 million at the end of 2004. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Borrowings from FHLB, short-term or long-term, are another source of funds. They total $125.2 million at September 30, 2005 and $100.2 million at December 31, 2004. The Bank's liquidity resources were sufficient in the first nine months of 2005 to fund the growth in loans and investments, increase the volume of interest earning assets and meet other cash needs when necessary. Management expects that deposit growth will continue to be the primary funding source of the Bank's liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities, and a strong capital position. Although federal funds purchased and borrowings from the FHLB provided funds in the first nine months of 2005, management expects deposit growth to be a reliable funding source in the future as a result of branch expansion efforts and marketing efforts to attract and retain core deposits. In addition, the Bank may acquire additional brokered deposits as funding for short-term liquidity needs. 32 Shorter-term liquidity needs will mainly be derived from growth in short-term borrowings, maturing federal funds sold and portfolio investments, loan maturities and access to other funding sources. In assessing liquidity, historical information such as seasonality (loan demand's affect on liquidity which starts before and during the tourist season and deposit draw down which affects liquidity shortly before and during the early part of the tourist season), local economic cycles and the economy in general are considered along with the current ratios, management goals and the unique characteristics of the Company. Management believes that, in the current economic environment, the Company's and the Bank's liquidity position is adequate. To management's knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material increase or decrease in the Bank's or the Company's liquidity. Capital Resources Stockholders' equity at September 30, 2005 increased $1.9 million or 2.4% to $78.1 million, compared with $76.2 million at end of year 2004. The increase in stockholders' equity in 2005 was primarily composed of the growth in retained earnings and proceeds from the exercise of stock options, partially offset by the change in unrealized losses on available for sale securities and the payment of dividends. The change in unrealized losses on available for sale securities amounted to $1.4 million for the first nine months of 2005; this change resulted from the effects of the increasing interest rate environment. Total dividends paid increased to $3.5 million in the nine months ended September 30, 2005 from $3.2 million for the same period in 2004, primarily as a result of an increase in the per share dividends rate to $0.45 from $0.42. Stockholders' equity to assets at September 30, 2005 was 7.10% compared to 7.27% at the end of 2004. In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory business trust organized for the sole purpose of issuing trust preferred securities and investing the proceeds thereof in junior subordinated debentures of the Company, the sole asset of the Trust. The trust preferred securities enhanced regulatory capital and added liquidity. The common securities of the Trust are wholly-owned by the Company. The trust preferred securities and common securities of the trust represent preferred undivided beneficial interests in the assets of Baylake Capital Trust I, and the holder of the preferred securities will be entitled to a preference over the common securities of the Trust upon an event of default with respect to distributions and amounts payable on redemption or liquidation. These trust preferred securities are tax-advantaged issues for the Company that qualify for Tier 1 capital treatment to the Company. Distributions on these securities are included in interest expense on guaranteed preferred beneficial interest. The Company had $16.6 million of junior subordinated debentures outstanding to the Trust and the Trust had $16.1 million of trust preferred securities outstanding at September 30, 2005 and December 31, 2004, respectively. Under applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of Trust Preferred Securities would qualify as Tier 2 capital. As of September 30, 2005, all $16.1 million of the Trust Preferred Securities qualify as Tier 1 Capital. The Company's capital base (before SFAS 115 change) increased primarily due to the retention of earnings. The Company's dividend reinvestment plan typically provides capital improvement, as the holders of approximately 19% of Company's Common Stock participate in the plan. 33 Cash dividends paid in the first nine months of 2005 were $0.45 per share compared with $0.42 in 2004. The Company provided a 7.1% increase in normal dividends per share in 2005 over 2004. Total funds utilized in the payment of dividends were $4.6 million in the first nine months of 2005, as compared to $4.3 million in the corresponding period of 2004. In 1997, the Company's Board of Directors authorized management, in its discretion, to repurchase up to 7,000 shares of the Company's common stock each calendar quarter in the market. The shares repurchased would be used to fill its needs for the dividend reinvestment program, any future benefit plans, and the Company's stock purchase plan. Shares repurchased are held as treasury stock and accordingly, are accounted for as a reduction of stockholders' equity. The Company repurchased none of its common shares in the first nine months of 2005. The adequacy of the Company's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. Management is confident that because of current capital levels and projected earnings levels, capital levels are more than adequate to meet the ongoing and future concerns of the Company. The Federal Reserve Board has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory - and possible additional discretionary- actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements. At September 30, 2005 and December 31, 2004, the Company was categorized as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. To be "well capitalized" under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%. 34 The following table presents the Company's and the Bank's capital ratios as of September 30, 2005 and December 31, 2004: TABLE 12 CAPITAL RATIOS ($ in thousands)
Required To Be Well Capitalized Required For under Prompt Capital Adequacy Corrective Action Actual Purposes Provisions Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of September 30, 2005 Total Capital (to Risk Weighted Assets) Company 98,802 10.69% 73,958 8.00% N/A N/A Bank 94,794 10.27% 73,857 8.00% 92,321 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 88,310 9.55% 36,979 4.00% N/A N/A Bank 84,302 9.13% 36,929 4.00% 55,393 6.00% Tier 1 Capital (to Average Assets) Company 88,310 8.06% 43,848 4.00% N/A N/A Bank 84,302 7.69% 43,848 4.00% 54,809 5.00% As of December 31, 2004 Total Capital (to Risk Weighted Assets) Company 95,433 10.95% 69,791 8.00% N/A N/A Bank 91,521 10.53% 69,580 8.00% 86,975 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 84,988 9.75% 34,895 4.00% N/A N/A Bank 81,076 9.33% 34,790 4.00% 52,185 6.00% Tier 1 Capital (to Average Assets) Company 84,988 8.27% 41,129 4.00% N/A N/A Bank 81,076 7.91% 41,025 4.00% 51,282 5.00%
Management believes that a strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share, and to provide depositor and investor confidence. The Company's capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. Management actively reviews capital strategies for the Company to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements. 35 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. The Company's primary market risk exposure is interest rate risk. Interest rate risk is the risk that the Company's earnings and capital will be adversely affected by changes in interest rates. The Company does not use derivatives to mitigate its interest rate risk. The Company's earnings are derived from the operations of its direct and indirect subsidiaries with particular reliance on net interest income, calculated as the difference between interest earned on loans and investments and the interest expense paid on deposits and other interest bearing liabilities, including advances from FHLB and other borrowings. Like other financial institutions, the Company's interest income and interest expense are affected by general economic conditions and by the policies of regulatory authorities, including the monetary policies of the Board of Governors of the Federal Reserve System. Changes in the economic environment may influence, among other matters, the growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing. Fluctuations in interest rates are not predictable or controllable. As of September 30, 2005, the Company was in compliance with its management policies with respect to interest rate risk with the exception that the effect of an immediate 200 basis point decrease in the prime rate over a one-year horizon would impact negatively net interest income by 11.1%. The Company's guidelines have internal limits of not more than a 10% change. The dollar change would equate to a $379,000 decrease in net interest income for that period exceeding the Company's internal limits. The Company has noted the issue and the Company feels that other mitigating factors minimize that potential effect given the current rate environment. The Company has not experienced any material changes to its market risk position since December 31, 2004, as described in the Company's 2004 Form 10-K Annual Report. The Company's overall interest rate sensitivity is demonstrated by net interest income analysis. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% to 2.0% increases and decreases in market interest rates. The table below presents the Company's projected changes in net interest income for the various rate shock levels at September 30, 2005. 36 TABLE 13 INTEREST SENSITIVITY ($ in thousands) Change in Net Interest Income over One Year Horizon
At September 30, 2005 At December 31, 2004 --------------------------- ------------------------- Change in levels of Percentage Percentage interest rates Dollar change change Dollar change change ------------------- ------------- ---------- ------------- ---------- +200 bp $ 2,324 6.7% $ 2,357 6.3% +100 bp 1,027 3.0% 1,092 2.9% Base 0 0% 0 0% -100 bp (1,826) (5.3%) (1,756) (4.7%) -200 bp (3,821) (11.1%) (3,656) (9.7%)
As shown above, at September 30, 2005, the effect of an immediate 200 basis point increase in interest rates would increase the Company`s net interest income by $2.3 million or 6.7%. The effect of an immediate 200 basis point reduction in rates would decrease the Company's net interest income by $3.8 million or 11.1%. Changes in the mix of earning assets and interest - bearing liabilities increased the Company's asset sensitivity during the past twelve months. Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. ITEM 4. CONTROLS AND PROCEDURES DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of September 30, 2005. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company's disclosure controls and procedures to the Company required to be included in this quarterly report on Form 10-Q. INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal controls subsequent to the date of such evaluation with the exception of enhancements made during the quarter to the calculation of the allowance for loan loss reserve. Such enhancement is explained in Item 2, Management's Discussion and Analysis found in the sections entitled "Provision for Loan Losses" and "Balance Sheet Analysis-Risk Management and the Allowance for Loan Losses" which discussions are incorporated by reference in this item. 37 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Baylake and its subsidiaries may be involved from time to time in various routine legal proceedings incidental to its business. Neither Baylake nor any of its subsidiaries is currently engaged in any legal proceedings that are expected to have a material adverse effect on the results of operations or financial position of Baylake. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L. Herlache, Chief Executive Officer, is attached hereto. 31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D. Jennerjohn, Chief Financial Officer, is attached hereto. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto.
38 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BAYLAKE CORP. Date: November 9, 2005 /s/ Thomas L. Herlache ------------------------ Thomas L. Herlache President (CEO) Date: November 9, 2005 /s/ Steven D. Jennerjohn -------------------------- Steven D. Jennerjohn Treasurer (CFO) 39