Item 1. Business.
Pavilion Bancorp, Inc. (the Company), a bank holding company, which was incorporated in Michigan in 1993, has two wholly-owned bank subsidiaries, Bank of Lenawee and Bank of Washtenaw (the “Banks”). On April 15, 1993, the Company acquired all of the stock of the Bank of Lenawee, a Michigan banking corporation chartered in 1869. On January 1, 2001 the Bank of Lenawee made the real estate origination component of its business a separate entity named Pavilion Mortgage Company. On January 8, 2001 the Company opened a new bank, the Bank of Washtenaw. The new bank is operating the former Saline Michigan branch of the Bank of Lenawee and has opened a new branch and administrative offices in Ann Arbor, Michigan. On April 22, 2002, the Company changed its name from Lenawee Bancorp, Inc. to Pavilion Bancorp, Inc.
Business is concentrated primarily in a single industry segment - commercial banking. Each Bank provides a full range of banking services to individuals, commercial businesses and industries located in its service area. Each Bank maintains diversified loan portfolios, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. Each Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit.
The principal markets for financial services are the mid-Michigan communities in which the Banks are located and the areas immediately surrounding these communities. The Banks serve these markets through 11 locations in or near their communities. The Banks do not have any material foreign assets or income.
The principal source of revenue is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 71% of total revenue in 2002 compared to 77% in 2001. Further reductions in interest rates during 2002 resulted in a significant increase in the volume of loan sale activity and gains on sales of mortgage loans. These gains accounted for 19% of the Company’s total revenue in 2002 as compared to 11% in 2001.
The Banks’ principal competitors are United Bank & Trust, Key Bank, Sky Bank, Standard Federal Bank, and TLC Community Credit Union. With the exception of United Bank & Trust and TLC Community Credit Union, each of these financial institutions has headquarters in larger metropolitan areas, and has significantly greater assets and financial resources than the Company. Based on deposit information as of June 30, 2002, the Bank of Lenawee holds an estimated 19.2 % of the FDIC insured deposits in Lenawee County and the Bank of Washtenaw holds an estimated 1.2 % of the FDIC insured deposits in Washtenaw County. Information as to asset size of competitor financial institutions is derived from publicly available reports filed by and with regulatory agencies.
SUPERVISION AND REGULATION
The following is a summary of certain statutes and regulations affecting the Company and the Banks. This summary is qualified in its entirety by such statutes and regulations. A change in applicable laws or regulations may have a material effect on the Company, the Banks and the business of the Company and the Banks.
General
Financial institutions and their holding companies are extensively regulated under federal and state law. Consequently, the growth and earnings performance of the Company and the Banks can be affected not only by management decisions and general economic conditions, but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities. Those authorities include, but are not limited to, the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the FDIC, the Commissioner of the Michigan Office of Financial and Insurance Services (“Commissioner”), the Internal Revenue Service, and state taxing authorities. The effect of such statutes, regulations and policies can be significant, and cannot be predicted with a high degree of certainty.
Federal and state laws and regulations generally applicable to financial institutions and their holding companies regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, lending activities and practices, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends. The system of supervision and regulation applicable to the Company and the Banks establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds, the depositors of the Banks, and the public, rather than shareholders of the Banks or the Company.
Federal law and regulations establish supervisory standards applicable to the lending activities of the Banks, including internal controls, credit underwriting, loan documentation and loan-to-value ratios for loans secured by real property.
The Company
General. The Company is a bank holding company and, as such, is registered with, and subject to regulation by, the Federal Reserve Board under the Bank Holding Company Act, as amended (the “BHCA”). Under the BHCA, the Company is subject to periodic examination by the Federal Reserve Board, and is required to file with the Federal Reserve Board periodic reports of its operations and such additional information as the Federal Reserve Board may require.
In accordance with Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Banks and to commit resources to support the Banks in circumstances where the Company might not do so absent such policy. In addition, if the Commissioner deems a Bank’s capital to be impaired, the Commissioner may require the Bank to restore its capital by a special assessment upon the Company as the Bank’s sole shareholder. If the Company were to fail to pay any such assessment, the directors of the Banks would be required, under Michigan law, to sell the shares of the Bank’s stock owned by the Company to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank’s capital.
Investments and Activities. In general, any direct or indirect acquisition by the Company of any voting shares of any bank which would result in the Company’s direct or indirect ownership or control of more than 5% of any class of voting shares of such bank, and any merger or consolidation of the Company with another bank company, will require the prior written approval of the Federal Reserve Board under the BHCA. In acting on such applications, the Federal Reserve Board must consider various statutory factors, including among others, the effect of the proposed transaction on competition in relevant geographic and product markets, and each party’s financial condition, managerial resources, and record of performance under the Community Reinvestment Act.
The merger or consolidation of an existing bank subsidiary of the Company with another bank, or the acquisition by such a subsidiary of assets of another bank, or the assumption of liability by such a subsidiary to pay any deposits in another bank, will require the prior written approval of the responsible Federal depository institution regulatory agency under the Bank Merger Act, based upon a consideration of statutory factors similar to those outlined above with respect to the BHCA. In addition, in certain such cases an application to, and the prior approval of, the Federal Reserve Board under the BHCA and/or the Commissioner under the Michigan Banking Code, may be required.
With certain limited exceptions, the BHCA prohibits any bank company from engaging, either directly or indirectly through a subsidiary, in any activity other than managing or controlling banks unless the proposed non-banking activity is one that the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Under current Federal Reserve Board regulations, such permissible non-banking activities include such things as mortgage banking, equipment leasing, securities brokerage, and consumer and commercial finance company operations. Well-capitalized and well-managed bank holding companies may engage de novo in certain types of non-banking activities without prior notice to, or approval of, the Federal Reserve Board, provided that written notice of the new activity is given to the Federal Reserve Board within 10 business days after the activity is commenced. If a bank holding company wishes to engage in a non-banking activity by acquiring a going concern, prior notice and/or prior approval will be required, depending upon the activities in which the company to be acquired is engaged, the size of the company to be acquired and the financial and managerial condition of the acquiring bank holding company.
Eligible bank holding companies that elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of nonbanking activities, including securities and insurance activities and any other activity that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. The Bank Holding Company Act generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank or financial holding companies. While the Company believes it is eligible to elect to operate as a financial holding company, as of the date of this filing, it has not applied for approval to operate as a financial holding company.
The Company’s common stock is registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). It is therefore subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act provides for numerous changes to the reporting, accounting, corporate governance and business practices of companies as well as financial and other professionals who have involvement with the U.S. public markets. The SEC continues to issue new and proposed rules implementing various provisions of the Sarbanes-Oxley Act.
Capital Requirements. The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank company may, among other things, be denied approval to acquire or establish additional banks or non-bank businesses.
The Federal Reserve Board’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: (i) a leverage capital requirement expressed as a percentage of total average assets, and (ii) a risk-based requirement expressed as a percentage of total risk-weighted assets. The leverage capital requirement consists of a minimum ratio of Tier 1 capital (which consists principally of shareholders’ equity) to total average assets of 3% for the most highly rated companies, with minimum requirements of 4% to 5% for all others. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, of which at least one-half must be Tier 1 capital.
The risk-based and leverage standards presently used by the Federal Reserve Board are minimum requirements, and higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. The Federal Reserve Board has not advised the Company of any specific minimum Tier 1 Capital leverage ratio applicable to it.
Dividends. The Company is a corporation separate and distinct from the Banks. Most of the Company’s revenues are received by it in the form of dividends paid by the Banks. Thus, the Company’s ability to pay dividends to its shareholders is indirectly limited by statutory restrictions on the Banks’ ability to pay dividends described below. Further, the Federal Reserve Board has issued a policy statement on the payment of cash dividends by bank holding companies. In the policy statement, the Federal Reserve Board expressed its view that a bank holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. Additionally, the Federal Reserve Board possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. Similar enforcement powers over the Banks are possessed by the FDIC. The “prompt corrective action” provisions of federal law and regulation authorizes the Federal Reserve Board to restrict the payment of dividends by the Company for an insured bank which fails to meet specified capital levels.
In addition to the restrictions on dividends imposed by the Federal Reserve Board, the Michigan Business Corporation Act provides that dividends may be legally declared or paid only if after the distribution a corporation, such as the Company, can pay its debts as they come due in the usual course of business and its total assets equal or exceed the sum of its liabilities plus the amount that would be needed to satisfy the preferential rights upon dissolution of any holders of preferred stock whose preferential rights are superior to those receiving the distribution. The Company’s Articles of Incorporation do not authorize the issuance of preferred stock and there are no current plans to seek such authorization.
The Banks
General. The Banks are Michigan banking corporations, are members of the Federal Reserve System and their deposit accounts are insured by the Bank Insurance Fund (the “BIF”) of the FDIC. As Federal Reserve System members and Michigan chartered banks, the Banks are subject to the examination, supervision, reporting and enforcement requirements of the Federal Reserve Board as their primary federal regulator and the Commissioner, as the chartering authority for Michigan banks. These agencies and the federal and state laws applicable to the Banks and their operations, extensively regulate various aspects of the banking business including, among other things, permissible types and amounts of loans, investments and other activities, capital adequacy, branching, interest rates on loans and on deposits, the maintenance of non-interest bearing reserves on deposit accounts, and the safety and soundness of banking practices.
Deposit Insurance. As FDIC-insured institutions, the Banks are required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums, based upon their respective levels of capital and results of supervisory evaluation. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.
The Federal Deposit Insurance Act (“FDIA”) requires the FDIC to establish assessment rates at levels which will maintain the Deposit Insurance Fund at a mandated reserve ratio of not less than 1.25% of estimated insured deposits. For several years, the BIF reserve ratio has been at or above the mandated ratio and assessments have ranged from 0% of deposits for institutions in the lowest risk category to .27% of deposits in the highest risk category.
FICO Assessments. The Banks, as members of the BIF, are subject to assessments to cover the payments on outstanding obligations of the Financing Corporation (“FICO”). FICO was created to finance the recapitalization of the Federal Savings and Loan Insurance Corporation, the predecessor to the FDIC’s Savings Association Insurance Fund (the “SAIF”) which insures the deposits of thrift institutions. From now until the maturity of the outstanding FICO obligations in 2019, BIF members and SAIF members will share the cost of the interest on the FICO bonds on a pro rata basis. It is estimated that FICO assessments during this period will be less than 0.025% of deposits.
Commissioner Assessments. Michigan banks are required to pay supervisory fees to the Commissioner to fund the operations of the Commissioner. The amount of supervisory fees paid by a bank is based upon the bank’s total assets, as reported to the Commissioner.
Capital Requirements. The Federal Reserve has established the following minimum capital standards for state-chartered, member banks, such as the Banks: a leverage requirement consisting of a minimum ratio of Tier 1 capital to total average assets of 3% for the most highly-rated banks with minimum requirements of 4% to 5% for all others, and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. Tier 1 capital consists principally of shareholders’ equity. These capital requirements are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, Federal Reserve regulations provide that higher capital may be required to take adequate account of, among other things, interest rate risk and the risks posed by concentrations of credit, nontraditional activities or securities trading activities.
Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators’ powers depends on whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.” Federal regulations define these capital categories as follows:
Total Tier 1 Risk-Based Risk-Based Capital Ratio Capital Ratio Leverage Ratio ------------- ------------- --------------
Well capitalized 10% or above 6% or above 5% or above Adequately capitalized 8% or above 4% or above 4% or above Undercapitalized Less than 8% Less than 4% Less than 4% Significantly undercapitalized Less than 6% Less than 3% Less than 3% Critically undercapitalized -- -- A ratio of tangible equity to total assets of 2% or less
As of December 31, 2002, each of the Banks’ ratios exceeded minimum requirements for the well capitalized category.
Depending upon the capital category to which an institution is assigned, the regulators’ corrective powers include: requiring the submission of a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution.
In general, a depository institution may be reclassified to a lower category than is indicated by its capital levels if the appropriate federal depository institution regulatory agency determines the institution to be otherwise in an unsafe or unsound condition or to be engaged in an unsafe or unsound practice. This could include a failure by the institution, following receipt of a less-than-satisfactory rating on its most recent examination report, to correct the deficiency.
Dividends. Under Michigan law, the Banks are restricted as to the maximum amount of dividends they may pay on their common stock. The Banks may not pay dividends except out of net income after deducting their losses and bad debts. A Michigan state bank may not declare or pay a dividend unless the bank will have surplus amounting to at least 20% of its capital after the payment of the dividend.
As a member of the Federal Reserve System, each of the Banks is required by federal law to obtain the prior approval of the Federal Reserve Board for the declaration or payment of a dividend, if the total of all dividends declared by the Bank’s Board of Directors in any year will exceed the total of (i) the Bank’s retained net income (as defined and interpreted by regulation) for that year plus (ii) the retained net income for the preceding two years, less any required transfers to surplus. Federal law generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Further, federal regulatory agencies can prohibit a banking institution or bank holding company from engaging in unsafe and unsound business practices and could prohibit payment of dividends if such payment could be deemed an unsafe and unsound business practice.
Insider Transactions. The Banks are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the Company or its subsidiaries, on investments in the stock or other securities of the Company or its subsidiaries and the acceptance of the stock or other securities of the Company or its subsidiaries as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by each Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal shareholders of the Company, and to “related interests” of such directors, officers and principal shareholders. In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal shareholder of the Company may obtain credit from banks with which the Banks maintain a correspondent relationship.
Safety and Soundness Standards. The federal banking agencies have adopted guidelines to promote the safety and soundness of federally insured depository institutions. These guidelines establish standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.
Investments and Other Activities. Under federal law and regulations, Federal Reserve System member banks and FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law, as implemented by regulations, also prohibits state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the bank’s primary federal regulator determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. Impermissible investments and activities must be divested or discontinued within certain time frames set by the bank’s primary federal regulator in accordance with federal law. These restrictions are not currently expected to have a material impact on the operations of the Bank.
Consumer Protection Laws. The Banks’ businesses include making a variety of types of loans to individuals. In making these loans, the Banks are subject to State usury and regulatory laws and to various federal statutes, including the privacy of consumer financial information provisions of the Gramm-Leach-Bliley Act and regulations promulgated thereunder, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act, and the Home Mortgage Disclosure Act, and the regulations promulgated thereunder, which prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs, and regulate the mortgage loan servicing activities of the Banks, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing. In receiving deposits, the Banks are subject to extensive regulation under State and federal law and regulations, including the Truth in Savings Act, the Expedited Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer Act, and the Federal Deposit Insurance Act. Violation of these laws could result in the imposition of significant damages and fines upon the Banks and their directors and officers.
Branching Authority. Michigan banks, such as the Banks, have the authority under Michigan law to establish branches anywhere in the State of Michigan, subject to receipt of all required regulatory approvals.
Banks may establish interstate branch networks through acquisitions of other banks. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.
Michigan permits both U.S. and non-U.S. banks to establish branch offices in Michigan. The Michigan Banking Code permits, in appropriate circumstances and with the approval of the Michigan Office of Financial and Insurance Services, Division of Financial Institutions, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan.
Item 2.
Item 2. Properties.
The Bank of Lenawee’s main office is located in Adrian and it serves other communities with branch offices in Hudson, Morenci, Tecumseh and Waldron. The Bank of Washtenaw’s main office is located in Saline and it has a branch office and an administrative office in Ann Arbor. The Banks’ offices are located throughout Lenawee County, in the southeastern portion of Hillsdale County, and the southern portion of Washtenaw County. The area in which the Banks’ offices are located, which is basically southeastern Michigan, has historically been rural in character but now has a growing urban population as residents choose the area to live in while commuting to Ann Arbor, Detroit, and Toledo. The populations of the cities in which the Banks’ offices are located are per the 2000 U.S. Census were as follows: Adrian-21,574; Ann Arbor-114,024; Hudson-2,499; Morenci-2,398; Saline-8,034; Tecumseh-8,574; and Waldron-590; The main office of Bank of Lenawee is a three story 40,768 square foot building constructed in 1906. The other offices of the Banks range in size from 1,200 square feet to 4,000 square feet. The majority of the offices of Bank of Lenawee are owned and those of Bank of Washtenaw are leased.
Item 3.
Item 3. Legal Proceedings.
There are no legal proceedings except routine litigation incidental to the ordinary course of business. Although litigation is subject to many uncertainties and the ultimate exposure with respect to many of these matters cannot be ascertained, management does not believe the ultimate outcome of these matters will have a material effect on the financial condition of the Company or the Banks, individually or in the aggregate.
Item 4.
Item 4. Submission of Matters to Vote of Security Holders.
No matters were submitted to a vote of the Company’s security holders during the fourth quarter of 2002.
Additional Item: Executive Officers of Registrant
The following information concerning executive officers of the Company has been omitted from the Registrant’s proxy statement pursuant to Instruction 3 to Regulation SK, Item 401(b).
Officers of the Company are appointed annually by the Board of Directors of the Company and serve at the pleasure of the Board of Directors. Information concerning these executive officers is given below:
Douglas L. Kapnick (age 59) was elected Chairman of the Board of the Company in September of 2000 and has been a director of Bank of Lenawee since 1982 and has been a director of the holding company since it was formed in 1993. Mr. Kapnick was elected interim President and Chief Executive Office of the Company and the Bank of Lenawee effective October 31, 2002, when Patrick K. Gill resigned those positions. Mr. Kapnick is President of Kapnick & Company a full service insurance broker with offices in Adrian and Southfield employing a total of approximately 85 persons.
Pamela S. Fisher (age 53) is the Corporate Secretary of the Company and Senior Vice President of Administrative Services of the Bank of Lenawee. Ms. Fisher joined the Bank of Lenawee in 1979 and has served the bank in various capacities. She was elected as Senior Vice President of Bank of Lenawee in 2000 and was elected Secretary of the Company in 1995.
Loren V. Happel (age 47) is the Company’s Chief Financial Officer and Senior Vice President and Chief Financial Officer of the Bank of Lenawee. Mr. Happel joined the Company and Bank of Lenawee in December of 1994. At that time he was appointed Treasurer of the Company and First Vice President and Chief Financial Officer of Bank of Lenawee.
PART II
Item 5.
Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters.
The information under the caption “COMMON STOCK INFORMATION” at page 43 of the Company’s 2002 Annual Report to shareholders, is here incorporated by reference to Exhibit 13.
Item 6.
Item 6. Selected Financial Data.
The information under the caption “SELECTED FINANCIAL DATA” at page 2 of the Company’s 2002 Annual Report to shareholders, is here incorporated by reference to Exhibit 13.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The information under the captions “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” at pages 3 through 11 of the Company’s 2002 Annual Report to shareholders, is here incorporated by reference to Exhibit 13.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
The information under the captions “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” at pages 11 through 14 of the Company’s 2002 Annual Report to shareholders, is here incorporated by reference to Exhibit 13.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The financial statements, notes and report of independent auditors included in the Company’s 2002 Annual Report to shareholders, is here incorporated by reference to Exhibit 13.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None
PART III Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Information with respect to the Company’s Executive Officers is included in this report in Part I. The information with respect to Directors of the Company, set forth under the caption “Information About Directors and Nominees” on pages 8 through 10 of the Company’s definitive proxy statement, as filed with the Commission and dated March 18, 2003, relating to the April 17, 2003 Annual Meeting of Shareholders, is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
The information set forth under the caption “COMPENSATION OF EXECUTIVE OFFICERS” on page 11 through 12 of the Company’s definitive proxy statement, as filed with the Commission and dated March 18, 2003, relating to the April 18, 2003 Annual Meeting of Shareholders, is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information set forth under the caption “VOTING SECURITIES AND BENEFICIAL OWNERSHIP OF MANAGEMENT AND OTHERS” on page 7 through 8 of the Company’s definitive proxy statement, as filed with the Commission and dated March 18, 2003, relating to the April 17, 2003 Annual Meeting of Shareholders, is incorporated herein by reference.
Securities Authorized for Issuance Under Equity Compensation Plans. The Company had the following equity compensation plans at December 31, 2002:
EQUITY COMPENSATION PLAN INFORMATION
Number of securities remaining available for future issuance under equity compensation Number of securities to Weighted-average plans (excluding be issued upon exercise exercise price of securities reflected in of outstanding options outstanding options column (1)) ---------------------- ------------------- ----------- Plan Category (1) (2) (3) ------------- --- --- ---
Equity compensation plans approved by security holders 38,760 $36.94 37,096
Equity compensation plans not approved by security holders none none none ---------------------------- ---------------------------- ----------------------------
Total 38,760 $36.94 37,096 ---------------------------- ---------------------------- ----------------------------
These equity compensation plans are more fully described in Note 12 to the Consolidated Financial Statements.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information set forth under the caption “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS” on page 14 of the Company’s definitive proxy statement, as filed with the Commission and dated March 18, 2003, relating to the April 17, 2003 Annual Meeting of Shareholders, is incorporated herein by reference.
Item 14.
Item 14. Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures.
The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) as of a date within 90 days of the filing date of this Form 10-K Annual Report (the “Evaluation Date”), have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company would be made known to them by others within the Company, particularly during the period in which this Form 10-K Annual Report was being prepared.
(b) Changes in Internal Controls.
There were no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of the most recent evaluation, nor any significant deficiencies or material weaknesses in such internal controls requiring corrective actions. As a result, no corrective actions were taken.
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Report on Form 8-K.
(a) 1.
Financial Statements
The following consolidated financial statements of the Company and Report of Crowe Chizek and Company LLP, Independent Auditors, are incorporated by reference under Item 8 “Financial Statements and Supplementary Data” of this document:
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Changes in Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Crowe Chizek and Company LLP, Independent Accountants
2.
Financial Statement Schedules
Not applicable
3.
Exhibits (Numbered in accordance with Item 601 of Regulation S-K)
The Exhibit Index is located on the final page of this report on Form 10-K.
(b) Reports on Form 8-K
The following reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 2002:
1.
Report dated October 31, 2002, reporting the resignation of the Registrant's President and CEO.
2.
Report dated October 15, 2002, reporting that Douglas L. Kapnick would serve as Interim Chairman and CEO of the Registrant.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, dated March 18, 2003.
PAVILION BANCORP, INC.
/s/ Douglas L. Kapnick
Douglas L. Kapnick
Chairman and Chief Executive officer
/s/ Loren V. Happel
Loren V. Happel
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each director of the Registrant, whose signature appears below, hereby appoints Douglas L. Kapnick and Loren V. Happel, and each of them severally, as his or her attorney-in-fact, to sign in his or her name and on his or her behalf, as a director of the Registrant, and to file with the Commission any and all Amendments to this Report on Form 10-K.
Signature
Date
/s/ Allan F. Brittain
Allan F. Brittain
March 18, 2003
/s/ Fred R. Duncan
Fred R. Duncan
March 18, 2003
/s/ Edward J. Engle, Jr.
Edward J. Engle, Jr.
March 18, 2003
/s/ William R. Gentner
William R. Gentner
March 18, 2003
/s/ Douglas L. Kapnick
Douglas L. Kapnick
March 18, 2003
/s/ Emory M. Schmidt
Emory M. Schmidt
March 18, 2003
/s/ J. David Stutzman
J. David Stutzman
March 18, 2003
CERTIFICATIONS
I, Douglas L. Kapnick, certify that:
1.
I have reviewed this annual report on Form 10-K of Pavilion Bancorp, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of 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 report;
3.
Based on my knowledge, the financial statements, and other financial information included in this annual 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 Annual 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 annual 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 annual report (the “Evaluation Date”); and
(c)
presented in this annual 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
6.
The registrant’s other certifying officers and I have indicated in this annual 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: March 18, 2003
/s/ Douglas L. Kapnick
Douglas L. Kapnick
Chairman and Chief Executive Officer
I, Loren V. Happel, certify that:
1.
I have reviewed this annual report on Form 10-K of Pavilion Bancorp, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of 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 report;
3.
Based on my knowledge, the financial statements, and other financial information included in this annual 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 Annual 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 annual 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 annual report (the “Evaluation Date”); and
(c)
presented in this annual 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
6.
The registrant’s other certifying officers and I have indicated in this annual 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: March 18, 2003
/s/ Loren V. Happel
Loren V. Happel
Chief Financial Officer
EXHIBIT INDEX The following exhibits are filed herewith, indexed according to the applicable assigned number:
Exhibit
Number
Rule 14a-3 2002 Annual Report to Security Holders (This report, except for those portions which are expressly incorporated by reference in this filing, is furnished for the information of the Securities and Exchange Commission and is not deemed “filed” as part of this filing).
Subsidiaries of Registrant
Consent of Crowe, Chizek and Company, LLP. - Independent Public Accountants.
Powers of Attorney. Contained on the signature page of this report.
99.1 Certificate of Chief Executive Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certificate of Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
The following exhibits, indexed according to the applicable assigned number, were previously filed by the Registrant and are incorporated by reference in this Form 10-K Annual Report.
Exhibit
Number
3.1 Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant’s Registration Statement on Form 10, as amended.
3.2 Amendment to Articles of Incorporation of Registrant incorporated by reference to Exhibit 3 of the Registrant’s Report on Form 10-Q for the quarter ended March 31, 2002.
3.3 Bylaws of the Registrant are incorporated by reference to Exhibit 3.2 of the Registrant's Registration Statement on Form 10, as amended.
Form of Registrant’s Stock Certificate is incorporated by reference to Exhibit 4 of the Registrant’s Registration Statement on Form 10, as amended.
2001 Stock Option Plan, incorporated by reference to Appendix A to the Registrant’s Definitive Proxy Statement filed with respect to its April 18, 2001 annual meeting of shareholders.
10.1 1996 Stock Option Plan, incorporated by reference to Exhibit 10.1 to the Registrant's Registration Statement filed on Form 10, as amended.
10.2 Employment Agreement dated February 22, 1999, and amended February 22, 2000, between Bank of Lenawee and Patrick K. Gill, incorporated by reference to Exhibit 10.2 of the Registrant’s Registration Statement on Form 10, as amended.
10.3 Supplemental Executive Retirement Agreement dated December 19, 1997, between Bank of Lenawee and Allan W. Brittain, incorporated by reference to the Registrant’s Registration Statement on Form 10, as amended.
10.4 Consulting Agreement dated January 1, 1998, between Bank of Lenawee and Allan W. Brittain, incorporated by reference to Registrant’s Registration Statement on Form 10, as amended.
Exhibit 13
Rule 14a-3 Annual Report to Security Holders
Lenawee Bancorp, Inc.
Annual Report
This 2002 Annual Report contains audited financial statements and a detailed financial review. This is Pavilion Bancorp’s 2002 annual report to shareholders. Although attached to our proxy statement, this report is not part of our proxy statement, is not deemed to be soliciting material, and is not deemed to be filed with the Securities and Exchange Commission (the “SEC”) except to the extent that it is expressly incorporated by reference in a document filed with the SEC.
The 2002 Summary Annual Report to Shareholders accompanies this proxy statement. This report presents information concerning the business and financial results of Pavilion Bancorp in a format and level of detail that we believe shareholders will find useful and informative. Shareholder who would like to receive even more detailed information than that contained in this 2002 Annual Report are invited to request our Annual Report on Form 10-K.
Pavilion Bancorp, Inc.‘s Form 10-K Annual Report to the Securities and Exchange Commission will be provided to any shareholder without charge upon written request. Requests should be addressed to Pavilion Bancorp, Inc., Attention: Pamela S. Fisher, 135 East Maumee Street, Adrian, Michigan 49221.
PAVILION BANCORP, INC.
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002 and 2001
CONTENTS
SELECTED FINANCIAL DATA............................................................................................................................
MANAGEMENT'S DISCUSSION AND ANALYSIS............................................................................................
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING.........................................................
REPORT OF INDEPENDENT AUDITORS.........................................................................................................
CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS..........................................................................................................
CONSOLIDATED STATEMENTS OF INCOME..........................................................................................
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY.................................
CONSOLIDATED STATEMENTS OF CASH FLOWS.................................................................................
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS......................................................................
COMMON STOCK INFORMATION.................................................................................................................
SELECTED FINANCIAL DATA
(In thousands, except per share data)
2002 2001 2000 1999 1998 For the Year: Total interest income $ 19,182 $ 21,012 $ 20,851 $ 17,923 $ 17,517 Total interest expense 6,029 8,198 8,710 6,312 7,205 Net interest income 13,153 12,814 12,141 11,611 10,312 Provision for loan losses 953 388 30 2,560 239 Noninterest income 5,975 4,151 2,064 2,237 2,850 Noninterest expense 13,993 12,182 9,414 8,994 8,913 Income before income taxes 4,182 4,395 4,761 2,294 4,010 Net income 2,855 3,043 3,205 1,563 2,660
Per Share Data: Basic earnings per share $ 3.39 $ 3.58 $ 3.75 $ 1.83 $ 3.13 Diluted earnings per share 3.37 3.54 3.71 1.83 3.12 Cash dividends declared per share .86 .80 .94 .75 .67 Shareholders' equity and net ESOP obligation per share 35.09 33.01 29.91 26.72 26.26 Shareholders' equity per share 30.16 27.77 23.90 21.64 21.92
At Year-End: Total assets $287,286 $278,277 $259,747 $ 239,904 $ 220,414 Loans receivable 235,770 214,749 214,512 197,308 158,487 Allowance for loan losses 2,660 2,200 2,287 4,646 2,182 Deposits 241,720 235,407 224,143 199,206 185,891 Borrowed funds 8,635 7,394 7,936 16,177 10,626 Shareholders' equity and net ESOP obligations 29,170 28,007 25,467 22,775 22,345 Shareholders' equity 25,059 23,563 20,353 18,449 18,648
Financial: Net interest income to average earning assets 5.12% 5.09% 5.26% 5.66% 5.07% Return on average shareholders' equity and net ESOP obligation 9.94 11.58 13.29 6.65 12.46 Return on average shareholders' equity 11.66 14.14 16.59 8.02 14.76 Return on average assets 1.02 1.12 1.28 .70 1.21 Tier 1 leverage ratio 12.00 11.90 9.90 9.90 9.90 Dividend payout ratio 25.37 22.35 25.07 40.98 21.41 Average shareholders' equity and net ESOP obligation to average total assets 10.26 9.66 9.60 10.52 9.72 Average shareholders' equity to average total assets 8.75 7.91 7.72 8.72 8.21
All per share data has been adjusted to reflect stock splits and stock dividends.
2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion provides information about the financial condition and results of operations of Pavilion Bancorp, Inc. It should be read in conjunction with the consolidated financial statements included elsewhere in this Annual Report.
BUSINESS OF PAVILION BANCORP, INC.
Pavilion Bancorp, Inc. (the Company), a bank holding company, was incorporated in Michigan in 1993. The shareholders elected to change its name to Pavilion Bancorp Inc. from Lenawee Bancorp Inc. on April 18, 2002. The Company holds all of the stock of the Bank of Lenawee, a Michigan banking corporation chartered in 1869, and the Bank of Washtenaw founded by the Company on January 8, 2001.
The business is concentrated primarily in a single industry segment - commercial banking. Each bank provides a full range of banking services to individuals, commercial businesses and industries located in its service area. Each bank maintains diversified loan portfolios, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. Each bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit.
The principal markets for financial services we provide are the mid-Michigan communities in which the banks are located and the areas immediately surrounding these communities. The banks serve these markets through 11 locations in or near their communities. The banks do not have any material foreign assets or income.
The principal source of revenue is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 71 % of our total revenue in 2002 compared to 77% in 2001. Lower than normal interest rates during 2002 and 2001 resulted in a significant increase in the volume of mortgage loan sale activity and gains on sales of mortgage loans. These gains accounted for 19 % of our total revenue in 2002 as compared to 11% in 2001.
2002 FINANCIAL HIGHLIGHTS
Net income for the year ended December 31, 2002 was $2,855,342, which was a 6.17% decrease from our 2001 net income of $3,043,072. As a result our basic earnings per share decreased to $3.39 in 2002 from $3.58 in 2001. Diluted earnings per share decreased from $3.54 in 2001 to $3.37 in 2002. Our return on average equity including net ESOP obligation declined from 11.58% in 2001 to 9.94% in 2002.
Total assets grew to $287.3 million in 2002 from $278.3 million in 2001. Our net loan balances increased $20.5 million or 9.62%, an amount consistent with the prior year activity.
NET INTEREST INCOME
The largest component of our operating income is net interest income. Net interest income is the difference between the interest and fees the Company earns on our earning assets and the interest we pay on deposits and other borrowings. A number of factors influence net interest income. These factors include: changes in volume and mix of interest-earning assets and interest-bearing liabilities, government monetary and fiscal policies, national and local market interest rates and customer preference.
Our net interest income was $13.2 million in 2002, an increase of $339,000 over 2001. The 2002 increase in net interest income was primarily the result of decreased funding costs and growth in interest-earning assets. The table below shows the yields earned on our interest-earning assets and our costs of interest-bearing liabilities. The table also reflects our net interest margin for the years ended December 31, 2002, 2001 and 2000.
3.
Average Balance Sheet and Analysis of Net Interest Income
Years ended December 31, ---------------2002------------ -------------2001-------------- -------------2000-------------- Average Yield/ Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Balance Interest Rate (Dollars in thousands) Interest-earning assets: Loans receivable $222,017 $17,786 8.01% $217,424 $19,284 8.87% $203,698 $19,268 9.46% Securities available for sale (1) 26,023 1,127 4.33 24,038 1,253 5.21 21,264 1,168 5.49 Federal funds sold 5,723 88 1.54 6,783 255 3.76 2,708 167 6.17 Federal Home Loan Bank Stock 2,504 161 6.43 2,504 181 7.23 2,504 200 7.99 Interest-bearing balances with other financial institutions 840 20 2.38 867 40 4.61 782 48 6.14 -------- ------- -------- ------- -------- ------ Total interest-earning assets 257,107 19,182 7.46 251,616 21,013 8.35 230,956 20,851 9.03 Noninterest-earning assets: Cash and due from financial institutions 11,684 10,316 8,369 Premises and equipment, net 6,562 6,526 6,333 Other assets 4,646 3,424 5,466 -------- -------- -------- Total assets $279,999 $271,882 $251,124 ======== ======== ========
Interest-bearing liabilities: Interest-bearing demand deposits $ 55,635 647 1.16 $56,113 $ 1,207 2.15 $ 53,156 $ 1,821 3.43% Savings deposits 27,856 278 1.00 24,389 340 1.39 23,756 358 1.51 Time deposits 106,388 4,441 4.17 115,060 6,233 5.42 97,827 5,675 5.80 Repurchase agreements and other borrowings 7,811 351 4.49 3,083 86 2.79 3,955 191 4.83 FHLB advances 5,143 312 6.07 5,519 333 6.03 10,637 665 6.25 -------- ------- -------- ------- -------- ------ Total interest-bearing liabilities 202,833 6,029 2.97 204,164 8,199 4.02 189,331 8,710 4.60 ------- ------- ------ Noninterest-bearing liabilities: Demand deposits 45,681 39,198 35,839 Other liabilities 2,764 2,251 1,846 -------- -------- -------- Total liabilities 251,278 245,613 227,016 Common stock subject to repurchase obligation in ESOP 4,225 4,756 4,720 Shareholders' equity 24,496 21,513 19,388 -------- -------- -------- Total liabilities and shareholders' equity $279,999 $271,882 $251,124 ======== ======== ========
Net interest income/interest rate spread $13,153 4.49% $12,814 4.33% $12,141 4.43% ======= ===== ======= ===== ======= =====
Net interest margin (2) 5.12% 5.09% 5.26% ===== ===== ===== Average interest-earning assets to average interest-bearing liabilities 126.76% 123.24% 121.99% ======= ======= =======
(1) Interest income on tax-exempt securities has not been adjusted to a taxable equivalent basis.
(2) Net interest earnings divided by average interest-earning assets.
4.
Net interest margin is net interest income divided by average earning assets. Our net interest margin increased slightly to 5.12% in 2002 from 5.09% in 2001. During 2001, the Federal Reserve decreased the discount rate by 475 basis points from 6.0% to 1.25%. During 2002, the Federal Reserve decreased the discount rate an additional 50 basis to .75%. As a result, our prime lending rate decreased from 9.5% at December 31, 2000 to 4.75% at December 31, 2001 and then to 4.25% at December 31, 2002. With such a drastic change in interest rates, we have experienced a proportionate decline in momentum of gross revenues from this decrease in the prime lending rate. A large portion of our variable rate business and consumer loan portfolios are tied directly to the prime lending rate. Offsetting the impact of this reduction in interest income on our loan products is the decrease in our costs of local deposit funding. Nearly all funding is from the local markets we serve and our costs of funds decreased from 4.02% in 2001 to 2.97% in 2002.
The following table analyzes the effect of volume and rate changes on interest income and expense for the periods indicated.
---------2002 Compared to 2001------- --------2001 Compared to 2000--------- Amount Amount Net Amount Amount Net Due to Due to Increase Due to Due to Increase Volume Rate (Decrease) Volume Rate (Decrease) ------ ---- ---------- ------ ---- ---------- (In thousands) Interest income Loans receivable $ 400 $ (1,898) $ (1,498) $ 1,256 $ (1,240) $ 16 Securities available for sale 98 (224) (126) 147 (62) 85 Federal funds sold (35) (132) (167) 173 (85) 88 Federal Home Loan Bank Stock - (20) (20) - (19) (19) Interest-bearing balances with financial institutions (1) (19) (20) 5 (13) (8) --------- --------- --------- -------- -------- --------- Total interest income 462 (2,293) (1,831) 1,581 (1,419) 162
Interest expense Interest-bearing deposits Demand (10) (550) (560) 96 (712) (616) Savings 44 (106) (62) 9 (27) (18) Time (443) (1,349) (1,792) 952 (394) 558 Repurchase agreements and other borrowings 190 75 265 (36) (69) (105) FHLB advances (23) 2 (21) (310) (22) (332) --------- --------- --------- -------- -------- --------- Total interest expense (242) (1,928) (2,170) 711 (1,224) (513) --------- --------- --------- -------- -------- ---------
Net interest income $ 704 $ (365) $ 339 $ 870 $ (197) $ 673 ========= ========= ========= ======== ======== =========
5.
PROVISION FOR LOAN LOSSES
The provision for loan losses is the amount added to the allowance for loan losses to absorb losses that have been incurred. The loan loss provision is based on historical loss experience and individual economic factors, which, in our judgment, deserve current recognition in maintaining an adequate allowance for loan losses balance.
The provision for loan losses was $953,000 in 2002 and $388,000 in 2001. This $565,000 increase in provision for loan losses is representative of the inherent risk associated with additional loan volume combined with necessary dollar coverage of outstanding nonperforming loans. Additional loan growth of $ 21.0 million primarily occurred in commercial loans to small businesses. Nonperforming loans, also primarily small business loans, increased from $1.3 million to $1.6 million.
NONINTEREST INCOME
Noninterest income was $6.0 million in 2002 as compared to $4.2 million in 2001. This represents a 44% increase from 2001.
The largest contributing factor to our 2002 noninterest income growth was a $2.1 million increase in net gains on mortgage loan sales. The historically low interest rates over the course of 2002 continued to expand our mortgage refinancing business. During 2002, we sold $231.4 million of loans in the secondary market, resulting in net gains of $4.8 million. In 2001, we sold $158.3 million of loans in the secondary market, resulting in net gains of $2.7 million. In 2000, we sold $45.0 million of loans resulting in net gains of $652,000. Loan sale gains were partially offset by increased amortization of mortgage servicing rights as a significant portion of our loan servicing portfolio refinanced during the current year.
Contributing further to noninterest income, were increases in our service charges and fees which grew to $1.9 million in 2002 from $1.4 million in 2001. This increase is primarily attributable to the growth of additional deposit customers.
NONINTEREST EXPENSE
Noninterest expense of $14.0 million in 2002 is an increase of $1.8 million or 15% compared to the noninterest expense of $12.2 million in 2001. A significant amount of the increase is continued organizational expenses associated with opening the Bank of Washtenaw. We increased our staff from 150 full time equivalents at December 31, 2001 to 155 full time equivalents at December 31, 2002. While the staff member increase is 3% over the course of the year, salaries and employee benefits increased 18%. The 18% increase reflects a full year tenure of organizational staff at the Bank of Washtenaw for 2002. Salary expenses also grew as a result of the increased levels of mortgage loan originations and sales. Mortgage originators earned additional amounts of commission payments for higher levels of mortgages sold. Our efficiency ratio (noninterest expense as a percentage of net interest income plus noninterest income) worsened from 71.81% in 2001 to 73.15% in 2002.
6.
INCOME TAX EXPENSE
Our income tax expense was $1.3 million in 2002 compared to $1.4 million in 2001 and $1.6 million in 2000.
The statutory federal tax rate during 2002, 2001 and 2000 was 34%. Our effective tax rate was lower than the statutory rate in all three years, primarily due to our tax-exempt interest income. Our effective tax rate was 32% in 2002, 31% in 2001, and 33% in 2000.
SECURITIES PORTFOLIO
The following table shows securities by classification as of December 31, 2002 and the amounts and weighted-average yields by maturity period. Securities that are not due at a single maturity date, primarily mortgage-backed securities, are not shown.
---------------------------------------------MATURING------------------------------------------------------ Within After One But After Five But After One Within Five Within Ten Ten Year Years Years Years Total (Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Available For Sale U.S. Treasuries and government agencies - -% $ 18,710 5.36% $ - -% $ - -% $ 18,710 5.36% State and municipal (1) 961 4.36% 2,395 4.87% 576 5.89% 448 6.75% 4,380 5.08% ---------- ---------- ---------- ---------- ---------- Total $ 961 $ 21,105 $ 576 $ 448 $ 23,090 ========== ========== ========== ========== ==========
(1) Yields on tax-exempt securities are computed on a fully taxable-equivalent basis.
Our Asset/Liability Management Committee (Committee) is responsible for developing investment guidelines and strategies. The Committee relies on the expertise of an investment advisor to select appropriate investments for the portfolio. Decisions to purchase securities and the maturity date selected are coordinated with an overall plan to manage liquidity and interest rate exposure.
We do not invest in derivative securities. We held no impaired securities at December 31, 2002. As of December 31, 2002, securities we held which were issued by the State of Michigan and its political subdivisions carried an aggregate market value of $4.0 million.
The U.S. government agency securities identified as available for sale are laddered to mature over five years with a three year average life. The goal is to reduce the volatility of the securities portfolio yield and still provide a predictable source of liquidity.
We had no held to maturity securities as of December 31, 2002, 2001 and 2000. The fair value of securities available for sale, as of the dates indicated, are summarized as follows:
-----------December 31,------------- 2002 2001 2000 (In thousands)
U.S. Treasuries and government agencies $ 18,710 $ 18,064 $ 7,283 State and municipal 4,380 5,133 6,911 Other securities 2,126 2,772 5,127 --------- -------- --------
$ 25,216 $ 25,969 $ 19,321 ========= ======== ========
7.
LOAN PORTFOLIO
Our lending efforts are concentrated primarily in the Michigan communities in which our banks’ branches are located. The banks have no foreign loans.
Our loan growth during 2002 was limited as a result of the significant refinancing activity experienced during 2002. Our total loans increased $21 million from year-end 2001 to 2002. Additionally, our loan servicing portfolio increased by approximately $73 million during the current year.
The following table presents the gross amount of loans outstanding by loan type:
--------------------------December 31,------------------------- 2002 2001 2000 1999 1998 (In thousands)
Commercial, financial and agricultural $ 183,433 $ 155,071 $ 149,058 $ 135,324 $ 112,451 Real estate - construction 9,013 7,318 13,383 9,934 - Real estate - mortgage 10,081 17,409 14,225 17,203 17,010 Consumer 33,243 34,951 37,846 34,847 29,026 ---------- ---------- ---------- --------- ----------
$ 235,770 $ 214,749 $ 214,512 $ 197,308 $ 158,487 ========== ========== ========== ========= ==========
The following table shows the maturity of loans outstanding (in thousands) at December 31, 2002. Also provided are the amounts due after one year, classified according to their sensitivity to changes in interest rates.
Due Due After One Due Within But Within After One Year Five Years Five Years Total -------- ---------- ---------- -----
Commercial, financial and agricultural $ 67,738 $ 106,116 $ 9,579 $ 183,433 Real estate-construction 9,013 - - 9,013 Real estate-mortgage 4,692 3,456 1,933 10,081 Consumer 15,795 12,207 5,241 33,243 ----------- ----------- ----------- -----------
$ 97,238 $ 121,779 $ 16,753 $ 235,770 =========== =========== =========== ===========
Loans due after one year: Fixed rate $ 54,442 Floating or adjustable rate 84,090 ----------- $ 138,532 ===========
8.
ASSET QUALITY
Management believes that a conservative credit culture is critical to successful performance. Through Officer and Director Loan Committees, management reviews and monitors the quality of the various loan portfolios. Internal and external loan review personnel also review our loan performance and underwriting regularly. The recent change in the momentum of the economy to static has begun to show signs of impacting some of our loan customers as shown in the nonperforming assets table below.
Loans are placed on non-accrual status when principal or interest is past due 90 days or more, the loan is not well-secured, is in the process of collection or when reasonable doubt exists concerning collectibility of interest or principal. Any interest previously accrued in the current period but not collected is reversed and charged against current earnings.
At December 31, 2002, the Banks were not aware of any loans for which payments were then current, but the borrowers were experiencing serious financial difficulties. As of December 31, 2002, 12.7% of the Banks loan portfolios were utilized to fund agricultural production, there were no other concentrations of loans exceeding 10% of total loans.
The following table summarizes non-accrual and past due loans and other real estate owned:
--------------------------December 31,------------------------- 2002 2001 2000 1999 1998 (In thousands)
Non-accruing loans past due $ 648 $ 230 $ 113 $ 3,071 $ 121 Loans past due 90 days or more 949 1,046 523 275 275 --------- --------- -------- -------- --------- Total nonperforming loans 1,597 1,276 636 3,346 396 Other real estate 1,783 879 294 255 341 --------- --------- -------- -------- ---------
Total nonperforming assets $ 3,380 $ 2,155 $ 930 $ 3,601 $ 737 ========= ========= ======== ======== =========
Nonperforming loans as a percent of total loans .68% .59% .30% 1.73% .25% Nonperforming assets as a percent of total assets 1.18% .77% .36% 1.50% .33% Nonperforming loans as a percent of the loan loss reserve 60.05% 58.00% 27.81% 77.50% 18.15%
9.
ALLOWANCE FOR LOAN LOSSES
The following table summarizes changes in the allowance for loan losses.
--------------------Years ended December 31,------------------- (in thousands) 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Loans: Average daily balance of loans for the year, net $ 222,017 $ 217,424 $203,698 $171,276 $ 163,916 Amount of loans outstanding at end of year, net $ 233,049 $ 212,589 $212,317 $192,721 $ 156,272
Allowance for loan losses: Balance at beginning of year $ 2,200 $ 2,287 $ 4,646 $ 2,182 $ 1,964 Loans charged off: Real estate - mortgage 23 - - 34 13 Real estate - construction - - 18 - - Commercial and agricultural 390 314 2,339 28 14 Consumer 231 265 120 96 26 --------- --------- -------- -------- --------- 644 579 2,477 158 53 --------- --------- -------- -------- --------- Recoveries of loans previously charged-off: Real estate-mortgage - - 2 15 - Commercial and agricultural 101 81 36 6 10 Consumer 50 23 50 41 22 --------- --------- -------- -------- --------- 151 104 88 62 32 --------- --------- -------- -------- ---------
Net loans charged-off (recoveries) 493 475 2,389 96 21 Additions to allowance charged to operations 953 388 30 2,560 239 --------- --------- -------- -------- --------- Balance at end of year $ 2,660 $ 2,200 $ 2,287 $ 4,646 $ 2,182 ========= ========= ======== ======== =========
Ratios: Net loans charged off to average net loans outstanding .22% .22% 1.17% .06% .01% Allowance for loan losses to net loans outstanding 1.14% 1.03% 1.08% 2.41% 1.40%
The allowance for loan losses is allocated to the loan portfolios in the amount deemed necessary to provide for probable incurred losses. The year-end allocations were as follows:
------------------------------------------------December 31,---------------------------------------------- 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Percent Percent Percent Percent Percent of Loans of Loans of Loans of Loans of Loans to Total to Total to Total to Total to Total Allowance Loans Allowance Loans Allowance Loans Allowance Loans Allowance Loans ---------------------------------------------------------------------------------------------------------- (In thousands) Commercial, financial and agricultural $ 2,034 77.80% $ 1,900 72.20% $ 1,774 69.49% $ 4,010 68.59% $ 1,680 70.95% Real estate - mortgage 18 4.28 5 8.11 1 6.63 33 8.72 18 10.73 Real estate - construction 25 3.82 23 3.41 134 6.23 99 5.03 74 - Consumer 207 14.10 148 16.28 119 17.65 135 17.66 130 18.32 Unallocated 376 - 124 - 259 - 369 - 280 - --------- -------- --------- -------- --------- -------- --------- -------- --------- -------- $ 2,660 100.00% $ 2,200 100.00% $ 2,287 100.00% $ 4,646 100.00% $ 2,182 100.00%
10.
LIQUIDITY
Liquidity is generally defined as the ability to meet cash flow needs of customers for loans and deposit withdrawals. To meet cash flow requirements, sufficient sources of liquid funds must be available. These sources include short-term investments, repayments of loans, maturing and called securities, sales of assets, growth in deposits and other liabilities and profits.
At present, Federal Reserve monetary policy combined with historically frail investment market conditions has placed a significant amount of unused cash in the markets we serve. These funds have been readily available in the form of bank deposits to cover our liquidity needs.
At December 31, 2002, we had $25.0 million of additional borrowing capacity at the Federal Home Loan Bank and $4.0 million of borrowing capacity with correspondent banks.
During 2002, we also generated $3.8 million in cash from operating activities. All of these sources are available to meet cash flow needs of loan and deposit customers.
We also need cash to pay dividends to our shareholders. Our primary source of cash is the dividends paid to the parent by our banks. We believe that cash from operations is sufficient to supply the cash needed to continue paying a reasonable dividend.
CAPITAL RESOURCES
At December 31, 2002, equity capital totaled $25.1 million. Management monitors the capital levels of the Company and the banks to provide for current and future business opportunities and to meet regulatory guidelines for “well capitalized” institutions. “Well capitalized” institutions are eligible for reduced FDIC premiums, and also enjoy other reduced regulatory restrictions.
At December 31, 2002, the Company and the banks exceeded all regulatory minimum capital requirements and are considered to be “well capitalized.”
ASSET LIABILITY MANAGEMENT
Asset liability management involves developing, implementing and monitoring strategies to maintain sufficient liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on earnings. Our banks’ Asset/Liability Committees are responsible for managing this process.
Quantitative and Qualitative Disclosures about Market Risk
Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Our banks’ transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Also, the banks have a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rate and commodity prices would have on interest rates are assumed to be insignificant.
Interest rate risk (IRR) is the exposure of a banking organization’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of IRR could pose a significant threat to earnings and capital. Accordingly, effective risk management that maintains IRR at prudent levels is essential to our safety and soundness.
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Evaluating exposure to changes in interest rates includes assessing both the adequacy of management’s process used to control IRR and the organization’s quantitative level of exposure. When assessing the IRR management process, we seek to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain IRR at prudent levels with consistency and continuity. Evaluating the quantitative level of IRR exposure requires the assessment of existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality.
We derive the majority of income from the excess of interest collected over interest paid. The rates of interest earned on assets and owed on liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profit margins (or losses) if we cannot adapt to interest rate changes. For example, assume that an institution’s assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise, by the time the short-term liabilities must be refinanced, the increase in the institution’s interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution’s profits could decrease because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate sensitive assets are funded by longer-term, fixed-rate liabilities in a decreasing rate environment.
Various techniques might be used by an institution to minimize IRR. We periodically analyze assets and liabilities and make future financing and investment decisions based on payment streams, interest rates, contractual maturities, and estimated sensitivity to actual or potential changes in market interest rates. Such activities fall under the broad definition of asset/liability management.
Several ways an institution can manage IRR include: selling existing assets or repaying certain liabilities; matching repricing periods for new assets and liabilities, for example, by shortening terms of new loans or investments and hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change IRR. Interest rate swaps, futures contracts, options on futures, and other such derivative financial instruments are often used for this purpose. Because these instruments are sensitive to interest rate changes, they require management’s expertise to be effective. We have not purchased derivative financial instruments in the past and do not presently intend to purchase such instruments.
We are also subject to repayment risk when interest rates fall. For example, mortgage loans and other financial assets may be prepaid by a debtor so that the debtor may refinance its obligations at new, lower rates. Prepayments of assets carrying higher rates reduces interest income and overall asset yields.
Certain portions of an institution’s liabilities may be short-term or due on demand, while most of its assets may be invested in long-term loans or investments. Accordingly, we seek to have in place sources of cash to meet short-term demands. These funds can be obtained by increasing deposits or selling assets. Also, Federal Home Loan Bank advances and short-term borrowings provide additional sources of liquidity.
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The following table provides information about our financial instruments that were sensitive to changes in interest rates as of December 31, 2002. We had no derivative financial instruments, or trading portfolio, as of that date. The expected maturity date values for loans receivable, mortgage-backed securities and investment securities were calculated without adjusting the instrument’s contractual maturity date for expectations of prepayments. Expected maturity date values for interest-bearing core deposits were not based upon estimates of the period over which the deposits would be outstanding, but rather the opportunity for repricing.
Principal/notional amount as of December 31, 2002 maturing in:
Fair 2003 2004 2005 2006 2007 Thereafter Total Value ---- ---- ---- ---- ---- ---------- ----- ----- (In thousands) Rate Sensitive Assets Fixed interest rate securities $ - $ - $ - $15,325 $ 3,590 $ 2,042 $ 20,957 $ 21,276 Average interest rate - - - 5.47% 4.96% 5.77% 5.37% Tax-exempt fixed rate securities 944 372 745 295 424 928 3,708 3,940 Average interest rate 4.36% 5.85% 4.49% 4.40% 4.05% 6.24% 4.97% FHLB stock 2,504 - - - - - 2,504 2,504 Average interest rate 6.25% - - - - - 6.25% FRB stock 493 - - - - - 493 493 Average interest rate 6.00% - - - - - 6.00% Fixed interest rate loans 59,924 10,920 5,238 28,234 7,233 2,817 114,366 114,733 Average interest rate 7.65% 7.97% 8.66% 7.36% 7.32% 6.96% 7.62% Variable interest rate loans 37,314 17,945 20,684 10,889 20,636 13,936 121,404 121,759 Average interest rate 5.59% 7.85% 7.45% 7.42% 7.40% 7.11% 6.89% -------- --------- ------- ------- ------- ------- ------- -------- Total earning assets 101,179 29,237 26,667 54,743 31,883 19,723 263,432 264,766 --------- ------- ------- ------- ------- ------- -------- -------
Rate Sensitive Liabilities Interest-bearing demand $ 59,549 $ - $ - $ - $ - $ - $ 59,549 $ 59,549 Average interest rate .49% - - - - - .49% - Savings 29,267 - - - - - 29,267 29,267 Average interest rate .71% - - - - - .71% Time deposits 65,349 26,592 8,923 1,827 1,385 - 104,076 108,289 Average interest rate 3.40% 4.32% 3.98% 3.82% 5.25% - 3.58% Repurchase agreements and federal funds purchased 3,507 - - - - - 3,507 3,507 Average interest rate% 2.00% - - - - - 2.00% Trust preferred securities - - - - - 4,836 4,836 4,836 variable rate - - - - - 5.17% 5.17% Fixed interest rate FHLB advances 408 441 477 3,803 - - 5,129 5,458 Average interest rate 6.04% 6.04% 6.04% 6.04% -% - 6.04% -------- --------- ------- ------- ------- ------- ------- -------- Total interest bearing liabilities 158,080 27,033 9,400 5,630 1,385 4,836 255,192 259,734 --------- ------- ------- ------- ------- ------- -------- --------
Interest rate sensitivity gap $ (56,901) $ 2,204 $17,267 $49,113 $30,498 $14,887 $ 8,240 ========= ======= ======= ======= ======= ======= ======== Cumulative interest rate sensitivity gap $ (56,901) $(54,697) $(37,430) $11,683 $42,181 $ 8,240 ========= ======== ======== ======= ======= =======
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Principal/notional amount as of December 31, 2001 maturing in:
Fair 2002 2003 2004 2005 2006 Thereafter Total Value ---- ---- ---- ---- ---- ---------- ----- ----- (In thousands) Rate Sensitive Assets Federal funds sold $ 8,290 $ - $ - $ - $ - $ - $ 8,290 $ 8,290 Average interest rate 1.50% - - - - - - Fixed interest rate securities 5,786 - 4,143 2,128 8,142 421 20,620 20,836 Average interest rate 5.14% - 5.24% 5.12% 5.85% 5.52% 5.44% Tax-exempt fixed rate securities 316 1,056 697 757 716 1,426 4,968 5,133 Average interest rate 5.94% 4.45% 5.24% 4.43% 5.32% 6.50% 5.37% FHLB stock 2,504 - - - - - 2,504 2,504 Average interest rate 6.00% - - - - - 6.00% FRB stock 480 - - - - - 480 480 Average interest rate 6.00% - - - - - 6.00% Fixed interest rate loans 10,049 7,152 16,476 15,321 19,348 25,715 94,061 95,792 Average interest rate 9.99% 9.13% 8.57% 8.43% 8.01% 7.58% 8.35% Variable interest rate loans 62,814 13,629 15,553 19,955 5,968 2,769 120,688 122,869 Average interest rate 5.35% 9.03% 8.11% 8.23% 8.71% 9.19% 6.85% --------- --------- ------- ------- ------- ------- ------- -------- Total earning assets 90,239 21,837 36,869 38,161 34,174 30,331 251,611 255,904 --------- ------- ------- ------- ------- ------- -------- ---------
Rate Sensitive Liabilities Interest-bearing demand $ 57,699 $ - $ - $ - $ - $ - $ 57,699 $ 57,699 Average interest rate 1.19% - - - - - 1.19% Savings 25,192 - - - - - 25,192 25,192 Average interest rate 1.50% - - - - - 1.50% Time deposits 73,044 20,995 10,920 1,095 975 - 107,029 109,503 Average interest rate 4.28% 5.67% 6.00% 4.64% 4.64% - 4.69% Securities sold under agreements to repurchase 1,889 - - - - - 1,889 1,889 Average interest rate% 1.54% - - - - - 1.54% Trust preferred securities - - - - - 4,850 4,850 4,850 variable rate - - - - - 6.02% 6.02% Fixed interest rate FHLB advances 376 407 441 477 3,804 - 5,505 5,510 Average interest rate 6.04% 6.04% 6.04% 6.04% 6.04% - 6.04% --------- --------- ------- ------- ------- ------- ------- -------- Total interest bearing liabilities 158,200 21,402 1,361 1,572 4,779 4,850 202,164 204,643 --------- ------- ------- ------- ------- ------- -------- ---------
Interest rate sensitivity gap $ (67,961) $ 435 $25,508 $36,589 $29,395 $ 25,487 $ 49,447 ========= ======= ======= ======= ======= ======== ========
Cumulative interest rate sensitivity gap $ (67,961) $(67,526) $(42,018) $(5,429) $23,966 $ 49,447 ========= ======== ======== ======= ======= ========
CRITICAL ACCOUNTING POLICIES
Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could effect these judgments include, but without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its
14.
critical accounting policies include determining the allowance for loan losses, determining the fair value of securities and other financial instruments and the valuation of mortgage servicing rights. The Company’s critical accounting policies are discussed in detail in Note 1 of the Notes to the Consolidated Financial Statements.
FORWARD-LOOKING STATEMENTS
This discussion and analysis of financial condition and results of operations and other sections of this Annual Report contain forward looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and about the Company itself. Words such as “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “foresee”, “intends”, “is likely”, “plans”, “product”, “projects”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements.
Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. Future Factors include:
changes in interest rates and interest rate relationships; demand for products and services;
the degree of competition by traditional and non-traditional competitors;
changes in banking regulations;
changes in tax laws;
changes in prices, levies and assessments;
the impact of technology, governmental and regulatory policy changes;
the outcome of pending and future litigation and contingencies;
trends in customer behavior as well as their ability to repay loans; and
changes in the national and local economies.
These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement.
15.
MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Pavilion Bancorp, Inc.‘s consolidated financial statements and related information appearing in this Annual Report. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions and reasonably present Pavilion Bancorp’s financial position and results of operations and were prepared in conformity with accounting principles generally accepted in the United States of America. Management also has included in the Company’s financial statements, amounts that are based on estimates and judgments which it believes are reasonable under the circumstances.
Pavilion Bancorp, Inc. maintains a system of internal controls designed to provide reasonable assurance that all assets are safeguarded and financial records are reliable for preparing the consolidated financial statements. The Company complies with laws and regulations relating to safety and soundness which are designated by the FDIC and other appropriate federal banking agencies. The selection and training of qualified personnel and the establishment and communication of accounting and administrative policies and procedures are elements of this control system. The effectiveness of internal controls is monitored by a program of internal audit. Management recognizes that the cost of a system of internal controls should not exceed the benefits derived and that there are inherent limitations to be considered in the potential effectiveness of any system. Management believes that Pavilion Bancorp’s system provides the appropriate balance between costs of controls and the related benefits.
The independent auditors have audited the Company’s consolidated financial statements in accordance with auditing standards generally accepted in the United States of America and provide an objective, independent review of the fairness of the reported operating results and financial position. The Board of Directors of Pavilion Bancorp has an Audit Committee composed of four non-management Directors. The Committee meets periodically with the internal auditors and the independent auditors.
Douglas L. Kapnick
Chairman and Chief Executive Officer Loren V. Happel
Chief Financial Officer
16.
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
Pavilion Bancorp, Inc.
Adrian, Michigan
We have audited the accompanying consolidated balance sheets of Pavilion Bancorp, Inc. as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the years ended December 31, 2002, 2001 and 2000. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Pavilion Bancorp, Inc. as of December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the years ended December 31, 2002, 2001 and 2000 in conformity with accounting principles generally accepted in the United States of America.
Grand Rapids, Michigan
February 4, 2003 Crowe, Chizek and Company LLP
17.
PAVILION BANCORP, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2002 and 2001
2002 2001 ---- ---- ASSETS Cash and due from banks $ 11,222,644 $ 15,986,998 Federal funds sold - 8,290,000 ----------------- ----------------- Total cash and cash equivalents 11,222,644 24,276,998
Securities available for sale 25,215,853 25,969,241 Federal Home Loan Bank stock, at cost 2,503,700 2,503,700 Federal Reserve Bank stock, at cost 493,350 480,000
Loans held for sale 1,473,300 416,600 Loans receivable, net of allowance for loan losses: $2,659,935 - 2002; $2,200,157 - 2001 233,048,728 212,589,534 Premises and equipment, net 6,314,240 6,611,126 Accrued interest receivable 1,867,988 1,877,744 Mortgage servicing rights 2,715,011 2,065,958 Other assets 2,431,180 1,485,761 ----------------- -----------------
Total assets $ 287,285,994 $ 278,276,662 ================= =================
LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest bearing $ 48,827,584 $ 45,487,597 Interest bearing 192,892,537 189,919,417 ----------------- ----------------- Total deposits 241,720,121 235,407,014
Borrowed funds 8,635,176 7,394,232 Accrued interest payable 506,603 849,994 Other liabilities 2,254,464 1,618,466 Guaranteed preferred beneficial interests in the Corporation's subordinated debentures (Note 9 - Trust Preferred Securities) 5,000,000 5,000,000 Common stock subject to repurchase obligation in ESOP 4,100,407 4,444,244 ----------------- ----------------- Total liabilities 262,216,771 254,713,950
Shareholders' equity Common stock and paid-in capital, no par value: 3,000,000 shares authorized; shares issued and outstanding: 831,182 - 2002; 848,537 - 2001 9,711,476 10,186,534 Retained earnings 15,254,440 13,124,430 Accumulated other comprehensive income 103,307 251,748 ----------------- ----------------- Total shareholders' equity 25,069,223 23,562,712 ----------------- -----------------
Total liabilities and shareholders' equity $ 287,285,994 $ 278,276,662 ================= =================
See accompanying notes to consolidated financial statements.
18.
PAVILION BANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ---- ---- ---- Interest and dividend income Loans receivable, including fees $ 17,785,876 $ 19,284,332 $ 19,267,973 Taxable securities 911,175 975,860 850,100 Nontaxable securities 202,868 247,890 289,436 Federal funds sold 88,331 255,321 166,828 Dividend income 173,911 208,194 229,023 Other 19,757 40,911 47,993 --------------- --------------- ---------------- Total interest and dividend income 19,181,918 21,012,508 20,851,353
Interest expense Deposits 5,365,835 7,779,154 7,853,587 Trust preferred securities 292,697 26,345 - Other borrowed funds 370,148 392,862 856,797 --------------- --------------- ---------------- Total interest expense 6,028,680 8,198,361 8,710,384 --------------- --------------- ----------------
Net interest income 13,153,238 12,814,147 12,140,969 Provision for loan losses 953,000 388,000 30,000 --------------- --------------- ----------------
Net interest income after provision for loan losses 12,200,238 12,426,147 12,110,969
Noninterest income Service charges and fees 1,887,831 1,362,691 980,745 Net gains on loan sales 4,839,085 2,715,924 651,733 Loan servicing fees, net of amortization (1,159,165) (290,590) 107,109 Gain on sale of securities 8,838 - - Other 398,155 363,256 324,282 --------------- --------------- ---------------- 5,974,744 4,151,281 2,063,869
Noninterest expense Salaries and employee benefits 8,456,260 7,188,368 5,018,659 Occupancy and equipment 2,367,665 2,067,338 1,588,555 Printing, postage and supplies 490,457 420,637 312,674 Professional and outside services 399,198 563,213 391,617 Mobile banking costs 448,227 425,563 341,658 Receivable financing services 201,938 249,149 296,733 Other 1,628,955 1,268,030 1,463,633 --------------- --------------- ---------------- 13,992,700 12,182,298 9,413,529 --------------- --------------- ----------------
Income before income taxes 4,182,282 4,395,130 4,761,309 Income tax expense 1,326,940 1,352,058 1,556,376 --------------- --------------- ----------------
Net income $ 2,855,342 $ 3,043,072 $ 3,204,933 =============== =============== ================
Basic earnings per share $ 3.39 $ 3.58 $ 3.75 =============== =============== ================
Diluted earnings per share $ 3.37 $ 3.54 $ 3.71 =============== =============== ================
See accompanying notes to consolidated financial statements.
19.
PAVILION BANCORP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31, 2002, 2001 and 2000
Common Accumulated Stock and Other Total Paid-In Retained Comprehensive Shareholders' Capital Earnings Income (Loss) Equity ------- -------- ------------- ------
Balance January 1, 2000 $ 10,430,303 $ 8,352,940 $ (334,282) $ 18,448,961
Comprehensive income: Net income 3,204,933 3,204,933 Unrealized gains (losses) on securities 454,418 Tax effect (154,539) -------------- Total other comprehensive income 299,879 299,879 -------------- --------------- Total comprehensive income 3,504,812 ---------------
Change in common stock subject to repurchase (787,470) (787,470)
Retirement of stock - 3,441 shares (151,405) (151,405)
Proceeds from sale of stock - 2,582 shares 117,065 117,065
Stock option expense 23,465 23,465
Cash dividends - $.94 per share (802,450) (802,450) ------------- ------------- -------------- ---------------
Balance December 31, 2000 9,631,958 10,755,423 (34,403) 20,352,978
Comprehensive income: Net income 3,043,072 3,043,072 Unrealized gains (losses) on securities 433,327 Tax effect (147,176) -------------- Total other comprehensive income 286,151 286,151 -------------- --------------- Total comprehensive income 3,329,223 ---------------
Change in common stock subject to repurchase 669,526 669,526
Retirement of stock - 5,619 shares (284,286) (284,286)
Proceeds from sale of stock - 2,605 shares 132,855 132,855
Stock option expense 36,481 36,481
Cash dividends - $.80 per share (674,065) (674,065) ------------- ------------- -------------- ---------------
Balance December 31, 2001 10,186,534 13,124,430 251,748 23,562,712
Comprehensive income: Net income 2,855,342 2,855,342 Establish minimum pension liability (398,683) Unrealized gains (losses) on securities 168,667 Tax effect 81,575 -------------- Total other comprehensive income (148,441) (148,441) -------------- --------------- Total comprehensive income 2,706,901 ---------------
Change in common stock subject to repurchase 343,837 343,837
Retirement of stock - 21,423 shares (1,019,130) (1,019,130)
Proceeds from sale of stock - 2,044 shares 105,260 105,260
Stock option expense 34,451 34,451
Stock options exercised 60,524 60,524
Cash dividends - $.86 per share (725,332) (725,332) ------------- ------------- -------------- ---------------
Balance December 31, 2002 $ 9,711,476 $ 15,254,440 $ 103,307 $ 25,069,223 ============= ============= ============== ===============
See accompanying notes to consolidated financial statements.
20.
PAVILION BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ---- ---- ---- Cash flows from operating activities Net income $ 2,855,342 $ 3,043,072 $ 3,204,933 Adjustments to reconcile net income to net cash from operating activities Depreciation 902,923 804,504 690,753 Stock option expense 34,451 36,481 23,465 Provision for loan losses 953,000 388,000 30,000 Net amortization and accretion on securities available for sale 291,654 102,372 69,728 Net realized (gain) loss on sales of securities (8,838) - - Amortization of mortgage servicing rights 1,782,696 790,896 314,534 Loans originated for sale (230,040,837) (156,501,748) (37,696,914) Proceeds from sales of mortgage loans 231,391,473 158,263,182 44,954,185 Net gains on sales of mortgage loans (4,839,085) (2,715,924) (651,733) Net change in: Deferred loan origination fees (101,649) (52,129) (33,877) Accrued interest receivable 9,756 21,203 (322,668) Other assets 589,924 1,532,660 (481,094) Accrued interest payable (343,391) (95,797) 301,960 Other liabilities 304,414 232,883 154,858 --------------- --------------- ---------------- Net cash from operating activities 3,781,833 5,849,655 10,558,130
Cash flows from investing activities Proceeds from: Maturities, calls and principal payments on securities available for sale 18,135,401 10,207,721 4,087,858 Sales of securities available for sale 3,508,838 - - Purchases of: Securities available for sale (21,005,000) (16,525,000) - Federal Reserve Bank Stock (13,350) (120,000) - Premises and equipment, net (606,037) (1,427,028) (158,331) Net increase in loans (22,982,728) (1,552,221) (26,951,438) Recoveries on loans charged-off 151,316 103,993 87,547 --------------- --------------- ---------------- Net cash from investing activities (22,811,560) (9,312,535) (22,934,364)
Cash flows from financing activities Net change in deposits 6,313,107 11,264,359 24,936,246 Net change in short term borrowings 1,617,356 (194,032) 80,917 Proceeds from FHLB advances - - 10,000,000 Net proceeds from issuance of trust preferred securities - 4,850,417 - Repayment of FHLB advances (376,412) (347,886) (18,321,521) Repurchase of common stock (1,019,130) (284,286) (151,405) Issuance of common stock 105,260 132,855 117,065 Stock options exercised 60,524 - - Dividends paid (725,332) (674,065) (802,450) --------------- --------------- ---------------- Net cash from financing activities 5,975,373 14,747,362 15,858,852 --------------- --------------- ----------------
Net change in cash and cash equivalents (13,054,354) 11,284,482 3,482,618
Cash and cash equivalents at beginning of year 24,276,998 12,992,516 9,509,898 --------------- --------------- ----------------
Cash and cash equivalents at end of year $ 11,222,644 $ 24,276,998 $ 12,992,516 =============== =============== ================
Supplemental schedule of noncash activities Transfer from: Loans to foreclosed real estate $ 1,520,867 $ 839,840 $ 126,318 Portfolio loans to loans held for sale - - 9,592,343 Loans held for sale to portfolio loans - - 2,447,377
Cash paid for: Interest $ 6,372,071 $ 8,294,158 $ 8,408,424 Income taxes 1,599,000 836,000 1,147,000
See accompanying notes to consolidated financial statements.
21.
PAVILION BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002, 2001 and 2000
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES
The accounting and reporting policies of Pavilion Bancorp, Inc. (the Company) and its wholly owned subsidiaries, Bank of Lenawee and Bank of Washtenaw (the Banks), conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry. The following describes the significant accounting and reporting policies which are employed in the preparation of the consolidated financial statements.
Principles of Consolidation: The consolidated financial statements include the accounts of the Company, Lenawee Capital Trust I, the Banks and Bank of Lenawee ‘s wholly owned subsidiaries, Pavilion Mortgage Company and Pavilion Financial Services. All significant intercompany balances and transactions have been eliminated in consolidation.
Lenawee Capital Trust I (“Capital Trust”) was formed in December 2001. All of the common securities of this special purpose trust are owned by the Company. The Trust exists solely to issue trust preferred securities. For financial reporting purposes, the Trust is reported as a subsidiary and is consolidated into the financial statements of the Company. The Trust Preferred Securities are presented as a separate line item on the consolidated balance sheet.
Nature of Operations, Industry Segments and Concentrations of Credit Risk: The Company is a two-bank holding company which conducts limited business activities. The Banks perform the majority of the business activities.
The Banks provide a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in their service area. They maintain a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Banks offer a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit. Pavilion Mortgage Company originates personal mortgage loans, and the majority of the mortgage loans originated are sold on the secondary market. While the Company’s chief decision maker monitors the revenue stream of various Company products and services, operations are managed and financial performance is evaluated on a Company wide basis. Accordingly, all of the Company’s banking operations are considered by management to be aggregated into one operating segment.
The principal market for the Banks’ financial services are the Michigan communities in which the Banks are located and the areas immediately surrounding these communities. The Banks serve these markets through their offices located in Lenawee, Hillsdale and Washtenaw Counties in Michigan.
Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, 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 future results could differ. The allowance for loan losses, mortgage servicing rights and fair values of securities and other financial instruments are particularly subject to change.
Cash Flow Reporting: Cash and cash equivalents include cash on hand, demand deposits with other financial institutions, federal funds sold and commercial paper with original maturities of 90 days or less. Cash flows are reported, net, for customer loan and deposit transactions, and borrowed funds with original maturities of 90 days or less.
(Continued)
22.
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES (Continued)
Securities: Securities are classified as available for sale when they might be sold before maturity. Ssuuch securities are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income. Other securities such as Federal Home Loan Bank and Federal Reserve Bank stock are carried at cost.
Gains and losses on sales are determined using the amortized cost of the specific security sold. Interest and dividend income, adjusted by amortization of purchase premiums and discounts, is included in earnings. Securities are written down to fair value when a decline in fair value is not temporary.
Loans Held for Sale: Loans held for sale are reported at the lower of cost or market value in aggregate. Net unrealized losses are recorded in a valuation allowance by charges to income.
Loans Receivable: Loans that management has the intent and the ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term.
Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days, unless the loan is both well secured and in the process of collection. Payments received on such loans are reported as principal reductions. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and 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. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.
A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual loan basis for other loans. 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.
(Continued)
23.
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES (Continued)
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using a combination of straight-line and accelerated methods with useful lives ranging from 10 to 40 years for buildings and improvements, and 3 to 10 years for furniture and equipment. These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur. Major improvements are capitalized.
Servicing Rights: Servicing rights represent the allocated value of servicing rights retained on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues.
Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance.
Other Real Estate Owned: Real estate properties acquired through or instead of foreclosure are initially recorded at fair value at acquisition. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Other real estate owned amounts to $1,783,000 and $879,000 at December 31, 2002 and 2001 and are included in other assets.
Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.
Benefit Plans: A defined benefit pension plan covers substantially all employees, with benefits based on years of service and compensation prior to retirement. Pension expense is the net of service and interest cost, return on plan assets, and amortization of gains and losses not immediately recognized. The Company records a minimum pension liability when the Company’s accumulated benefit obligation exceeds the fair value of plan assets by reducing accumulated other comprehensive income, net of tax. Profit-sharing and 401(k) plan expense is the amount contributed as determined by Board decision.
Stock Compensation: Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income unless options granted have an exercise price that is less than the market price of the underlying common stock at date of grant. During 2001 and 2000, stock options were granted with exercise prices that were less than the fair market value of the underlying common stock as of the grant date; therefore, the Company is recording compensation expense for the difference between the strike price and fair market value of the underlying common stock as of the respective grant dates for the 2001 and 2000 stock option grants. Accordingly compensation expense for these stock options has been recorded during 2002, 2001 and 2000 based on the vesting schedules of the related stock options. Compensation expense for stock options was $34,000, $36,000 and $23,000 during 2002, 2001 and 2000. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provision of FASB Statement No. 123, Accounting for Stock-Based Compensation.
(Continued)
24.
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES (Continued)
2002 2001 2000 ---- ---- ----
Net income as reported $ 2,855,342 $ 3,043,072 $ 3,204,933 Less: Stock-based compensation expense determined under fair value based method 61,002 69,534 53,808 -------------- --------------- --------------
Proforma net income $ 2,794,340 $ 2,973,538 $ 3,151,125 ============== =============== ==============
Basic earnings per share as reported $ 3.39 $ 3.58 $ 3.75 Proforma basic earnings per share 3.32 3.50 3.69
Diluted earnings per share as reported 3.37 3.54 3.71 Proforma diluted earnings per share 3.29 3.46 3.64
The pro forma effects are computed using option pricing models, using the following weighted average assumptions as of grant date for the years ended December 31, 2002, 2001 and 2000:
2002 2001 2000 ---- ---- ----
Risk-free interest rate 4.78% 4.88% 6.64% Expected option life 8 years 8 years 8 years Expected dividend yield 1.38% 1.44% 1.35% Expected stock price volatility 22.92% 23.16% 20.92%
The weighted average fair value of stock options granted was $16.69, $20.18 and $24.86 for 2002, 2001 and 2000.
Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. No valuation allowance was needed as of December 31, 2002 and 2001.
Earnings and Dividends Per Share: Basic earnings per common share is based on net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share shows the dilutive effect of any additional potential common shares issuable under stock options.
Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes the net change in unrealized appreciation (depreciation) on securities available for sale, net of tax, and the change in the Company’s minimum pension liability, net of tax, which are also recognized as a separate component of shareholders’ equity.
Financial Instruments with Off-Balance-Sheet Risk: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit issued to meet customer’s needs. The face amount for these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
(Continued)
25.
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES (Continued)
Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on and off-balance-sheet financial instruments does not include the value of anticipated future business or values of assets and liabilities not considered financial instruments.
Newly Issued But Not Yet Effective Accounting Standards: New accounting standards on asset retirement obligations, restructuring activities and exit costs, operating leases, and early extinguishment of debt were issued in 2002. Management determined that when the new accounting standards are adopted in 2003 they will not have a material impact on the Company’s financial condition or results of operations.
Reclassifications: Some items in the prior year financial statements have been reclassified to conform with the current year presentation.
NOTE 2 - SECURITIES
Year-end securities available for sale were as follows:
Gross Gross Fair Unrealized Unrealized Value Gains Losses ----- ----- ------ ---- U. S. Treasury and government agencies $ 18,710,181 $ 204,836 $ - Obligations of states and political subdivisions 4,380,088 261,462 - Mortgage-backed securities 2,125,584 83,625 - --------------- ------------- --------------
$ 25,215,853 $ 549,923 $ - =============== ============= ==============
Gross Gross Fair Unrealized Unrealized Value Gains Losses ----- ----- ------ ---- U. S. Treasury and government agencies $ 18,064,679 $ 180,506 $ (1,490) Obligations of states and political subdivisions 5,132,785 164,693 - Mortgage-backed securities 2,771,777 37,547 - --------------- ------------- --------------
$ 25,969,241 $ 382,746 $ (1,490) =============== ============= ==============
(Continued)
26.
NOTE 2 - SECURITIES (Continued)
Contractual maturities of debt securities at year-end 2002 were as follows. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
Fair Value -----
Due in one year or less $ 961,297 Due from one to five years 21,105,002 Due from five to ten years 576,286 Due after ten years 447,684 -------------- 23,090,269 Mortgage-backed securities 2,125,584 --------------
$ 25,215,853 ==============
Sales of securities available for sale were:
2002 2001 2000 ---- ---- ----
Proceeds from sales $ 3,508,838 $ - $ - Gross gains from sales 8,838 - - Gross losses from sales - - -
In addition to Federal Home Loan Bank (FHLB) stock, securities with a fair value of approximately $4,030,000 and $5,023,000 at year-end 2002 and 2001 were pledged to secure, public deposits, repurchase agreements and U.S. Treasury demand notes. Except as indicated, total securities of any state (including all its political subdivisions) were less than 10% of shareholders’ equity. At year-end 2002 and 2001, fair value of securities issued by the state of Michigan and all its political subdivisions totaled $3,953,000 and $4,714,000.
NOTE 3 - LOANS RECEIVABLE
Year-end loans receivable are as follows:
2002 2001 ---- ----
Commercial $ 152,854,003 $ 123,306,677 Agricultural 30,578,909 31,764,155 Real Estate Mortgage 10,081,177 17,408,540 Real Estate Construction 9,013,211 7,318,226 Consumer 33,242,400 34,951,480 ---------------- ---------------- Gross loans receivable 235,769,700 214,749,078 Deferred loan origination fees/costs, net (61,037) 40,613 Allowance for loan losses (2,659,935) (2,200,157) ---------------- ----------------
Net loans receivable $ 233,048,728 $ 212,589,534 ================ ================
(Continued)
27.
NOTE 3 - LOANS RECEIVABLE (Continued)
Certain directors and executive officers of the Company, including associates of such persons, were loan customers of the Company during 2002 and 2001. A summary of aggregate related party loan activity for loans aggregating $60,000 or more to any related party is as follows:
2002 2001 ---- ----
Balance at January 1 $ 3,876,891 $ 2,441,625 New loans 6,174,454 4,840,600 Repayments (6,713,026) (3,489,144) Other adjustments (78,794) 83,810 ---------------- ----------------
Balance at December 31 $ 3,259,525 $ 3,876,891 ================ ================
NOTE 4 - ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses was as follows:
2002 2001 2000 ---- ---- ----
Beginning balance $ 2,200,157 $ 2,287,438 $ 4,646,484 Loan charge-offs (644,538) (579,274) (2,476,593) Loan recoveries 151,316 103,993 87,547 ---------------- ----------------- ---------------- Net loan charge-offs (493,222) (475,281) (2,389,046) Provision for loan losses 953,000 388,000 30,000 ---------------- ----------------- ----------------
Ending balance $ 2,659,935 $ 2,200,157 $ 2,287,438 ================ ================= ================
Impaired loans were as follows:
2002 2001 2000 ---- ---- ---- Year-end loans with no allowance for loan losses allocated $ 54,000 $ - $ - Year-end loans with allowance for loan losses allocated 1,119,000 652,000 325,000 ---------------- ----------------- ----------------
Total impaired loans $ 1,173,000 $ 652,000 $ 325,000 ================ ================= ================
Amount of the allowance allocated $ 153,000 $ 367,000 $ 106,000
Average of impaired loans during the year 1,195,000 433,000 1,946,000
Interest income recognized during impairment 101,000 5,000 49,000
Cash-basis interest income recognized 75,000 1,000 14,000
(Continued)
28.
NOTE 4 - ALLOWANCE FOR LOAN LOSSES (Continued)
Nonperforming loans were as follows:
2002 2001 ---- ----
Loans past due over 90 days still on accrual $ 949,000 $ 1,046,000 Nonaccrual loans 648,000 230,000
Nonperforming loans and impaired loans are defined differently. Some loans may be included in both categories, whereas other loans may only be included in one category.
NOTE 5 - LOAN SERVICING
Loans serviced for others are not reported as assets. These loans totaled $300,255,000 and $227,205,000 at year-end 2002 and 2001. Related escrow balances were $632,000 and $459,000 at year-end 2002 and 2001.
Activity for capitalized mortgage servicing rights was as follows:
2002 2001 2000 ---- ---- ---- Servicing rights: Beginning of year $ 2,065,958 $ 1,515,924 $ 1,335,419 Additions 2,431,749 1,340,930 495,039 Amortization (1,782,696) (790,896) (314,534) ---------------- ---------------- --------------
End of year $ 2,715,011 $ 2,065,958 $ 1,515,924 ================ ================ ==============
There was no valuation allowance at year-end 2002, 2001 or 2000 for mortgage servicing rights.
NOTE 6 - PREMISES AND EQUIPMENT
Year-end premises and equipment consist of:
2002 2001 ---- ----
Land $ 697,001 $ 669,812 Buildings and improvements 6,950,416 6,873,193 Furniture and equipment 6,984,371 6,527,324 ----------------- -------------- Total cost 14,631,788 14,070,329 Accumulated depreciation (8,317,548) (7,459,203) ----------------- --------------
$ 6,314,240 $ 6,611,126 ================= ==============
(Continued)
29.
NOTE 7 - DEPOSITS
At year-end 2002, stated maturities of time deposits were as follows, for the years ending December 31:
2003 $ 65,349,430 2004 26,592,262 2005 8,923,313 2006 1,826,533 2007 1,384,450 -----------------
$ 104,075,988 =================
Time deposits exceeding $100,000 were approximately $37,137,000 and $41,964,000 at year-end 2002 and 2001.
At year-end 2002, stated maturities of time deposits exceeding $100,000 were as follows:
In 3 months or less $ 17,491,183 Over 3 through 6 months 6,917,298 Over 6 through 12 months 3,240,731 Over 12 months 9,487,906 -----------------
$ 37,137,118 =================
Related party deposits were $1,081,000 and $756,000 at year-end 2002 and 2001.
NOTE 8 - BORROWED FUNDS
Repurchase Agreements
Information concerning repurchase agreements is summarized as follows:
2002 2001 ---- ----
Amount outstanding at year-end $ 2,216,604 $ 1,889,248 Weighted average interest rate at year-end 1.38% 1.54% Average daily balance during the year $ 2,851,826 $ 2,145,855 Weighted average interest rate during the year 1.98% 2.76% Maximum month-end balance during the year $ 3,653,102 $ 4,615,219
Federal Home Loan Bank Advances
Federal Home Loan Bank (FHLB) advances totaled $5,128,572 and $5,504,984 at year-end 2002 and 2001. The balance at both year-ends consisted of one fixed rate advance with an interest rate of 6.04%. The Company has additional borrowing capacity at the FHLB as well as some borrowing capacity with correspondent banks.
(Continued)
30.
NOTE 8 - BORROWED FUNDS (Continued)
Pursuant to collateral agreements with the Federal Home Loan Bank, in addition to Federal Home Loan stock, advances are secured under a blanket lien arrangement by qualified 1-to-4 family mortgage loans with a carrying value of approximately $10,689,000 and $13,176,000 at year-end 2002 and 2001.
At year-end 2002, scheduled principal reductions on the advance were as follows for the years ending December 31:
----
2003 $ 407,278 2004 440,675 2005 476,810 2006 3,803,809 ---------------
Total FHLB advances $ 5,128,572 ===============
Borrowed funds include $1,290,000 of federal funds purchased as of December 31, 2002, and these borrowings matured in January of 2003. There were no federal funds purchased as of December 31, 2001.
NOTE 9 - TRUST PREFERRED SECURITIES
In December 2001, Lenawee Capital Trust I (“Capital Trust”), a wholly owned subsidiary of the Company, closed a pooled private offering of 5,000 Trust Preferred Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures with terms similar to the Trust Preferred Securities. The sole assets of Capital Trust are the junior subordinated debentures of the Company and payment thereunder. The junior subordinated debentures and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of Capital Trust under the Trust Preferred Securities. Distributions on the Trust Preferred Securities are payable semi-annually at a variable rate of interest and are included in interest expense in the consolidated financial statements. The variable rate of interest is equal to the sum of the six month London Interbank Offered Rate and 3.75% with a maximum rate of 11.0% during the first five years, and the rate of interest is equal to 5.17% as of December 31, 2002. These securities are considered Tier 1 capital (with certain limitations applicable) under current regulatory guidelines. As of December 31, 2002 and 2001, the outstanding principal balance of the Trust Preferred Securities was $5,000,000. The principal balance of the Trust Preferred Securities are presented as a liability in the financial statements.
The trust preferred securities, which mature December 8, 2031, are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption at the liquidation preference plus accrued but unpaid distributions. The subordinated debentures are redeemable prior to the maturity date at the option of the Company on or after December 8, 2006 at their principal amount plus accrued but unpaid interest. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The Company has the option to defer distributions on the subordinated debentures from time to time for a period not to exceed 5 consecutive years
NOTE 10 - INCOME TAXES
Income tax expense consists of:
2002 2001 2000 ---- ---- ----
Current $ 1,255,086 $ 1,189,935 $ 753,556 Deferred 71,854 162,123 802,820 --------------- -------------- -------------- Total $ 1,326,940 $ 1,352,058 $ 1,556,376 =============== ============== ==============
(Continued)
31.
Income tax expense calculated at the statutory federal income tax rate of 34% differs from actual income tax expense as follows:
2002 2001 2000 ---- ---- ----
Statutory rates $ 1,421,976 $ 1,494,344 $ 1,618,845 Increase (decrease) from: Tax-exempt securities income (89,050) (108,880) (105,095) Non-deductible interest expense 4,280 8,766 15,615 Other, net (10,266) (42,172) 27,011 --------------- -------------- --------------
$ 1,326,940 $ 1,352,058 $ 1,556,376 =============== ============== ==============
Year-end deferred tax assets and liabilities consist of:
2002 2001 ---- ---- Deferred tax assets Allowance for loan losses $ 654,745 $ 503,356 Net deferred loan fees 214,356 216,207 Pension expense 77,481 32,187 Minimum pension liability 135,552 - Other 75,190 74,716 --------------- -------------- Total deferred tax assets 1,157,324 826,466 --------------- -------------- Deferred tax liabilities Depreciation (293,568) (305,330) Mortgage servicing rights (923,104) (644,182) Net unrealized gains on securities available for sale (188,772) (129,688) --------------- -------------- Total deferred tax liabilities (1,405,444) (1,079,200) --------------- -------------- Net deferred tax asset (liability) $ (248,120) $ (252,734) =============== ==============
(Continued)
32.
NOTE 11 - EARNINGS PER SHARE
A reconciliation of the numerators and denominators of the basic earnings per share and diluted earnings per share computations for the years ended is presented below:
2002 2001 2000 Basic earnings per share ---- ---- ---- Net income available to common shareholders $ 2,855,342 $ 3,043,072 $ 3,204,933 ============== =============== ==============
Weighted average common shares outstanding 841,947 849,833 853,910 ============== =============== ==============
Basic earnings per share $ 3.39 $ 3.58 $ 3.75 ========= ======= ========
Diluted earnings per share Net income available to common shareholders $ 2,855,342 $ 3,043,072 $ 3,204,933 ============== =============== ==============
Weighted average common shares outstanding 841,947 849,833 853,910 Add: Dilutive effects of exercise of stock options 6,174 9,554 10,881 -------------- --------------- --------------
Weighted average common and dilutive potential common shares outstanding 848,121 859,387 864,791 ============== =============== ==============
Diluted earnings per share $ 3.37 $ 3.54 $ 3.71 ========= ======= ========
Stock options for 20,120 shares of common stock were not considered in computing diluted earnings per common share for 2002 because these options were not dilutive. All stock options outstanding were dilutive during 2001 and 2000.
(Continued)
33.
NOTE 12 - EMPLOYEE BENEFITS
Defined Benefit Plan
Information about the pension plan was as follows.
2002 2001 ---- ---- Change in benefit obligation: Beginning benefit obligation $ 2,179,093 $ 1,958,501 Service cost 180,930 146,675 Interest cost 157,242 138,067 Actuarial (gain) loss 239,102 (589) Benefits paid (62,891) (63,561) --------------- --------------
Ending benefit obligation $ 2,693,476 $ 2,179,093 =============== ==============
Change in plan assets, at fair value: Beginning plan assets $ 1,627,333 $ 1,444,811 Actual return (149,669) (67,809) Employer contribution 262,384 313,892 Benefits paid (62,891) (63,561) --------------- --------------
Ending plan assets $ 1,677,157 $ 1,627,333 =============== ==============
Net amount recognized: Funded status $ (1,016,319) $ (551,760) Unrecognized net actuarial loss 1,044,315 585,855 Unrecognized transition obligation 4,108 8,213 Minimum pension liability (398,683) - Unrecognized prior service cost 5,390 8,099 --------------- --------------
Prepaid (accrued) benefit cost $ 361,189 $ 50,407 =============== ==============
The components of pension expense and related actuarial assumptions were as follows.
2002 2001 2000 ---- ---- ----
Service cost $ 180,930 $ 146,675 $ 154,300 Interest cost 157,242 138,067 122,931 Expected return on plan assets (112,919) (103,156) (94,578) Amortization of prior service cost 2,709 2,709 2,709 Amortization of transition obligation 4,105 4,105 4,105 Recognized net actuarial loss 43,230 17,435 12,141 Special termination benefit loss - - 65,300 -------------- --------------- --------------
Net pension expense $ 275,297 $ 205,835 $ 266,908 ============== =============== ==============
Discount rate on benefit obligation 6.75% 7.25% 7.5% Long-term expected rate of return on plan assets 8.0% 8.0% 8.0% Rate of compensation increase 5.0% 5.0% 5.0%
(Continued)
34.
NOTE 12 - EMPLOYEE BENEFITS (continued)
Accumulated other comprehensive income was decreased by $263,000, net of tax effects, to recognize the Company’s minimum pension liability at December 31, 2002.
ESOP and 401(k) Plan
The Company maintains an employee stock ownership plan (ESOP) covering employees hired before January 1, 1995. On January 1, 1995, the Company ceased making contributions to the ESOP.
At year-end 2002 and 2001, the ESOP held 78,103 and 86,296 shares of the Company’s stock, all of which is allocated to employees. Upon distribution of shares to a participant, the participant has the right to require the Company to purchase shares at the most recent appraised value in accordance with the terms and conditions of the plan. As such, these shares are classified as a liability in the financial statements. The appraisal value of the shares held by the ESOP was $4,100,000 and $4,444,000 at year-end 2002 and 2001.
The ESOP plan includes a 401(k) provision. Employees may elect to contribute up to 15% of their salaries, and the Company will match 100% of the contribution up to 2% of the eligible salaries. Expense relating to the 401(k) provision was $110,000, $119,000 and $97,000 in 2002, 2001 and 2000.
(Continued)
35.
NOTE 12 - EMPLOYEE BENEFITS (Continued)
Stock Option Plan
Stock option plans are used to reward directors and certain executive officers and provide them with an additional equity interest. Options are issued for 10 year periods and vest over five years. Information about options available for grant and options granted follows:
Weighted- Average Available Options Exercise For Grant Outstanding Price --------- ----------- -----
Balance at January 1, 2000 27,460 22,160 25.14 Options issued (5,720) 5,720 44.00 ------------ ----------- ----------- Balance at December 31, 2000 21,740 27,880 29.01 Expiration of non-granted options (21,740) - - Options approved 50,000 - - Options issued (7,200) 7,200 51.00 ------------ ----------- ----------- Balance at December 31, 2001 42,800 35,080 33.53 Options issued (7,200) 7,200 51.50 Options exercised - (2,024) 22.90 Options forfeited 1,496 (1,496) 45.92 ------------ ----------- ----------- Balance at December 31, 2002 37,096 38,760 $ 36.94 ============ =========== ===========
Options exercisable at year-end are as follows:
Weighted- Average Number of Exercise Options Price ------- -----
2002 20,052 $ 27.88 2001 16,176 24.52 2000 9,964 22.25
Options outstanding at year-end 2002 were as follows:
---------------Outstanding---------------- -------Exerciseable------- Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Contractual Exercise Exercise Prices Number Life Price Number Price ------ ------ ---- ----- ------ -----
$18-$25 14,600 4.0 $21.40 13,412 $21.08 $36-$44 10,560 6.6 $40.00 5,280 $39.20 $51-$52 13,600 8.8 $51.25 1,360 $51.00 --------- ---------
Outstanding at year end 38,760 6.4 $36.94 20,052 $27.88 ========= =========
(Continued)
36.
NOTE 13 - COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES
At year-end 2002 and 2001, reserves of $2,699,000 and $3,308,000 were required as deposits with the Federal Reserve or as cash on hand. These reserves do not earn interest.
Some financial instruments are used in the normal course of business to meet the financing needs of customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. These involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the financial statements.
The Company has the following commitments outstanding at year-end:
2002 2001 ---- ----
Commitments to extend credit $ 59,819,000 $ 56,017,000 Credit card arrangements 3,220,000 3,023,000 Standby letters of credit 1,870,000 2,197,000 --------------- ---------------
$ 64,909,000 $ 61,237,000 =============== ===============
Commitments outstanding as of December 31, 2002 include fixed rate commitments totaling $22,827,000, and the majority of these fixed rate commitments have interest rates ranging from 6% to 9%.
Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit, standby letters of credit, and financial guarantees written. The same credit policies are used for commitments and conditional obligations as are used for loans.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being used, the total commitments do not necessarily represent future cash requirements. Standby letters of credit and financial guarantees written are conditional commitments to guarantee a customer’s performance to a third party.
NOTE 14 - PARENT CORPORATION CONDENSED
The Company’s primary source of funds to pay dividends to shareholders is the dividends it receives from the Banks. The Banks are subject to certain restrictions on the amount of dividends they may declare without prior regulatory approval. At December 31, 2002, approximately $11,900,000 of the Banks’ retained earnings is available for transfer in the form of dividends without prior approval from regulatory agencies.
Following are condensed parent corporation financial statements.
(Continued)
37.
NOTE 14 - PARENT CORPORATION CONDENSED (Continued)
CONDENSED BALANCE SHEETS December 31, 2002 and 2001
2002 2001 ---- ---- Assets Cash and cash equivalents $ 1,516,614 $ 4,814,693 Securities available for sale 372,961 621,133 Investment in subsidiaries 32,481,854 27,764,249 Other 173,758 158,235 -------------- ---------------
Total assets $ 34,545,187 $ 33,358,310 ============== ===============
Liabilities and Shareholders' Equity Trust preferred securities $ 5,000,000 $ 5,000,000 Other 375,557 351,354 Common stock subject to repurchase obligation in ESOP 4,100,407 4,444,244 Shareholders' equity 25,069,223 23,562,712 -------------- ---------------
Total liabilities and shareholders' equity $ 34,545,187 $ 33,358,310 ============== ===============
CONDENSED STATEMENTS OF INCOME Years ended December 31,
2002 2001 2000 ---- ---- ----
Dividends from subsidiaries $ 1,300,000 $ 4,375,000 $ 1,200,000 Interest on securities 22,625 29,363 38,183 Interest on trust preferred securities (292,697) (26,345) - Other expenses (79,004) (44,559) (118,318) -------------- -------------- ---------------
Income before equity in undistributed income of subsidiary banks 950,924 4,333,459 1,119,865
Equity (excess) in undistributed net income of subsidiaries 1,868,688 (1,290,387) 2,085,068 -------------- -------------- ---------------
Income before income taxes 2,819,612 3,043,072 3,204,933
Income tax expense (benefit) (35,730) - - -------------- -------------- ---------------
Net income $ 2,855,342 $ 3,043,072 $ 3,204,933 ============== ============== ===============
(Continued)
38.
NOTE 14 - PARENT CORPORATION CONDENSED (Continued)
CONDENSED STATEMENTS OF INCOME Years ended December 31,
2002 2001 2000 ---- ---- ---- Operating activities Net income $ 2,855,342 $ 3,043,072 $ 3,204,933 Adjustments to reconcile net income to net cash provided by operating activities (Equity) excess in undistributed net income of subsidiaries (1,868,688) 1,290,387 (2,085,068) Net amortization of investment securities (118) 1,420 4,100 Stock option expense 34,451 36,481 23,465 Other 7,319 271,982 87,862 -------------- ------------- ------------- Net cash from operating activities 1,028,306 4,643,342 1,235,292
Investing Activities Investment in banking subsidiaries (3,000,000) (5,000,000) - Activity in available for sale securities Maturities and calls 252,293 115,000 215,000 -------------- ------------- ------------- Net cash from investing activities (2,747,707) (4,885,000) 215,000
Financing Activities Net proceeds from trust preferred securities - 4,850,417 - Repurchase of common stock (1,019,130) (284,286) (151,405) Issuance of common stock 105,260 132,855 117,065 Stock options exercised 60,524 - - Dividends paid (725,332) (674,065) (802,450) -------------- ------------- ------------- Net cash from financing activities (1,578,678) 4,024,921 (836,790) -------------- ------------- -------------
Net change in cash and cash equivalents (3,298,079) 3,783,263 613,502
Beginning cash and cash equivalents 4,814,693 1,031,430 417,928 -------------- ------------- -------------
Ending cash and cash equivalents $ 1,516,614 $ 4,814,693 $ 1,031,430 ============== ============= =============
(Continued)
39.
NOTE 15 - FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate fair values for financial instruments. The carrying amount is considered to approximate fair value for cash and cash equivalents, demand and savings deposits, short-term borrowings, accrued interest, and variable rate loans or deposits that reprice frequently and fully. Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and on information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, the fair value is estimated by discounted cash flow analysis using current market rates for the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Fair value of loans held for sale is based on market estimates. Fair value of mortgage servicing rights is estimated using discounted cash flows based on current market interest rates. The fair value of long-term borrowings is based on currently available rates for similar financing. The fair value of other financial instruments and off-balance-sheet items approximate cost and are not considered significant to this presentation.
The estimated year-end fair values of financial instruments were:
2 0 0 2 2 0 0 1 ------- ------- Carrying Carrying Amount Fair Value Amount Fair Value ------ ---------- ------ ---------- Financial assets: ----------------
Cash and cash equivalents $ 11,222,644 $ 11,223,000 $ 24,276,998 $ 24,277,000 Securities available for sale 25,215,853 25,216,000 25,969,241 25,969,000 Federal Home Loan Bank stock 2,503,700 2,504,000 2,503,700 2,504,000 Federal Reserve Bank stock 493,350 493,000 480,000 480,000 Loans held for sale 1,473,300 1,473,000 416,600 416,000 Loans, net 233,048,728 233,832,000 212,589,534 216,501,000 Accrued interest receivable 1,867,988 1,868,000 1,877,744 1,878,000 Mortgage servicing rights 2,715,011 2,715,000 2,065,958 2,066,000
Financial liabilities: ---------------------
Demand and savings deposits $ (137,644,133) $ (137,644,000) $ (128,377,476) $ (128,377,000) Time deposits (104,075,988) (108,289,000) (107,029,538) (109,503,000) Borrowed funds (8,635,176) (8,964,000) (7,394,232) (7,399,000) Trust preferred securities (5,000,000) (5,000,000) (5,000,000) (5,000,000)
(Continued)
40.
NOTE 16 - REGULATORY MATTERS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required.
The Company and both banks were categorized as well capitalized at year-end. Actual and required capital levels (in millions) and ratios were:
Minimum Required To Be Well Minimum Required Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations ------ ----------------- ------------------ Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- ---- Total capital (to risk weighted assets) Consolidated $ 36.7 14.6% $ 20.2 8.0% $ 25.2 10.0% Bank of Lenawee 27.8 14.0 15.9 8.0 19.9 10.0 Bank of Washtenaw 7.2 13.7 4.2 8.0 5.3 10.0 Tier 1 capital (to risk weighted assets) Consolidated 34.1 13.5 10.1 4.0 15.1 6.0 Bank of Lenawee 25.7 12.9 8.0 4.0 12.0 6.0 Bank of Washtenaw 6.7 12.6 2.1 4.0 3.2 6.0 Tier 1 capital (to average assets) Consolidated 34.1 12.0 11.3 4.0 14.2 5.0 Bank of Lenawee 25.7 10.6 9.7 4.0 12.2 5.0 Bank of Washtenaw 6.7 10.9 2.4 4.0 3.1 5.0
---- Total capital (to risk weighted assets) Consolidated $ 34.9 15.3% $ 18.3 8.0% $ 22.9 10.0% Bank of Lenawee 25.2 12.8 15.8 8.0 19.8 10.0 Bank of Washtenaw 4.5 14.6 2.5 8.0 3.1 10.0 Tier 1 capital (to risk weighted assets) Consolidated 32.6 14.3 9.1 4.0 13.7 6.0 Bank of Lenawee 23.3 11.8 7.9 4.0 11.9 6.0 Bank of Washtenaw 4.2 13.6 1.2 4.0 1.9 6.0 Tier 1 capital (to average assets) Consolidated 32.6 11.9 11.0 4.0 13.7 5.0 Bank of Lenawee 23.3 9.2 10.1 4.0 12.6 5.0 Bank of Washtenaw 4.2 12.1 1.4 4.0 1.7 5.0
(Continued)
41.
NOTE 16 - REGULATORY MATTERS (Continued)
Regulatory capital includes trust preferred securities issued by Lenawee Capital Trust I in December 2001 subject to certain limitations. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in Tier 1 capital of the Company to 25% of total Tier 1 capital. At year-end 2002 and 2001, all of the trust preferred securities were included as Tier 1 capital of the Company.
NOTE 17 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Interest Net Interest Net Earnings per Share Income Income Income Basic Diluted ------ ------ ------ ----- ------- ---- First quarter $ 4,781,000 $ 3,180,000 $ 747,000 $ 0.88 $ 0.87 Second quarter 4,686,000 3,140,000 560,000 0.66 0.66 Third quarter 4,871,000 3,376,000 668,000 0.80 0.79 Fourth quarter 4,844,000 3,457,000 880,000 1.05 1.05
---- First quarter $ 5,409,000 $ 3,135,000 $ 733,000 $ 0.86 $ 0.85 Second quarter 5,419,000 3,165,000 723,000 0.85 0.84 Third quarter 5,220,000 3,270,000 767,000 0.90 0.89 Fourth quarter 4,964,000 3,244,000 820,000 0.97 0.96
(Continued)
42.
COMMON STOCK INFORMATION
There is a limited market for the Company’s common stock, which is traded in the over-the-counter market and quoted on the OTC Bulletin Board under the symbol PVLN. There are occasional sales through brokers and direct sales by shareholders of which the Company’s management is aware.
The following table sets forth the range of high and low sales prices of the Company’s Common Stock during 2002, 2001, and 2000, based on information made available to the Company, as well as per share cash dividends declared during those periods. Although management is not aware of any transactions at higher or lower prices, there may have been transactions at prices outside the ranges listed below:
Cash Sales Prices (1) Dividends Declared (1) ---------------- ---------------------- 2002 High Low ---- ---- --- First Quarter............... $50.50 $46.00 0.20 Second Quarter.............. $50.00 $38.00 0.22 Third Quarter............... $42.00 $35.00 0.22 Fourth Quarter.............. $43.50 $40.65 0.22
2001 High Low ---- ---- --- First Quarter............... $64.00 $50.00 0.20 Second Quarter.............. $63.00 $53.00 0.20 Third Quarter............... $60.25 $56.00 0.20 Fourth Quarter.............. $56.00 $47.75 0.20
2000 High Low ---- ---- --- First Quarter............... $72.50 $65.00 0.34 Second Quarter.............. $67.50 $62.50 0.20 Third Quarter............... $65.00 $60.00 0.20 ------------------------------ $67.50 $60.00 0.20 Fourth Quarter..............
(1) Adjusted for all stock splits.
The prices quoted above were obtained from the Bloomberg System. The over-the-counter market quotations reflect interdealer prices without retail mark-up, mark-down or commission.
There are 3,000,000 shares of the Company’s common stock authorized, of which 831,182 shares were issued and outstanding as of December 31, 2002. There were approximately 598 shareholders of record, including trusts and shares jointly owned, as of that date.
The holders of the Company’s common stock are entitled to dividends when, as and if declared by the Board of Directors of the Company out of funds legally available for that purpose. Dividends have been paid four times annually. In determining dividends, the Board of Directors considers the earnings, capital requirements and financial condition of the Company and the Banks, along with other relevant factors. The Company’s principal source of funds for cash dividends is the dividends paid by the Banks. The ability of the Company and the Banks to pay dividends is subject to regulatory restrictions and requirements.
43.
Exhibit 21 Subsidiaries of Registrant
Name Ownership Incorporation
Bank of Lenawee 100% Michigan
Bank of Washtenaw 100% Michigan
Lenawee Financial Services, Inc. 100% by
Bank of Lenawee Michigan
Pavilion Mortgage Company 100% by
Bank of Lenawee Michigan
EXHIBIT 23
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the Registration Statements of Pavilion Bancorp, Inc. on Form S-8 (File Nos. 333-86636 of our report dated February 4, 2003 on the 2002 Consolidated Financial Statements of Pavilion Bancorp, Inc., which report is included in the 2002 Annual Report on Form 10-K of Pavilion Bancorp, Inc.
CROWE, CHIZEK AND COMPANY LLP
Grand Rapids, Michigan
March 18, 2003
EXHIBIT 99-1
I, Douglas L. Kapnick, Interim Chief Executive Officer of Pavilion Bancorp, Inc., certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) the Annual Report on Form 10-K for the year ended December 31, 2002 which this statement accompanies fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and
(2) the information contained in the Annual Report on Form 10-K for the year ended December 31, 2002 fairly presents, in all material respects, the financial condition and results of operations of Pavilion Bancorp, Inc.
Dated: March 18, 2003
/s/ Douglas L. Kapnick
Douglas L. Kapnick
Chairman and Chief Executive Officer
EXHIBIT 99-2 I, Loren V. Happel, Chief Financial Officer of Pavilion Bancorp, Inc., certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1) the Annual Report on Form 10-K for the year ended December 31, 2002 which this statement accompanies fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and
(2) the information contained in the Annual Report on Form 10-K for the year ended December 31, 2002 fairly presents, in all material respects, the financial condition and results of operations of Pavilion Bancorp, Inc..
Dated: March 18, 2003
/s/ Loren V. Happel
Loren V. Happel
Financial Officer