10-Q 1 e-9185.txt QUARTERLY REPORT FOR QTR ENDED 09/30/2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002 OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from _____ to ____ Commission file number 33-24728C CAPITOL BANCORP LTD. (Exact name of registrant as specified in its charter) MICHIGAN 38-2761672 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 200 WASHINGTON SQUARE NORTH, LANSING, MICHIGAN (Address of principal executive offices) 48933 (Zip Code) (517) 487-6555 (Registrant's telephone number) Not Applicable (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common stock, No par value: 11,187,263 shares outstanding as of October 15, 2002. Page 1 of 29 INDEX PART I. FINANCIAL INFORMATION FORWARD-LOOKING STATEMENTS Certain of the statements contained in this document, including Capitol's consolidated financial statements, Management's Discussion and Analysis of Financial Condition and Results of Operations and in documents incorporated into this document by reference that are not historical facts, including, without limitation, statements of future expectations, projections of results of operations and financial condition, statements of future economic performance and other forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, are subject to known and unknown risks, uncertainties and other factors which may cause the actual future results, performance or achievements of Capitol and/or its subsidiaries and other operating units to differ materially from those contemplated in such forward-looking statements. The words "intend", "expect", "project", "estimate", "predict", "anticipate", "should", "believe", and similar expressions also are intended to identify forward-looking statements. Important factors which may cause actual results to differ from those contemplated in such forward-looking statements include, but are not limited to: (i) the results of Capitol's efforts to implement its business strategy, (ii) changes in interest rates, (iii) legislation or regulatory requirements adversely impacting Capitol's banking business and/or expansion strategy, (iv) adverse changes in business conditions or inflation, (v) general economic conditions, either nationally or regionally, which are less favorable than expected and that result in, among other things, a deterioration in credit quality and/or loan performance and collectability, (vi) competitive pressures among financial institutions, (vii) changes in securities markets, (viii) actions of competitors of Capitol's banks and Capitol's ability to respond to such actions, (ix) the cost of capital, which may depend in part on Capitol's asset quality, prospects and outlook, (x) changes in governmental regulation, tax rates and similar matters, and (xi) other risks detailed in Capitol's other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated. All subsequent written or oral forward-looking statements attributable to Capitol or persons acting on its behalf are expressly qualified in their entirety by the foregoing factors. Investors and other interested parties are cautioned not to place undue reliance on such statements, which speak as of the date of such statements. Capitol undertakes no obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events. Page ---- Item 1. Financial Statements (unaudited): Consolidated balance sheets - September 30, 2002 and December 31, 2001. 3 Consolidated statements of income - Three months and nine months ended September 30, 2002 and 2001. 4 Consolidated statements of changes in stockholders' equity - Nine months ended September 30, 2002 and 2001. 5 Consolidated statements of cash flows - Nine months ended September 30, 2002 and 2001. 6 Notes to consolidated financial statements. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 12 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 23 Item 4. Controls and Procedures. 23 PART II. OTHER INFORMATION Item 1. Legal Proceedings. 24 Item 2. Changes in Securities and Use of Proceeds. 24 Item 3. Defaults Upon Senior Securities. 24 Item 4. Submission of Matters to a Vote of Security Holders. 24 Item 5. Other Information. 24 Item 6. Exhibits and Reports on Form 8-K. 24 SIGNATURES 25 CERTIFICATIONS 26 Page 2 of 29 PART I, ITEM I CAPITOL BANCORP LIMITED Consolidated Balance Sheets As of September 30, 2002 and December 31, 2001
(Unaudited) September 30 December 31 2002 2001 ------------ ------------ (in thousands) ASSETS Cash and due from banks $ 119,281 $ 83,833 Money market funds, mutual funds and interest-bearing deposits 39,755 10,999 Federal funds sold 68,125 68,859 ------------ ------------ Cash and cash equivalents 227,161 163,691 Loans held for resale 65,496 62,487 Investment securities: Available for sale, carried at market value 37,821 35,598 Held for long-term investment, carried at amortized cost which approximates market value 8,057 8,089 ------------ ------------ Total investment securities 45,878 43,687 Portfolio loans: Commercial 1,749,122 1,535,451 Real estate mortgage 130,713 121,676 Installment 78,985 77,462 ------------ ------------ Total portfolio loans 1,958,820 1,734,589 Less allowance for loan losses (27,898) (23,238) ------------ ------------ Net portfolio loans 1,930,922 1,711,351 Premises and equipment 19,232 16,441 Accrued interest income 9,699 9,471 Goodwill and other intangibles 20,286 8,527 Other assets 28,920 28,351 ------------ ------------ TOTAL ASSETS $ 2,347,594 $ 2,044,006 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Noninterest-bearing $ 333,246 $ 272,593 Interest-bearing 1,684,805 1,467,792 ------------ ------------ Total deposits 2,018,051 1,740,385 Debt obligations 83,168 89,911 Accrued interest on deposits and other liabilities 15,628 14,244 ------------ ------------ Total liabilities 2,116,847 1,844,540 GUARANTEED PREFERRED BENEFICIAL INTERESTS IN THE CORPORATION'S SUBORDINATED DEBENTURES 51,567 48,621 MINORITY INTERESTS IN CONSOLIDATED SUBSIDIARIES 34,342 70,673 STOCKHOLDERS' EQUITY Common stock, no par value, 25,000,000 shares authorized; issued and outstanding: 2002 - 11,181,368 shares 2001 - 7,829,178 shares 124,022 67,692 Retained earnings 22,435 14,173 Market value adjustment (net of tax effect) for investment securities available for sale (accumulated other comprehensive income) 232 158 ------------ ------------ 146,689 82,023 Less note receivable from exercise of stock options and unallocated ESOP shares (1,851) (1,851) ------------ ------------ Total stockholders' equity 144,838 80,172 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,347,594 $ 2,044,006 ============ ============
Page 3 of 29 CAPITOL BANCORP LIMITED Consolidated Statements of Income (Unaudited) For the Three Months and Nine Months Ended September 30, 2002 and 2001 (in thousands, except per share data)
Three Months Ended Nine Months Ended September 30 September 30 ---------------------- ---------------------- 2002 2001 2002 2001 --------- --------- --------- --------- Interest income: Portfolio loans (including fees) $ 38,807 $ 36,682 $ 111,508 $ 108,190 Loans held for resale 535 984 1,769 2,218 Taxable investment securities 357 455 1,142 1,802 Federal funds sold and other 763 937 1,859 3,556 --------- --------- --------- --------- Total interest income 40,462 39,058 116,278 115,766 Interest expense: Deposits 12,113 16,361 36,121 51,441 Debt obligations and other 2,156 1,989 6,720 5,453 --------- --------- --------- --------- Total interest expense 14,269 18,350 42,841 56,894 --------- --------- --------- --------- Net interest income 26,193 20,708 73,437 58,872 Provision for loan losses 3,918 2,316 8,692 5,637 --------- --------- --------- --------- Net interest income after provision for loan losses 22,275 18,392 64,745 53,235 Noninterest income: Service charges on deposit accounts 1,041 836 2,980 2,356 Trust fee income 712 400 1,882 1,409 Fees from origination of non-portfolio residential mortgage loans 2,011 803 4,382 2,194 Realized gains (losses) on sale of investment securities available for sale 12 -- (6) 3 Other 377 343 1,137 1,032 --------- --------- --------- --------- Total noninterest income 4,153 2,382 10,375 6,994 Noninterest expense: Salaries and employee benefits 12,113 9,355 34,916 28,098 Occupancy 1,655 1,571 4,797 4,274 Equipment rent, depreciation and maintenance 1,052 1,170 3,396 3,320 Other 4,109 3,773 13,653 11,666 --------- --------- --------- --------- Total noninterest expense 18,929 15,869 56,762 47,358 --------- --------- --------- --------- Income before federal income taxes and minority interest 7,499 4,905 18,358 12,871 Federal income taxes 2,686 1,437 6,380 4,238 --------- --------- --------- --------- Income before minority interest 4,813 3,468 11,978 8,633 Minority interest in net income of consolidated subsidiaries (366) (696) (574) (878) --------- --------- --------- --------- NET INCOME $ 4,447 $ 2,772 $ 11,404 $ 7,755 ========= ========= ========= ========= NET INCOME PER SHARE -- Note C Basic $ 0.42 $ 0.35 $ 1.17 $ 1.00 ========= ========= ========= ========= Diluted $ 0.40 $ 0.35 $ 1.12 $ 0.98 ========= ========= ========= =========
Page 4 of 29 CAPITOL BANCORP LIMITED Consolidated Statements of Changes in Stockholders' Equity (Unaudited) For the Nine Months Ended September 30, 2002 and 2001 (in thousands except share data)
Note Receivable from Exercise of Stock Accumulated Options and Other Unallocated Common Retained Comprehensive ESOP Stock Earnings Income Shares Total --------- --------- --------- --------- --------- NINE MONTHS ENDED SEPTEMBER 30, 2001 Balances at January 1, 2001 $ 65,939 $ 6,569 $ (108) $ (1,996) $ 70,404 Proceeds from the sale of 130,000 shares of common stock and 32,500 warrants to purchase common stock 1,495 1,495 Issuance of 3,287 shares of common stock upon exercise of warrants 36 36 Issuance of 17,043 shares of common stock upon exercise of stock options 161 161 Cash dividends paid ($.30 per share) (2,328) (2,328) Components of comprehensive income: Net income for the period 7,755 7,755 Market value adjustment for investment securities available for sale (net of income tax effect) 379 379 --------- Comprehensive income for the period 8,134 --------- --------- --------- --------- --------- BALANCES AT SEPTEMBER 30, 2001 $ 67,631 $ 11,996 $ 271 $ (1,996) $ 77,902 ========= ========= ========= ========= ========= NINE MONTHS ENDED SEPTEMBER 30, 2002 Balances at January 1, 2002 $ 67,692 $ 14,173 $ 158 $ (1,851) $ 80,172 Issuance of common stock and stock options to acquire shares of Sun Community Bancorp held by shareholders other than Capitol 43,160 43,160 Issuance of common stock and stock options to acquire shares of Sunrise Capital Corporation held by shareholders other than Capitol 6,725 6,725 Issuance of restricted common stock and stock options to acquire shares of Indiana Community Bancorp held by shareholders other than Capitol 4,259 4,259 Issuance of 113,398 shares of common stock upon exercise of stock options 1,340 1,340 Issuance of 53,804 shares of common stock upon exercise of warrants 596 596 Issuance of 15,598 shares of restricted common stock in exchange for investment security 250 250 Cash dividends paid ($.32 per share) (3,142) (3,142) Components of comprehensive income: Net income for the period 11,404 11,404 Market value adjustment for investment securities available for sale (net of income tax effect) 74 74 --------- Comprehensive income for the period 11,478 --------- --------- --------- --------- --------- BALANCES AT SEPTEMBER 30, 2002 $ 124,022 $ 22,435 $ 232 $ (1,851) $ 144,838 ========= ========= ========= ========= =========
Page 5 of 29 CAPITOL BANCORP LTD. Consolidated Statements of Cash Flows (Unaudited) For the Nine Months Ended September 30, 2002 and 2001
2002 2001 --------- --------- (in thousands) OPERATING ACTIVITIES Net income $ 11,404 $ 7,755 Adjustments to reconcile net income to net cash provided (used) by operating activities: Provision for loan losses 8,692 5,637 Depreciation of premises and equipment 2,517 2,522 Amortization of goodwill and other intangibles 266 602 Net accretion of investment security discounts (33) (75) Loss (gain) on sale of premises and equipment (4) 106 Minority interest in net income of consolidated subsidiaries 574 878 Originations and purchases of loans held for resale (593,581) (444,502) Proceeds from sales of loans held for resale 590,572 423,505 Increase in accrued interest income and other assets (3,710) (4,506) Increase in accrued interest expense and other liabilities 1,384 3,037 --------- --------- NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES 18,081 (5,041) INVESTING ACTIVITIES Proceeds from sale of investment securities available for sale 6,477 500 Proceeds from calls, prepayments and maturities of investment securities 45,865 49,301 Purchases of investment securities (54,388) (24,098) Net increase in portfolio loans (228,263) (305,481) Proceeds from sales of premises and equipment 56 301 Purchases of premises and equipment (5,360) (4,976) --------- --------- NET CASH USED BY INVESTING ACTIVITIES (235,613) (284,453) FINANCING ACTIVITIES Net increase in demand deposits, NOW accounts and savings accounts 213,679 206,704 Net increase in certificates of deposit 63,987 79,891 Net borrowings from (payments on) debt obligations (6,743) 19,287 Resources provided by minority interests 8,386 3,729 Net proceeds from issuance of common stock 1,936 1,692 Net proceeds from issuance of trust-preferred securities 2,899 24,248 Cash dividends paid (3,142) (2,328) --------- --------- NET CASH PROVIDED BY FINANCING ACTIVITIES 281,002 333,223 --------- --------- INCREASE IN CASH AND CASH EQUIVALENTS 63,470 43,729 Cash and cash equivalents at beginning of period 163,691 142,784 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 227,161 $ 186,513 ========= =========
Page 6 of 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. NOTE A - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Capitol Bancorp Ltd. ("Capitol") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all information and footnotes necessary for a fair presentation of consolidated financial position, results of operations and cash flows in conformity with generally accepted accounting principles. The statements do, however, include all adjustments of a normal recurring nature (in accordance with Rule 10-01(b)(8) of Regulation S-X) which Capitol considers necessary for a fair presentation of the interim periods. The results of operations for the nine-month period ended September 30, 2002 are not necessarily indicative of the results to be expected for the year ending December 31, 2002. The consolidated balance sheet as of December 31, 2001 was derived from audited consolidated financial statements as of that date. Certain 2001 amounts have been reclassified to conform to the 2002 presentation. NOTE B - NEW BANKS AND OTHER BANK DEVELOPMENT ACTIVITIES Bank of Las Vegas, located in Las Vegas, Nevada, opened in February 2002. It is majority-owned by Nevada Community Bancorp Limited, which is a majority-owned subsidiary of Capitol. Napa Community Bank, located in Napa, California, opened in March 2002. It is majority-owned by First California Northern Bancorp, which is a majority-owned subsidiary of Capitol. Sunrise Bank of Arizona, a wholly-owned subsidiary of Sunrise Capital Corporation (a wholly-owned subsidiary of Capitol) has expanded its operations in 2002 through opening a private banking center in Scottsdale, Arizona and loan production offices in the states of California, Georgia and Texas. Bank development efforts are currently under consideration at September 30, 2002 in the states of California, Indiana and Michigan. Activities include pre-development exploratory discussions in a number of other states. Page 7 of 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. - CONTINUED NOTE C - NET INCOME PER SHARE The computations of basic and diluted earnings per share were as follows:
Three Months Ended Nine Months Ended September 30 September 30 ------------------------- ------------------------- 2002 2001 2002 2001 ----------- ----------- ----------- ----------- Numerator--net income for the period $ 4,447,000 $ 2,772,000 $11,404,000 $ 7,755,000 =========== =========== =========== =========== Denominator: Weighted average number of common shares outstanding (denominator for basic earnings per share) 10,713,287 7,822,606 9,776,774 7,769,316 Effect of dilutive securities--stock options and warrants 525,301 197,753 420,179 151,008 ----------- ----------- ----------- ----------- Denominator for dilutive net income per share-- Weighted average number of common shares and potential dilution 11,238,588 8,020,359 10,196,953 7,920,324 =========== =========== =========== =========== Number of antidilutive stock options excluded from diluted earnings per share computation 160,637 121,665 249,849 158,190 =========== =========== =========== ===========
NOTE D - SHARE EXCHANGE TRANSACTIONS Share exchange transactions regarding Sunrise Capital Corporation (Sunrise) and Indiana Community Bancorp Limited (Indiana) were completed effective September 30, 2002. An earlier share exchange transaction regarding Sun Community Bancorp Limited (Sun) was completed effective March 31, 2002. In each transaction, the shares acquired from shareholders other than Capitol were exchanged for Capitol's common stock according to a fixed, but differing, exchange ratio. To the extent those subsidiaries had stock options outstanding, such stock options were similarly exchanged for stock options of Capitol. Capitol's common shares issued in the Sun and Sunrise share exchanges are unrestricted; shares issued in the Indiana exchange have resale and transfer restrictions which expire in 2004. In total, Capitol has issued approximately 3.2 million shares of its common stock and 1.1 million stock options resulting from these share exchanges (for aggregate consideration approximating $54.1 million), of which about 450,000 shares were issued effective September 30, 2002. These transactions have been recorded using the purchase-method of accounting. Had these transactions occurred at the beginning of the periods presented, net income would have approximated $11.7 million ($1.01 per diluted share) and $7.9 million ($.71 per diluted share) for the nine months ended September 30, 2002 and 2001, respectively. Page 8 of 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. - CONTINUED NOTE D - SHARE EXCHANGE TRANSACTIONS - CONTINUED Sun, Sunrise and Indiana were previously included in Capitol's consolidated financial statements. The carrying value of assets and liabilities of those entities closely approximated their fair values at the date of the share exchanges with Capitol. Identified intangible assets (principally core deposit intangibles relating to the Sun share exchange) were estimated to approximate $2.7 million, and are being amortized over a period of approximately five years. Additionally, goodwill of approximately $9.4 million was recorded in conjunction with the share exchanges and will not be amortized, but will be reviewed at least annually for impairment (see Note E). As of September 30, 2002, potential share exchange transactions were pending regarding the minority shareholders of Detroit Commerce Bank and East Valley Community Bank which, if completed, would result in Capitol issuing approximately 54,000 additional shares of common stock and those majority-owned subsidiaries becoming wholly-owned. NOTE E - IMPACT OF NEW ACCOUNTING STANDARDS In July 2001, the Financial Accounting Standards Board issued Statement No. 141, BUSINESS COMBINATIONS, and No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. Statement No. 141 requires that all business combinations be accounted for under a prior standard of purchase accounting, eliminating the so-called pooling-method which was used to account for some business combinations. This standard did not have a material effect on Capitol's consolidated financial statements. Statement No. 142 requires that goodwill no longer be amortized and charged against earnings, but instead be reviewed for impairment. Amortization of goodwill ceased upon adoption of the Statement on January 1, 2002. This new standard requires that goodwill be reviewed annually for impairment and, accordingly, impairment adjustments of goodwill be charged against earnings, if and when determined. Capitol's previous business combinations (generally, acquisitions of minority interests) have been accounted for using the purchase method. As of September 30, 2002, the net carrying amount of reporting-unit goodwill approximated $17.9 million and other intangible assets approximated $2.4 million. Upon implementation, this new standard has not had a material effect on Capitol's consolidated financial statements, other than the elimination of goodwill amortization. Page 9 of 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. - CONTINUED NOTE E - IMPACT OF NEW ACCOUNTING STANDARDS - CONTINUED Statement No. 142 requires that intangible assets not subject to amortization, such as Capitol's reporting-unit goodwill, be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Such potential impairment is measured by comparing the fair value of a reporting unit with its carrying amount within the consolidated group. When goodwill is reviewed for potential impairment, impairment losses must be charged against earnings if and when determined. Substantially all of Capitol's recorded reporting-unit goodwill relates to acquisitions of minority interests in consolidated subsidiaries. Such acquisitions have been made at modest premiums in relation to the underlying fair value of net assets when acquired. Based on management's review of recorded reporting-unit goodwill at the transition date for Statement No. 142, January 1, 2002, no impairment losses were identified as of that date. Paragraph 61 of Statement No. 142 requires supplemental disclosure of historical information, as adjusted to exclude amortization of goodwill no longer being amortized, which is summarized below (in $1,000s except per share amounts):
Periods Ended September 30, 2001 Year Ended December 31 ------------------------- --------------------------------------- Three Months Nine Months 2001 2000 1999(1) ------------ ----------- ----------- ----------- ----------- Net income, as reported $ 2,772 $ 7,755 $ 10,718 $ 8,035 $ 5,409 Add back -- goodwill amortization 216 602 979 561 318 ----------- ----------- ----------- ----------- ----------- Net income, as adjusted $ 2,988 $ 8,357 $ 11,697 $ 8,596 $ 5,727 =========== =========== =========== =========== =========== Net income per share, as reported: Basic $ 0.35 $ 1.00 $ 1.38 $ 1.14 $ 0.84 =========== =========== =========== =========== =========== Diluted $ 0.35 $ 0.98 $ 1.35 $ 1.13 $ 0.83 =========== =========== =========== =========== =========== Add back -- goodwill amortization per share: Basic $ 0.03 $ 0.08 $ 0.12 $ 0.08 $ 0.05 =========== =========== =========== =========== =========== Diluted $ 0.02 $ 0.08 $ 0.12 $ 0.08 $ 0.05 =========== =========== =========== =========== =========== Net income per share, as adjusted: Basic $ 0.38 $ 1.08 $ 1.50 $ 1.22 $ 0.89 =========== =========== =========== =========== =========== Diluted $ 0.37 $ 1.06 $ 1.47 $ 1.21 $ 0.88 =========== =========== =========== =========== ===========
(1) Including cumulative effect of change in accounting principle, which required write-off of previously capitalized start-up costs as of January 1, 1999 ($197, net of income tax effect, or $.03 per share). Page 10 of 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. - CONTINUED NOTE E - IMPACT OF NEW ACCOUNTING STANDARDS - CONTINUED Statement No. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS, becomes effective January 1, 2003. Management has not completed its analysis of this new standard; however, implementation of this new standard is not expected to have a material impact on Capitol's consolidated financial statements. Statement No. 144, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, became effective on January 1, 2002. This new standard did not have a material impact on Capitol's consolidated financial statements. Statement No. 145, which updates, clarifies and simplifies certain existing accounting pronouncements (rescission of Statements No. 4, 44 and 64, amendment of Statement No. 13 and technical corrections) beginning at various dates in 2002/2003 is not expected to have a material effect on Capitol's consolidated financial statements. Statement No. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES, becomes effective January 1, 2003. Management has not completed its analysis of this new standard; however, it is not expected to have a material impact on Capitol's consolidated financial statements, upon implementation. Statement No. 147, ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS, amends prior standards relating to some acquisitions of financial institutions, requiring such transactions to be accounted for in accordance with Statements No. 141 and 142 and is generally effective October 1, 2002. Management has not completed its analysis of this new standard; however, it is not expected to have a material effect on Capitol's consolidated financial statements, upon implementation. A variety of proposed or otherwise potential accounting standards are currently under study by standard-setting organizations and various regulatory agencies. Because of the tentative and preliminary nature of these proposed standards, management has not determined whether implementation of such proposed standards would be material to Capitol's consolidated financial statements. Page 11 of 29 PART I, ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Total assets approximated $2.3 billion at September 30, 2002, an increase of $304 million from the December 31, 2001 level of $2.0 billion. The balance sheet includes Capitol and its consolidated subsidiaries: Total Assets (in $1,000's) -------------------------- Sept 30 Dec 31 2002 2001 ----------- ----------- Great Lakes Region: Ann Arbor Commerce Bank $ 310,263 $ 271,116 Brighton Commerce Bank 77,834 70,530 Capitol National Bank 200,824 173,177 Detroit Commerce Bank 30,250 33,768 Grand Haven Bank 119,008 98,740 Kent Commerce Bank 72,992 66,873 Macomb Community Bank 86,072 97,113 Muskegon Commerce Bank 85,301 74,284 Oakland Commerce Bank 119,755 115,249 Paragon Bank & Trust 103,947 93,667 Portage Commerce Bank 138,170 127,884 Indiana Community Bancorp Limited: Elkhart Community Bank 47,875 35,939 Goshen Community Bank 36,907 28,681 ----------- ----------- Great Lakes Region Total 1,429,198 1,287,021 Southwestern Region: Arrowhead Community Bank 43,557 33,658 Bank of Tucson 128,665 121,075 Camelback Community Bank 78,439 67,210 East Valley Community Bank 35,490 39,591 Mesa Bank 58,305 52,308 Southern Arizona Community Bank 76,169 55,423 Valley First Community Bank 42,276 58,625 Yuma Community Bank 37,336 23,202 Nevada Community Bancorp Limited: Bank of Las Vegas(2) 23,486 n/a Black Mountain Community Bank 59,857 50,909 Desert Community Bank 56,488 56,844 Red Rock Community Bank 103,498 84,971 Sunrise Capital Corporation: Sunrise Bank of Albuquerque 44,017 35,984 Sunrise Bank of Arizona 75,411 63,141 ----------- ----------- Southwestern Region Total 862,994 742,941 California Region: Sunrise Bank of San Diego(1) 53,951 37,912 First California Northern Bancorp: Napa Community Bank(2) 29,855 n/a ----------- ----------- California Region Total 83,806 37,912 Other, net (28,404) (23,868) ----------- ----------- Consolidated $ 2,347,594 $ 2,044,006 =========== =========== n/a Not applicable (1) Commenced operations as a DE NOVO bank in 2001. Sunrise Bank of San Diego is a majority-owned subsidiary of Sunrise Capital Corporation. (2) Commenced operations as DE NOVO banks in 2002. Page 12 of 29 Portfolio loans increased during the nine-month 2002 period by approximately $224 million. Loan growth was funded primarily by higher levels of time deposits. The majority of portfolio loan growth occurred in commercial loans, consistent with the banks' emphasis on commercial lending activities. Portfolio loan growth in 2002 is net of about $51 million of commercial loans sold to other financial institutions. The allowance for loan losses at September 30, 2002 approximated $28 million or 1.42% of total portfolio loans, an increase from the year-end 2001 ratio of 1.34%. The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses inherent in the loan portfolio at the balance sheet date. Management's determination of the adequacy of the allowance is based on evaluation of the portfolio (including potential impairment of individual loans and concentrations of credit), past loss experience, current economic conditions, volume, amount and composition of the loan portfolio, loan commitments outstanding and other factors. The allowance is increased by provisions charged to operations and reduced by net charge-offs. The table below summarizes portfolio loan balances and activity in the allowance for loan losses for the interim periods (in thousands): 2002 2001 ---------- ---------- Allowance for loan losses at January 1 $ 23,238 $ 17,449 Loans charged-off: Commercial 4,079 1,269 Real estate mortgage 204 42 Installment 206 301 ---------- ---------- Total charge-offs 4,489 1,612 Recoveries: Commercial 318 314 Real estate mortgage 61 36 Installment 78 25 ---------- ---------- Total recoveries 457 375 ---------- ---------- Net charge-offs 4,032 1,237 Additions to allowance charged to expense 8,692 5,637 ---------- ---------- Allowance for loan losses at September 30 $ 27,898 $ 21,849 ========== ========== Average total portfolio loans for period ended September 30 $1,847,149 $1,513,528 ========== ========== Ratio of net charge-offs (annualized) to average portfolio loans outstanding 0.29% 0.11% ========== ========== Page 13 of 29 Net charge-offs of loans increased $2.8 million in 2002, compared to the nine-month period in 2001. Of that increase, $1.4 million occurred during the quarter ended September 30, 2002, mainly due to losses associated with loans secured by business equipment and accounts receivable. Loan charge-offs have increased throughout 2002. The amounts of the allowance for loan losses allocated in the following table (in thousands) include all loans for which, based on Capitol's loan rating system, management has concerns, and should not be interpreted as an indication of future charge-offs.
September 30, 2002 December 31, 2001 ---------------------- ---------------------- Percentage Percentage of Total of Total Portfolio Portfolio Amount Loans Amount Loans ---------- ---------- ---------- ---------- Commercial $ 26,167 1.34% $ 20,570 1.19% Real estate mortgage 185 0.01 1,630 0.09 Installment 1,546 0.07 1,038 0.06 ---------- ----- ---------- ----- Total allowance for loan losses $ 27,898 1.42% $ 23,238 1.34% ========== ===== ========== ===== Total portfolio loans outstanding $1,958,820 $1,734,589 ========== ==========
In addition to the allowance for loan losses, certain commercial loans in Michigan and Indiana are enrolled in state-sponsored loan programs and have additional reserves established to provide for loss protection. At September 30, 2002, total loans under these programs approximated $32 million. Reserves related to these loans, which are represented by earmarked funds on deposit at some of the bank subsidiaries, approximated $1.1 million and are not included in the allowance for loan losses. The state agency administering the Michigan program has announced plans to terminate its program. Upon termination of the program, loans previously enrolled in the program and related reserves will continue until the underlying loans are repaid, but no new loans will be enrolled in the program. While this program has complimented the lending efforts of Capitol's Michigan banks, termination of the program is not expected to have a material adverse affect on those banks' lending activities in the future. The termination of the program may adversely affect the future availability of credit for those borrowers who otherwise would have been eligible for enrollment in the program. Page 14 of 29 Nonperforming loans (i.e., loans which are 90 days or more past due and loans on nonaccrual status) are summarized below (in thousands): Sept 30 Dec 31 2002 2001 -------- -------- Nonaccrual loans: Commercial $ 16,198 $ 11,220 Real estate 986 356 Installment 682 466 -------- -------- Total nonaccrual loans 17,866 12,042 Past due (>=90 days) loans: Commercial 6,721 4,290 Real estate 1,444 787 Installment 270 119 -------- -------- Total past due loans 8,435 5,196 -------- -------- Total nonperforming loans $ 26,301 $ 17,238 ======== ======== Nonperforming loans increased approximately $9 million during the nine-month period ended September 30, 2002. Of the nonperforming loans at September 30, 2002, about 70% are real estate secured. Those loans, when originated, had appropriate loan-to-value ratios and, accordingly, have loss exposure which is expected to be minimal; however, underlying real estate values depend upon current economic conditions and liquidation strategies. Most other nonperforming loans are generally secured by other business assets. Nonperforming loans at September 30, 2002 are in various stages of resolution for which management believes such loans are adequately collateralized or otherwise appropriately considered in its determination of the adequacy of the allowance for loan losses. In addition to the identification of nonperforming loans involving borrowers with payment performance difficulties (i.e., nonaccrual loans and loans past-due 90 days or more), management utilizes an internal loan review process to identify other potential problem loans which may warrant additional monitoring or other attention. This loan review process is a continuous activity which periodically updates internal loan ratings. At inception, all loans are individually assigned a rating which grades the credits on a risk basis, based on the type and discounted value of collateral, financial strength of the borrower and guarantors and other factors such as nature of the borrower's business climate, local economic conditions and other subjective factors. The loan rating process is fluid and subjective. Potential problem loans include loans which are generally performing as agreed; however, because of loan review's and/or lending staff's risk assessment, increased monitoring is deemed appropriate. In addition, some loans are assigned a more adverse classification, with specific performance issues or other risk factors requiring close management and development of specific remedial action plans. Page 15 of 29 At September 30, 2002, potential problem loans (including the previously mentioned nonperforming loans) approximated $93 million, or about 5% of total consolidated portfolio loans. These potential problem loans do not necessarily have significant loss exposure (nor are they necessarily deemed `impaired'), but rather are classified by management in this manner to aid in loan administration and risk management. Management believes such loans to be adequately considered in its evaluation of the adequacy of the allowance for loan losses. Management believes, however, that current general economic conditions may result in higher levels of future loan losses, in comparison to previous years, as evidenced by higher loan losses in the interim 2002 period. Other real estate owned (generally real estate acquired through foreclosure or a deed in lieu of foreclosure and classified as a component of other assets) approximated $3.7 million at September 30, 2002 and $3.0 million at December 31, 2001. The majority of these properties had sale offers pending at September 30, 2002. The following comparative analysis summarizes each bank's total portfolio loans, allowance for loan losses, nonperforming loans and ratio of the allowance as a percentage of portfolio loans (dollars in thousands):
Allowance as a Percentage Total Allowance for Nonperforming of Total Portfolio Loans Loan Losses Loans Portfolio Loans ----------------------- ----------------------- ----------------------- --------------- Sept 30 Dec 31 Sept 30 Dec 31 Sept 30 Dec 31 Sept 30 Dec 31 2002 2001 2002 2001 2002 2001 2002 2001 ---------- ---------- ---------- ---------- ---------- ---------- ------- ------ Great Lakes Region: Ann Arbor Commerce Bank $ 271,217 $ 233,920 $ 3,810 $ 3,219 $ 3,743 $ 1,960 1.40% 1.38% Brighton Commerce Bank 66,227 60,984 822 732 227 227 1.24 1.20 Capitol National Bank 152,402 144,485 2,212 1,983 1,597 465 1.45 1.37 Detroit Commerce Bank 28,666 29,243 463 351 669 539 1.62 1.20 Grand Haven Bank 109,980 89,989 1,548 1,212 1,503 1,234 1.41 1.35 Kent Commerce Bank 69,317 63,782 853 766 362 55 1.23 1.20 Macomb Community Bank 70,685 79,844 1,083 1,088 2,265 1,431 1.53 1.36 Muskegon Commerce Bank 78,152 70,151 977 842 1,439 123 1.25 1.20 Oakland Commerce Bank 82,861 81,711 997 1,063 2,623 406 1.20 1.30 Paragon Bank & Trust 87,238 81,430 1,131 1,018 3,240 586 1.30 1.25 Portage Commerce Bank 125,947 109,393 1,700 1,550 3,208 2,845 1.35 1.42 Indiana Community Bancorp Limited: Elkhart Community Bank 40,670 31,492 611 473 420 222 1.50 1.50 Goshen Community Bank(1) 33,299 22,966 500 345 -- -- 1.50 1.50 ---------- ---------- ---------- ---------- ---------- ---------- Great Lakes Region Total 1,216,661 1,099,390 16,707 14,642 21,296 10,093 Southwestern Region: Arrowhead Community Bank(1) 35,595 30,430 534 457 72 -- 1.50 1.50 Bank of Tucson 93,735 88,218 1,500 1,224 421 407 1.60 1.39 Camelback Community Bank 66,836 56,555 877 743 96 334 1.31 1.31 East Valley Community Bank 26,797 27,402 389 423 121 432 1.45 1.54 Mesa Bank 54,213 45,672 797 594 456 542 1.47 1.30 Southern Arizona Community Bank 59,321 50,879 867 662 241 298 1.46 1.30 Valley First Community Bank 34,170 41,851 619 670 331 1,018 1.81 1.60 Yuma Community Bank(1) 24,158 18,539 363 285 -- -- 1.50 1.54 Nevada Community Bancorp Limited: Bank of Las Vegas(1) 16,506 n/a 248 n/a -- n/a 1.50 n/a Black Mountain Community Bank(1) 52,257 40,111 784 602 144 240 1.50 1.50 Desert Community Bank 42,818 50,361 694 806 447 989 1.62 1.60 Red Rock Community Bank(1) 80,446 67,117 1,352 1,008 1,791 942 1.68 1.50 Sunrise Capital Corporation: Sunrise Bank of Albuquerque(1) 34,919 28,061 472 379 292 614 1.35 1.35 Sunrise Bank of Arizona 60,448 55,730 817 753 593 1,329 1.35 1.35 ---------- ---------- ---------- ---------- ---------- ---------- Southwestern Region Total 682,219 600,926 10,313 8,606 5,005 7,145 California Region: Sunrise Bank of San Diego(1) 42,738 32,910 577 455 -- -- 1.35 1.38 First California Northern Bancorp: Napa Community Bank(1) 13,695 n/a 206 n/a -- n/a 1.50 n/a ---------- ---------- ---------- ---------- ---------- ---------- California Region Total 56,433 32,910 783 455 -- -- Other, net 3,507 1,363 95 (465) ---------- ---------- ---------- ---------- ---------- ---------- ----- ----- Consolidated $1,958,820 $1,734,589 $ 27,898 $ 23,238 $ 26,301 $ 17,238 1.42% 1.34% ========== ========== ========== ========== ========== ========== ===== =====
n/a Not applicable (1) As a condition of charter approval, bank is required to maintain an allowance for loan losses of not less than 1% for the first three years of operations. Page 16 of 29 RESULTS OF OPERATIONS Net income for the quarter ended September 30, 2002, was $4.4 million, an increase of $1.7 million or 60% over the same period last year. Diluted earnings per share were $0.40 compared to $0.35 for the prior year period. Net income for the nine-month 2002 period was $11.4 million ($1.12 per diluted share), a 47% increase from $7.8 million ($0.98 per diluted share) in the comparable period of 2001. The percentage increase in net income per share was less than the percentage increase in the amount of net income in 2002 because of the larger share base resulting from Capitol's share exchange regarding Sun Community Bancorp effective March 31, 2002. The share exchange transactions regarding Sunrise Capital Corporation and Indiana Community Bancorp, which are discussed elsewhere in this narrative, had no significant effect on results of operations for the interim 2002 periods inasmuch as those share exchange transactions were consummated effective September 30, 2002. Net interest income for the third quarter of 2002 totaled $26.2 million, a 26% increase as compared to $20.7 million for the comparable period in 2001. Net interest income for the nine-month 2002 period was $73.4 million, compared to $58.9 million for the same period in 2001, an increase of 25% during the nine-month period versus 22% in the corresponding period of 2001. These increases are attributable to the expansion in number of banks, the banks' growth and a stable interim 2002 interest rate environment. Noninterest income for the quarter ended September 30, 2002 was $4.2 million, an increase of $1.8 million, or 74%, over the same period in 2001. On a year-to-date basis, noninterest income totaled $10.4 million in 2002, compared to $7.0 million in 2001. Fees from origination of non-portfolio residential mortgage loans totaled $2 million for the third quarter of 2002, and were $4.4 million for the nine-month period, as compared to $803,000 and $2.2 million for the comparable periods in 2001, respectively, due to higher loan volume resulting from lower interest rates. Service charges on deposit accounts and trust fee income both increased in the third quarter of 2002 by 42% on a combined basis, compared to 2001. Service charges on deposits and trust fee income totaled $3 million and $1.9 million, respectively, for the nine-month period in 2002, as compared to $2.4 million and $1.4 million, respectively, in 2001. Increases in service charges on deposit accounts and trust fee income in 2002 resulted from increased transaction volume. The provision for loan losses for the third quarter of 2002 was $3.9 million as compared to $2.3 million during the corresponding 2001 period. The loan loss provision for the nine-month 2002 period was $8.7 million, compared to $5.6 million in 2001. Increases in the provision for loan losses are principally related to higher levels of loan charge-offs, increases in nonperforming loans and aggregate loan growth. The provision for loan losses is based upon management's analysis of the adequacy of the allowance for loan losses, as previously discussed. Noninterest expense totaled $18.9 million for the third quarter, and $56.8 million for the nine-month period in 2002, as compared to $15.9 million and $47.4 million, respectively, for the comparable periods in 2001. The increase in noninterest expense is associated with newly formed banks, growth and increases in general operating costs. Increases in both occupancy and salaries and employee benefits relate primarily to the growth in the number of banks within the consolidated group. Page 17 of 29 Operating results (dollars in thousands) were as follows:
Nine months ended September 30 -------------------------------------------------------------------------------------------- Return on Return on Total Revenues Net Income Average Equity Average Assets ---------------------- ---------------------- ------------------ ------------------ 2002 2001 2002 2001 2002 2001 2002 2001 --------- --------- --------- --------- ------- ------- ------- ------- Great Lakes Region: Ann Arbor Commerce Bank $ 17,041 $ 17,586 $ 3,670 $ 3,075 22.23% 22.21% 1.71% 1.64% Brighton Commerce Bank 4,204 4,217 679 407 14.46 9.74 1.21 .83 Capitol National Bank 9,670 10,074 2,307 1,914 22.28 21.96 1.69 1.64 Detroit Commerce Bank 1,752 2,001 (275) (155) n/a n/a n/a n/a Grand Haven Bank 6,774 5,799 1,454 764 21.26 15.60 1.72 1.21 Kent Commerce Bank 4,378 3,431 745 (15) 14.09 n/a 1.33 n/a Macomb Community Bank 4,441 6,582 438 823 8.25 11.96 .91 1.02 Muskegon Commerce Bank 4,829 4,716 1,038 545 14.46 11.93 1.21 1.07 Oakland Commerce Bank 5,502 6,688 1,034 1,013 15.76 17.30 1.35 1.30 Paragon Bank & Trust 6,132 6,258 664 127 9.47 2.40 .90 .20 Portage Commerce Bank 7,800 8,549 1,441 1,230 18.09 16.79 1.50 1.27 Indiana Community Bancorp Limited: Elkhart Community Bank 2,093 1,833 163 (29) 4.65 n/a .54 n/a Goshen Community Bank 1,663 788 75 (322) 2.28 n/a .30 n/a --------- --------- --------- --------- Great Lakes Region Total 76,279 78,522 13,433 9,377 Southwestern Region: Arrowhead Community Bank 2,485 1,174 64 (359) 2.33 n/a .26 n/a Bank of Tucson 7,439 7,873 1,688 1,609 21.62 23.63 1.82 2.00 Camelback Community Bank 4,461 3,770 449 325 8.39 9.58 .77 .81 East Valley Community Bank 2,061 2,509 (275) (35) n/a n/a n/a n/a Mesa Bank 3,718 3,168 579 302 13.46 9.35 1.34 .95 Southern Arizona Community Bank 3,658 3,067 459 200 10.03 6.62 .89 .58 Valley First Community Bank 2,793 3,677 127 354 2.99 8.64 .33 .86 Yuma Community Bank 1,874 825 63 (356) 2.33 n/a .26 n/a Nevada Community Bancorp Limited: Bank of Las Vegas(2) 774 n/a (535) n/a n/a n/a n/a n/a Black Mountain Community Bank 2,869 2,383 235 (12) 6.74 n/a .61 n/a Desert Community Bank 3,260 3,261 129 100 3.44 2.97 .29 .29 Red Rock Community Bank 5,032 4,233 734 542 10.94 8.77 1.08 1.17 Sunrise Capital Corporation: Sunrise Bank of Albuquerque 2,054 2,169 (61) 64 n/a 2.32 n/a .27 Sunrise Bank of Arizona 4,567 4,912 65 472 1.41 11.78 .13 .97 --------- --------- --------- --------- Southwestern Region Total 47,045 43,021 3,721 3,206 California Region: Sunrise Bank of San Diego(1) 2,971 1,740 250 (833) 4.55 n/a .75 n/a First California Northern Bancorp: Napa Community Bank(2) 816 n/a (535) n/a n/a n/a n/a n/a --------- --------- --------- --------- California Region Total 3,787 1,740 (285) (833) Other, net (458) (523) (5,465) (3,995) n/a n/a n/a n/a --------- --------- --------- --------- ------ ------ ----- ----- Consolidated $ 126,653 $ 122,760 $ 11,404 $ 7,755 13.78% 14.82% .70% .57% ========= ========= ========= ========= ====== ====== ===== =====
n/a Not applicable (1) Commenced operations as a DE NOVO bank in 2001. (2) Commenced operations as DE NOVO banks in 2002. LIQUIDITY AND CAPITAL RESOURCES The principal funding source for asset growth and loan origination activities is deposits. Total deposits increased $278 million for the nine-month 2002 period, slightly less than the $287 million increase in the corresponding period of 2001. Growth occurred in all deposit categories, with the majority coming from time deposits. The banks generally do not rely on brokered deposits as a key funding source; brokered deposits approximated $193 million as of September 30, 2002, or about 10% of total deposits, an increase of $50 million during the interim 2002 period. Brokered deposits, as a funding source, have increased in recent periods due to competitive environments and selective opportunities to grow deposits at a faster pace and/or lower cost than traditional sources, and may similarly increase in future periods. Page 18 of 29 Noninterest-bearing deposits approximated 17% of total deposits at September 30, 2002 and 16% at December 31, 2001. Levels of noninterest-bearing deposits fluctuate based on customers' transaction activity. Interim 2002 deposit growth was deployed primarily into commercial loans, consistent with the banks' emphasis on commercial lending activities. Cash and cash equivalents amounted to $227 million or 10% of total assets at September 30, 2002 as compared with $164 million or 8% of total assets at December 31, 2001. As liquidity levels vary continuously based on customer activities, amounts of cash and cash equivalents can vary widely at any given point in time. Management believes the banks' liquidity position at September 30, 2002 is adequate to fund loan demand and meet depositor needs. In addition to cash and cash equivalents, a source of long-term liquidity is the banks' marketable investment securities. Liquidity needs have not historically necessitated the sale of investments in order to meet funding requirements. The banks have not engaged in active trading of their investments. At September 30, 2002, the banks had approximately $38 million of investment securities classified as available for sale which can be utilized to meet various liquidity needs as they arise. Some of the banks have secured lines of credit with a Federal Home Loan Bank. Borrowings thereunder approximated $69.8 million and additional borrowing capacity approximated $11.2 million at September 30, 2002. These borrowings increased ($6.6 million in the interim periods of 2002) as a lower-cost funding source versus various rates and maturities of time deposits. At September 30, 2002, Capitol had unused lines of credit from an unrelated financial institution aggregating $15 million. Share exchange transactions regarding Sunrise Capital Corporation (Sunrise) and Indiana Community Bancorp Limited (Indiana) were completed effective September 30, 2002. An earlier share exchange transaction regarding Sun Community Bancorp Limited (Sun) was completed effective March 31, 2002. In each transaction, the shares acquired from shareholders other than Capitol were exchanged for Capitol's common stock according to a fixed, but differing, exchange ratio. To the extent those subsidiaries had stock options outstanding, such stock options were similarly exchanged for stock options of Capitol. Capitol's common shares issued in the Sun and Sunrise share exchanges are unrestricted; shares issued in the Indiana exchange have resale and transfer restrictions which expire in 2004. In total, Capitol has issued approximately 3.2 million shares of its common stock and 1.1 million stock options resulting from these share exchanges (for aggregate consideration approximating $54.1 million), of which about 450,000 shares were issued effective September 30, 2002. These transactions have been recorded using the purchase-method of accounting. Had these transactions occurred at the beginning of the periods presented, net income would have approximated $11.7 million ($1.01 per diluted share) and $7.9 million ($.71 per diluted share) for the nine months ended September 30, 2002 and 2001, respectively. Page 19 of 29 As of September 30, 2002, potential share exchange transactions were pending regarding the minority shareholders of Detroit Commerce Bank and East Valley Community Bank which, if completed, would result in Capitol issuing approximately 54,000 additional shares of common stock and those majority-owned subsidiaries becoming wholly-owned. Capitol and its banks are subject to complex regulatory capital requirements, which require maintaining certain minimum capital ratios. These ratio measurements, in addition to certain other requirements, are used by regulatory agencies to determine the level of regulatory intervention and enforcement applied to financial institutions. Management believes Capitol and each of its banks are in compliance with regulatory requirements and are expected to maintain such compliance. Stockholders' equity, as a percentage of total assets, approximated 6.2% at September 30, 2002 and increased from 3.9% at the beginning of the year, primarily as a result of the previously-mentioned share exchanges regarding Sun, Sunrise and Indiana. Total capital funds (Capitol's stockholders' equity, plus minority interests in consolidated subsidiaries, plus guaranteed preferred beneficial interests in the Corporation's subordinated debentures) aggregated $230.7 million or 10% of total assets at September 30, 2002. Capitol's operating strategy continues to be focused on the ongoing growth and maturity of its existing banks, coupled with new bank expansion in selected markets as opportunities arise. Accordingly, Capitol may invest in, acquire or otherwise develop additional banks in future periods, subject to economic conditions and other factors, although the timing of such additional banking units, if any, is uncertain. Such future new banks and/or additions of other operating units could be either wholly-owned, majority-owned or otherwise controlled by Capitol. TRENDS AFFECTING OPERATIONS One of the most significant trends which can impact the financial condition and results of operations of financial institutions are changes in market rates of interest. Changes in interest rates, either up or down, have an impact on net interest income (plus or minus), depending on the direction and timing of such changes. At any point in time, there is an imbalance between interest rate-sensitive assets and interest rate-sensitive liabilities. This means that when interest rates change, the timing and magnitude of the effect of such interest rate changes can alter the relationship between asset yields and the cost of funds. During 2001, the Open Market Committee of the Federal Reserve Board decreased interbank interest rates on numerous separate dates, for an unprecedented decrease of 475 basis points during the year. In the first nine months of 2002, interest rates have remained relatively stable. Page 20 of 29 Because variable rate loans reprice more rapidly than interest-bearing deposits, such market interest rate decreases compressed net interest margins at Capitol's banks in 2001. In 2002, however, a more stable interest rate environment has favorably impacted net interest margins at Capitol's banks from interest-bearing deposits repricing at lower rates. As the Open Market Committee continues to influence interest rates and other economic policy during the remainder of 2002, including the potential of rate increases (or decreases), net interest margins may become more compressed (having an adverse impact on earnings) in future periods. Start-up banks generally incur operating losses during their early periods of operations. Recently-formed start-up banks are expected to detract from consolidated earnings performance and start-up banks formed in 2002 and beyond will similarly negatively impact short-term profitability. General economic conditions also have a significant impact on both the results of operations and the financial condition of financial institutions. Media reports of raising questions about the health of the domestic economy have continued in 2002. In 2002, nonperforming loans have increased and it is anticipated that levels of nonperforming loans and related loan losses may increase as economic conditions, locally and nationally, evolve. IMPACT OF NEW ACCOUNTING STANDARDS In July 2001, the Financial Accounting Standards Board issued Statement No. 141, BUSINESS COMBINATIONS, and No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. Statement No. 141 requires that all business combinations be accounted for under a prior standard of purchase accounting, eliminating the so-called pooling-method which was used to account for some business combinations. This standard did not have a material effect on Capitol's consolidated financial statements. Statement No. 142 requires that goodwill no longer be amortized and charged against earnings, but instead be reviewed for impairment. Amortization of goodwill ceased upon adoption of the Statement on January 1, 2002. This new standard requires that goodwill be reviewed annually for impairment and, accordingly, impairment adjustments of goodwill be charged against earnings, if and when determined. Capitol's previous business combinations (generally, acquisitions of minority interests) have been accounted for using the purchase method. As of September 30, 2002, the net carrying amount of goodwill approximated $17.9 million and other intangible assets approximated $2.4 million. Upon implementation, this new standard did not have a material effect on Capitol's consolidated financial statements, other than the elimination of goodwill amortization (such amortization approximated $602,000 for the nine months ended September 30, 2001). Page 21 of 29 Statement No. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS, becomes effective January 1, 2003. Management has not completed its analysis of this new standard; however, implementation of this new standard is not expected to have a material impact on Capitol's consolidated financial statements. Statement No. 144, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, became effective on January 1, 2002. This new standard did not have a material impact on Capitol's consolidated financial statements. Statement No. 145, which updates, clarifies and simplifies certain existing accounting pronouncements (rescission of Statements No. 4, 44 and 64, amendment of Statement No. 13 and technical corrections) beginning at various dates in 2002/2003 is not expected to have a material effect on Capitol's consolidated financial statements. Statement No. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES, becomes effective January 1, 2003. Management has not completed its analysis of this new standard; however, it is not expected to have a material impact on Capitol's consolidated financial statements, upon implementation. Statement No. 147, ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS, amends prior standards relating to some acquisitions of financial institutions, requiring such transactions to be accounted for in accordance with Statements No. 141 and 142 and is generally effective October 1, 2002. Management has not completed its analysis of this new standard; however, it is not expected to have a material effect on Capitol's consolidated financial statements, upon implementation. A variety of proposed or otherwise potential accounting standards are currently under study by standard-setting organizations and various regulatory agencies. Because of the tentative and preliminary nature of these proposed standards, management has not determined whether implementation of such proposed standards would be material to Capitol's consolidated financial statements. CRITICAL ACCOUNTING POLICIES In May 2002, the Securities and Exchange Commission proposed significant changes in disclosure rules applicable to public companies. One of those proposed significant changes involves the identification of "critical accounting policies". Capitol's significant accounting policies are described in the financial section of its 2001 Annual Report. In the circumstances of Capitol, management believes its "critical accounting policies" are those which encompass the allowance for loan losses (due to the inherent subjectivity in estimating loan losses), accounting for income taxes (due to the significant U.S. corporate income tax rate and realization of deferred tax assets), accounting for loan fees (relating to the periods of revenue recognition) and accounting for goodwill (due to new accounting standards effective at the beginning of 2002). Page 22 of 29 PART I, ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. PART I, ITEM 4 CONTROLS AND PROCEDURES (a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Disclosure controls and procedures were evaluated as of September 30, 2002 ("Evaluation Date"). Such evaluation concluded that Capitol's disclosure controls and procedures are effective to ensure that material information relating to Capitol, including its consolidated subsidiaries, is made known to Capitol's senior management, particularly during the period for which this quarterly report has been prepared. (b) CHANGES IN INTERNAL CONTROL. As of the signature date of this report, there have been no significant changes in Capitol's internal controls or in other factors that could significantly affect internal controls subsequent to the Evaluation Date referred to in (a) above. (c) ASSET-BACKED ISSUERS. Not applicable. [The remainder of this page intentionally left blank] Page 23 of 29 PART II. OTHER INFORMATION Item 1. Legal Proceedings. Capitol and its subsidiaries are parties to certain ordinary, routine litigation incidental to their business. In the opinion of management, liabilities arising from such litigation would not have a material effect on Capitol's consolidated financial position or results of operations. Item 2. Changes in 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 and Reports on Form 8-K. (a) Exhibits: EXHIBIT NO. DESCRIPTION OF EXHIBIT ----------- ---------------------- 99.1 Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the three months ended September 30, 2002. Page 24 of 29 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. CAPITOL BANCORP LTD. (Registrant) /s/ Joseph D. Reid ----------------------------------- Joseph D. Reid Chairman and CEO (duly authorized to sign on behalf of the registrant) /s/ Lee W. Hendrickson ----------------------------------- Lee W. Hendrickson Executive Vice President and Chief Financial Officer Date: November 11, 2002 Page 25 of 29 CERTIFICATIONS I, Joseph D. Reid, Chairman and CEO, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capitol Bancorp Ltd.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and Page 26 of 29 CERTIFICATIONS--CONTINUED 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 11, 2002 /s/ Joseph D. Reid ----------------------------------- Joseph D. Reid Chairman and CEO [The remainder of this page intentionally left blank] Page 27 of 29 CERTIFICATIONS--CONTINUED I, Lee W. Hendrickson, Executive Vice President and Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capitol Bancorp Ltd.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and Page 28 of 29 CERTIFICATIONS--CONTINUED 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 11, 2002 /s/ Lee W. Hendrickson ----------------------------------- Lee W. Hendrickson Executive Vice President and Chief Financial Officer [The remainder of this page intentionally left blank] Page 29 of 29