ITEM 1. - BUSINESS
GENERAL
University Bancorp, Inc. a Delaware corporation (individually and on a consolidated basis with its subsidiary where the context indicates, the Company" or the "Corporation"), operates as a bank holding company for its wholly-owned subsidiary, University Bank. University Bank (the "Bank") is a state chartered community bank. The Bank was chartered by the state of Michigan in 1908 as successor to a banking organization organized in 1890. The Bank changed its name from "The Newberry State Bank" to its current name in July 1995 to more closely identify the name of the Bank with its current place of business. Ann Arbor, the home of the University of Michigan, is a university town. The Bank's accounts are insured by the Federal Deposit Insurance Corporation.
University Bancorp, Inc. is essentially a holding company for the Bank and it invests available cash resources in marketable equity and debt securities and interest bearing deposits. At December 31, 1998 University Bancorp, Inc. had cash on deposit of $33,702 and other investments at fair value of $88,305. University Bancorp, Inc. changed its name to University Bancorp, Inc. from Newberry Bancorp, Inc. in June 1996, to more closely identify the bank holding company with the Bank.
University Bank is headquartered in the town of Ann Arbor, Michigan, which is the largest city in Washtenaw County, just west of the Detroit Metropolitan Statistical Area ("Detroit MSA"). Following the closing of its sale of bank office assets and liabilities relating to its former main office in Newberry, Michigan and its two branch offices in Sault Ste. Marie, Michigan on December 5, 1994, more fully described below, during 1995, the Bank relocated its main office to the former offices of its mortgage operation in Sault Ste. Marie, Michigan. Sault Ste. Marie is the largest city in the eastern Upper Peninsula of Michigan and the county seat of Chippewa County. During 1995 the Bank was primarily engaged in residential mortgage lending and servicing operations, and the investment of deposits and other bank borrowings in various investments, including investment securities issued by government agencies and U.S. Treasury securities. On February 6, 1996, the Bank opened its new Ann Arbor main office. During the fourth quarter of 1997, the Bank closed its Sault Ste. Marie office and centralized its accounting function in Ann Arbor.
The Bank conducts its banking business from its headquarters office in Ann Arbor. The Bank's primary market area is defined as the City of Ann Arbor and surrounding areas in greater Washtenaw County.
Mortgage Banking. In October 1995, the Bank established a new mortgage banking subsidiary, Varsity Funding, L.L.C. ("Varsity Funding"). Varsity Funding specialized in the purchase and origination of impaired credit, or subprime quality, residential mortgages, for sale to non-U.S. government agency-backed mortgage
conduits. Varsity Funding's offices were located in Farmington Hills, Michigan, which is located on the northwest side of the Detroit MSA. During early 1997, Varsity Funding also established a retail residential mortgage operation through an office in Farmington Hills, Michigan. The retail division was expanded to include an office in Columbus, Ohio in January 1998.
In February 1996, Varsity Funding expanded the scope of its operations by establishing another subsidiary of the Bank, Varsity Mortgage, L.L.C. ("Varsity Mortgage"). The Varsity Mortgage mortgage banking operation purchases residential home loans which generally qualify for sale to secondary market investors under the underwriting criteria of the Federal Home Loan Mortgage Corporation ("FHLMC") and Federal National Mortgage Association ("FNMA") from correspondents in Michigan and in adjacent states. Loans purchased from correspondents or originated internally by the Bank are then either pooled into mortgage-backed securities and the securities are sold to investors or they are sold directly to FHLMC or FNMA. The Bank's mortgage banking operations sell on a continuous basis the servicing rights to the loans or securities it originates. In December 1998, the Bank sold the bulk of a small portfolio of owned mortgage servicing rights.
The Bank itself also originates residential loans from its Ann Arbor office and sells them to secondary mortgage correspondents including Varsity Mortgage. The Bank, through its Sault Ste. Marie mortgage banking office, previously operated in similar fashion to Varsity Mortgage, by purchasing, from correspondents in Michigan, or by originating, residential home loans which generally qualify for sale to secondary market investors under the underwriting criteria of the FHLMC and FNMA. In November 1996, the Bank discontinued its wholesale operation in Sault Ste. Marie and transferred all pooling and packaging of residential loans to Varsity Mortgage. The Bank's accounting department continues to administer the Bank's table funding mortgage broker lending operation from the Ann Arbor office.
The profit of Varsity Mortgage is subject to an agreement (the "Net Branch Agreement") with the executives who have organized and supervised the operation under which profits and/or revenues are shared between the Bank and the employees of the subsidiaries. In future years, as a result of a profit sharing agreement, the Bank is entitled to share profits of Varsity Mortgage on a 50/50 basis with the managers and employees of this subsidiary.
As a result of upheavals in the national secondary market for subprime quality residential mortgages, in December 1998 Varsity Funding exited the subprime business. Varsity Mortgage acquired the retail operations of Varsity Funding, which will be operated as the Retail Division of Varsity Mortgage. As a result of changes in the types of loans that FNMA and FHMLC are willing to buy, in early 1999 Varsity Mortgage began purchasing and pooling A- credit quality residential mortgages.
Mortgage Subservicing. In July 1995 the Bank terminated its mortgage servicing operation in Sault Ste. Marie by outsourcing its servicing operations under a contract with Midwest Loan Services,
Inc., of Houghton, Michigan ("Midwest Loan Services"). In December 1995, the Bank acquired 80% of the common stock of Midwest Loan Services, which specializes in subservicing, for the account of credit unions, financial institutions and mortgage brokers, of residential mortgage loans sold to FNMA, FHLMC and other private residential mortgage conduits.
Michigan BIDCO. In May 1993, the Company established a Business and Industrial Development Company (the "BIDCO") called Michigan BIDCO, Inc. ("Michigan BIDCO"). The BIDCO is licensed by the Michigan Financial Institutions Bureau under the State of Michigan BIDCO program. Michigan BIDCO invests in businesses in Michigan with the objective of fostering job growth and economic development. Michigan BIDCO is currently 44.1%-owned by the Bank, and is accounted for under the equity method. Such percentage is subject to reduction in the event of conversion of the BIDCO's outstanding convertible bonds. The BIDCO changed its name to Michigan BIDCO, Inc. from Northern Michigan BIDCO, Inc. in late 1995 to reflect its strategic plan of seeking investment opportunities throughout the entire state of Michigan. Originally, the BIDCO limited its investments to the northern half of Michigan.
Northern Michigan Foundation. In December 1995, the BIDCO donated $225,000 to capitalize Northern Michigan Foundation (the "Foundation"), and in early 1996, donated an additional $75,000 to the Foundation. The Foundation is an IRS-approved 501c(3) non-profit which is an intermediary lender to rural small businesses under the U.S. Rural Economic Community Development Service Agency ("U.S. RECDS") Intermediary Relending Program. As a result of its capitalization by the BIDCO, the Foundation was able to gain the right to borrow a total of up to $2,000,000 from the U.S. RECDS at 1% interest with a 30 year term. A portion of the BIDCO's overhead is reimbursed by the Foundation under the terms of a management services contract. The BIDCO is paid a monthly fee reflecting reimbursement for expenses incurred. The BIDCO and the Foundation share administrative staffs and offices, with the Foundation reimbursing the BIDCO for these management services.
University Insurance & Investment Services. On December 31, 1996, the Bank established a new insurance and investment sales agency subsidiary, called, University Insurance & Investment Services, Inc., based in its Ann Arbor main office. The agency is licensed by the State of Michigan as an insurance agency. The focus of the insurance agency is life and healthcare insurance brokerage, and mutual fund and annuity sales. On December 18, 1998, the agency acquired University Insurance Center, Inc., a fully-licensed but inactive commercial insurance agency. University Insurance Center, Inc. ("UIC") commenced business on February 25, 1999 and is a full service property and casualty insurance agency offering insurance for homes, autos, apartments and businesses.
EMPLOYEES
The Company employed 67 full-time persons at January 31, 1999, including the following:
LINES OF BUSINESS
COMMUNITY BANKING, ANN ARBOR
The Bank opened its office in Ann Arbor on February 6, 1996. The retail savings products and services of the Bank include demand deposit and NOW interest-bearing checking accounts, money market deposit accounts, regular savings accounts and term deposit certificates ranging in maturity from three to three hundred months. The Bank also offers self-directed retirement accounts, free access to 24-Hour ATM machines, telephone banking, VISA debit cards and Gold VISA accounts. The Bank also is a member of Mastercard, but currently is not offering a Mastercard product. The Bank also offers Canadian Dollar foreign exchange services. From time to time to raise liquidity, the Bank sells CDs through brokers.
The Bank's community banking operation offers a range of traditional lending products, including commercial small business loans, residential real estate mortgage loans and home equity loans, commercial real estate mortgage loans, consumer installment loans, and land development and construction loans.
MORTGAGE BANKING
The Bank became a seller/servicer of Federal Home Loan Mortgage Corporation insured mortgages ("FHLMC mortgages") in late 1991 and began to originate FHLMC mortgages for sale into the secondary market. In late 1994 the Bank became a seller/servicer of Federal National Mortgage Association insured mortgages ("FNMA mortgages") and began to originate FNMA mortgages for sale into the secondary market. Varsity Mortgage utilizes the Bank's seller/servicer licenses to pool, package and sell both FNMA and FHLMC mortgages.
The Bank is currently, and Varsity Mortgage has since inception been, selling the servicing right on all mortgages originated. The Bank's accounting department administers the Bank's table funding of its mortgage banking subsidiaries from the Ann Arbor office.
Reference is made to the discussion of the mortgage banking business in ITEM 7. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, in the section entitled
"Non-Interest Income and Non-Interest Expense", under the heading Mortgage Banking.
MORTGAGE SUBSERVICING
The Bank's 80% owned subsidiary, Midwest Loan Services, specializes in subservicing, for the account of other financial institutions and mortgage brokers, residential mortgage loans sold to FNMA and FHLMC and other non-agency private conduits. Mortgage servicing firms receive monthly payments from loan customers, aggregate and account for these payments, and send the funds to mortgage-backed securities holders, such as pension funds and financial institutions. Mortgage servicers also dun delinquent accounts and foreclose loans, if required. Midwest is regulated by FHLMC and FNMA. Mortgage servicers receive a fixed monthly fee for performing this service. As of December 31, 1998, Midwest Loan Services subserviced a total of 4,029 loans, 3,113 for non-affiliated companies, and 916 loans serviced for the Bank and Midwest Loan Service's own account.
INVESTMENT SECURITIES
The Bank maintains surplus available funds in investments consisting of short-term money market instruments, U.S. government bonds, U.S. federal agency obligations, and mortgage-backed securities backed by federal agency obligations. The Bank's investments and the Company's cash and equity portfolio are managed by the President of the Company, subject to the review and approval of the Board of Directors of the applicable corporate entity. The securities of the Company and the Bank provide a source of liquidity to meet operating needs. At December 31, 1998, the Bank's investments had a net unrealized loss of approximately $183,122 versus a net unrealized loss of approximately $18,880 at December 31, 1997.
The following table discloses certain information regarding securities held by the Company, the amortized cost of which exceeded more than 10% of stockholders' equity as of December 31, 1998:
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(1) The floating rate Resolution Trust Corporation bond is backed by a portfolio of single family home mortgages. Due to the structure of the issue, the expected average life is 2-3 years. Although issued by a government sponsored agency they are not government guaranteed. The bonds are rated "AA" by Standard & Poor's and the coupon floats at 100 basis points over the 11th District Cost of Funds Index, adjusted monthly.
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(2) The coupon of these FNMA securities adjusts every month to 1.60% over the three month T-Bill rate, with a 9% life of security cap.
(3) The rate varies quarterly. The Bank is required to maintain the investment in Federal Home Loan Bank of Indianapolis (the "FHLBI") common stock in an amount related to the Bank's single family mortgage related assets and FHLBI advances. Shares can be redeemed or sold at par value to the FHLBI as required from time to time.
(4) This Principal Only strip has an expected average life of six years.
MICHIGAN BIDCO
Michigan BIDCO, Inc., which was founded in May 1993, is licensed by the Michigan Financial Institutions Bureau under the State of Michigan BIDCO Act. The BIDCO is 44.1%-owned by the Bank, and is accounted for under the equity method. There are $3,000,000 in convertible bonds outstanding. An initial investment of $280,000 to buy 280 shares of common stock was made by the Bank in Michigan BIDCO in 1993.
At the time of establishment, the BIDCO received $3,000,000 in financing from the Michigan Strategic Fund. This investment was made in the form of a ten year loan which carries concessionary terms allowing it to be converted to a grant over time under certain circumstances. The BIDCO earns grants applied against the $3,000,000 Michigan Strategic Fund financing if there is growth in the sales and jobs of the businesses the BIDCO invests in. At the time of establishment, Michigan BIDCO sold in installments $3,000,000 in 9% Senior Convertible Bonds to match the State of Michigan's commitment, all of which amount had been issued at December 31, 1998.
The financial statements of the BIDCO are presented using the investment company method, and, accordingly, investments in stocks, stock warrants, limited liability companies and loans ("BIDCO Investments") are reported at fair value. BIDCO typically invests in companies for which current market quotations are not readily available; therefore management estimates the fair value of BIDCO Investments on a quarterly basis and the Board of Directors approves the fair value estimates. In deriving its estimates, management reviews the financial condition and operating performance of the investee companies, as well as performance of the company with its contractual arrangements with BIDCO. The fair value of BIDCO Investments is then estimated by the use of operating cash flow multiples applicable to a company's industry, discounted cash flow analyses, and other valuation techniques. Management and the Board of Directors believe the procedures used and assumptions made are reasonable in the circumstances; however, the fair value estimates may differ significantly from the values that would have been used had current market quotations been available.
The Bank's investment in the BIDCO is accounted for under the equity method, and $50,301, ($55,499) and $128,219 of income (loss)
from the BIDCO was included in the results of operations for the years ended December 31, 1996, 1997, and 1998, respectively. At December 31, 1998, the Company owned $67,977 in bonds issued by the BIDCO. If there were a conversion of outstanding convertible bonds, the Bank and the Company would together own 12.17% and 15.61% at December 31, 1998 and 1997. In addition, upon conversion, certain Corporation officers and directors and their immediate family (two of whom serve as President and Chairman of the Corporation) would have an ownership interest in the BIDCO of 29.4%. The conversion may take place, at the election of the BIDCO, subsequent to any time that the BIDCO's equity pursuant to an audit performed using generally accepted auditing standards exceeds $1,500,000. If the bonds are converted and the Company's ownership of the BIDCO at that time is less than 20%, the net income of the BIDCO may not be included in the Company's statement of operations under the equity method. There is no assurance that the Company's ownership of the BIDCO will not drop under 20% in the future.
Michigan BIDCO invests in businesses in Michigan with the objective of fostering job growth and economic development. The BIDCO has, by general policy of its board of directors, a loan to one borrower limit of $500,000. In order to be able to make investments larger than this lending limit, Michigan BIDCO will leverage its investment with loan guarantees from government agencies, the guaranteed portion of which is sold in the form of a participation, or if a government agency loan guarantee is unavailable, a participation may be sold to one or more investors, including BIDCO management, bondholders and directors. As of December 31, 1998, the BIDCO had made twenty-seven investments, amounting to a total of $13,413,600 at original cost. At December 31, 1998, Michigan BIDCO had total assets of $5,327,697.
Michigan BIDCO makes its investments in the form of loans or direct equity investments, or a combination thereof. The BIDCO typically receives warrants or participation rights in the companies in which it invests. As a matter of policy, the Bank restricts itself from investing or lending to a business that the BIDCO finances, and related parties which co-invest with the BIDCO must do so on a basis equal to or less favorable than the BIDCO's. As of December 31, 1998, investments (at original investment cost) have been made in the following types of businesses:
The $1,600,000 80% guaranteed portion of the $2,000,000 loan to the plastic injection molding firm was sold to Federal Agricultural Mortgage Corporation and subsequently the loan was paid off. The $1,245,150 guaranteed portion of the $1,962,000 loan to the paper converting firm was sold to Federal Agricultural Mortgage Corporation. An $800,000 participation in the railroad boxcar lease was sold to a private investor group of nine individuals including Joseph and Stephen Ranzini. This same investor group purchased a $280,000 participation in the recycled paper pulp mill financing, and also purchased a $28,000 investment in one limited service hotel project to reduce the BIDCO's net exposure to $500,000. The BIDCO's investment in the recycled paper pulp mill consisted of an equity investment and a royalty on sales of a new $238,000,000 mixed office waste paper recycling/de-inking pulp mill in Menominee, Michigan.
In December 1995, the Bank acquired 80% of the common stock of the residential mortgage servicing business, Midwest Loan Services. In connection with this acquisition, the BIDCO received 34,500 shares of Common Stock of the Company, puttable to the Company for $115,000 in December 1996, in exchange for its ownership of 10% of the common stock of Midwest Loan Services and options to buy an additional 30% of the common
stock of that company. The consideration the BIDCO received for its stake was on substantially similar terms to the terms the other selling shareholders of Midwest Loan Services received from the Bank and the Company.
Reference is made to the discussion of the BIDCO's investments and operations in Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations, in the section entitled "Non-Interest Income and Non-Interest Expense", under the heading Michigan BIDCO.
COMPETITION
COMMUNITY BANKING, ANN ARBOR
The Bank's attraction and retention of deposits depend on its ability to provide investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The Bank competes for these deposits by offering personal service, competitive rates and fees, and a variety of savings programs including tax-deferred retirement programs.
The Bank competes for loan originations primarily through the the quality of services it provides to its loan customers, competitive interest rates and loan fees, rapid and local decision-making and the range of services it offers. The Bank's competition in originating loans comes principally from other commercial banks, credit unions, insurance companies, mortgage banking companies and savings and loans.
The following table shows market share of deposits for Washtenaw County by financial institution for June 1998, June 1997 and June 1996 (from the FDIC's annual branch deposit survey:
WASHTENAW COUNTY FINANCIAL INSTITUTION DEPOSITS:
Total deposits in the county increased 12.7% from June 1997 to June 1998 and increased 2.9% from June 1996 to June 1997. In attracting deposits, the Bank's primary competitors for deposits are mutual funds, other commercial banks, credit unions, savings and loans and insurance companies.
The Bank's main office is adjacent to the University of Michigan Hospital Complex. The Complex employs a total of 7,800 persons. In mid-February 1999, the nearest competitor to the Bank's main office, a National City Bank branch, was permanently closed. The other major competitor in the local deposit market is Midwest Financial Credit Union, formerly known as Hospital & Health Services Credit Union. The Bank's main office was formerly the headquarters of the latter credit union, which moved its office to a new office building three miles from the Medical Center Complex.
The Ann Arbor banking market is dominated by banks which are owned by out-of-area holding companies. In the city of Ann Arbor, the University of Michigan Credit Union is the largest locally-owned financial institution. The only locally-owned community financial institutions, excluding University Bank, are Huron River Area Credit Union, Midwest Financial Credit Union, Bank of Ann Arbor, Automotive Federal Credit Union and several smaller credit unions.
MORTGAGE BANKING
Origination. The Bank's Ann Arbor community bank, Varsity Mortgage and to a lesser extent Midwest Loan Services' retail origination division purchase or originate internally residential home loans which generally qualify for sale to secondary market investors under the underwriting criteria of the Federal Home Loan Mortgage Corporation (FHLMC) or the Federal National Mortgage Association (FNMA) from correspondents in Michigan and Ohio. Loans purchased or originated internally are either sold directly to FHLMC or FNMA, or are pooled into mortgage-backed securities and the securities are sold to investors in the secondary market.
The Bank's retail mortgage origination operations encounter competition for the origination of residential real estate loans primarily from savings institutions, commercial banks, insurance companies and other mortgage banking firms. Many of these firms have a well established customer and/or borrower client base. Some competitors, primarily savings institutions, insurance companies and commercial banks, have the ability to create unique loan products from time to time because they are able to close the loans for their own portfolio rather than sell into the secondary market. Most loans sold into the secondary market, however, go to the same sources, those being Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC") and Government National Mortgage Association ("GNMA") guaranteed securities. Most lenders have access to these secondary market sources; therefore, competition often becomes more a matter of service and pricing than that of product. As a mortgage loan originator and a purchaser of mortgage loans through correspondents, the Bank and its affiliates must be able to compete with respect to the types of loan products offered by competitors to borrowers and correspondents, including the price of the loan in terms of origination fees or fee premium or discount, loan processing costs, interest rates, and the service provided by the Bank's staff. An important element in the Bank's ability to compete is master purchase agreements negotiated periodically with FNMA and FHLMC with low and competitive loan guarantee fees, a wide variety of mortgage programs, and a variety of flexible underwriting criteria. The Bank's ability to secure these master purchase agreements is dependent upon the performance from a quality perspective of loans previously sold to the agencies.
During lower interest rate environments, competition for loans is less intense due to the large number of loans available for origination. As interest rates rise and the number of loans available for origination diminishes, competition becomes quite intense and companies with larger investor bases, flexibility with respect to type of product offered and greater experience in dealing in these types of markets tend to be the most successful.
The Bank also originates residential loans to be held in portfolio, and management believes that this product together with the product offerings which FHLMC and FNMA have is sufficient for its competitive needs. Although the Bank is currently licensed as a HUD Title 1, Title 2 and Multifamily seller/servicer, it has no plans at
this time to expand its utilization of HUD or GNMA programs. However, Varsity Mortgage's retail division does originate a small number of GNMA single family residential loans utilizing the Bank's HUD seller/servicer licenses. The Bank and Varsity Mortgage also are correspondents for several impaired credit conduits and sell this type of residential mortgage on a non-recourse, servicing released basis.
Varsity Mortgage's retail origination operation also originates secondary market conforming loans. Varsity Mortgage competes primarily with other mortgage banking firms, insurance companies, commercial banks, and savings and loans.
Mortgage Subservicing and Servicing. Over the last three years, the Bank has sold its portfolio of mortgage servicing rights, while selling all newly originated secondary market mortgage loans, servicing released. In December 1998 the Bank sold the final 1/3 of its retained FHLMC and FNMA mortgage servicing rights portfolio for a loss of $121,224. In the third quarter of 1996, the Bank sold 1/3 of its portfolio of accumulated servicing rights to reduce its investment in this class of asset for a gain of $256,840. In the third quarter of 1997, the Bank sold an additional 1/3 of its accumulated portfolio at no significant gain. Servicing competition is somewhat less intense than the loan origination aspect of mortgage banking. Due to net worth and management requirements, many mortgage origination companies do not have the capacity to service loans. Falling interest rates present competitive challenges for the mortgage servicing operation in that mortgagors are more likely to refinance existing mortgages. The quality of service and the ability of the origination operation to compete on price and service is important in retaining such customers by refinancing them internally, rather than losing the refinancing transaction to a competitor. Increased refinancing activity as a result of falling interest rates should decrease profitability of mortgage servicing by increasing amortization charges on purchased mortgage servicing rights.
In the subservicing business, Midwest Loan Services competes primarily with a small group of specialized servicing units of mortgage banking companies, and a few specialized units owned by banks and savings and loans. Most of these companies have substantially larger financial resources than Midwest Loan Services.
Midwest Loan Services is located in Houghton, Michigan in the western Upper Peninsula of Michigan. Personnel and occupancy costs are the largest costs in a mortgage servicing operation, and the prevailing wages and occupancy costs in the Upper Peninsula of Michigan are generally lower than the national average. As a result, the Company believes that Midwest Loan Services' mortgage servicing operation potentially offers its mortgage banking operations a competitive advantage in the future. During 1998, growth in loans serviced for third parties was offset by payoffs due to record low interest rates, sales of Bank owned servicing and the end of an agreement to subservice a portfolio of 900 loans that had been sold by University Bank last year under a one year subservicing agreement, so that the amount of loans serviced by Midwest fell by approximately 19% during the year. Since the Bank has completed its plan of selling
servicing rights, if Midwest Loan Services adds additional subservicing customers in the future, there may be an increase in overall loans serviced. Previously, the Bank was selling servicing as Midwest gained additional customers. At year-end 1998, 916 loans serviced by Midwest Loan Services were serviced for the Bank or Midwest Loan Services' own account.
MICHIGAN BIDCO AND NORTHERN MICHIGAN FOUNDATION
Michigan BIDCO seeks to invest in businesses located in Michigan. The BIDCO's objective is to seek profit while fostering job growth and economic development in its market area. Michigan BIDCO makes its investments directly, or through investment entities formed with other participants, to make investments, in the form of loans or direct equity investments, or a combination thereof. As such, it competes with other specialized lenders and wealthy investors who make risk-oriented investments in businesses located in Michigan. The BIDCO assumes more credit risk in a typical investment than commercial banks generally are willing to assume when they make loans. The BIDCO does not make an investment in a company unless it can be shown that the funds are not available from a traditional bank lender; therefore, the BIDCO does not compete with banks. There is only one other BIDCO in Northern Michigan; the BIDCO is one of eleven BIDCOs in Michigan. Since year-end 1996, the BIDCO has pursued a strategy of liquidating its existing investment portfolio to raise cash for for two purposes: the buyout of some of the original minority investors in the BIDCO, and two options in expanding its funds under management through other government agency economic development programs.
The BIDCO's staff manages under a management contract a 501(c)3 IRS-qualified non-profit relending company, Northern Michigan Foundation, which has received the right to borrow $2,000,000 at 1% interest for 30-years from the U.S. RECDS under the RECDS-sponsored intermediate relending program. The Foundation is one of three non-profit, privately-run, U.S. Rural Economic Community Development Service intermediate relending programs located in Northern Michigan. U.S. RECDS was formerly the Farmers Home Administration. Each of these community development loan funds covers six counties as its primary market area.
Certain Financial Information for the years ended December 31, 1998, 1997 and 1996 (in $000s)(1):
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Liabilities and Stockholders' Equity, at Dec. 31, 1998, 1997 and 1996 (in thousands):
NOTES TO CERTAIN FINANCIAL INFORMATION TABLE for the years ended December 31, 1998, 1997 and 1996 (in thousands)
(1) Reflects only the Bank's share of Michigan BIDCO's net income in 1998, 1997 and 1996 under the equity method which was 44.1%.
(2) Includes all Varsity LLCs. Varsity Funding commenced operations in October 1995, and Varsity Mortgage commenced operations in March 1996.
Regulation
The Company and the Bank are extensively regulated under federal law and state law.
As a bank holding company under the Federal Bank Holding Company Act of 1956, as amended, the Company is required to file semi-annual reports and other information as required under the rules of the Board of Governors of the Federal Reserve System (the "FRB") and is also subject to examination by the FRB.
In connection with obtaining the consent of the FRB to a 1989 merger transaction involving the Bank and University Bancorp, Inc., the Company has made certain commitments to the Federal Reserve Bank of Minneapolis providing that the Company will not incur additional debt, and that its Employee Stock Ownership Plan would not purchase more than 10% of the common stock or 5% of any other class of voting shares of the Company, without the prior approval of such Reserve Bank.
Michigan-chartered commercial banks, such as the Bank, are regulated and supervised by the Michigan Department of Commerce, Financial Institutions Bureau, Bank and Trust Division (the "FIB"). As an insured bank, the Bank is also subject to supervision and regulation by the Federal Deposit Insurance Corporation (the "FDIC") and is required to file quarterly reports and other information as
required. As subsidiaries of the Bank, Midwest Loan Services, Varsity Funding, Varsity Mortgage and University Insurance & Investment Services (the "Agency") are all also subject to examination by both the FIB and the FDIC. In addition, the Agency is also subject to examination by the State of Michigan's Financial Institutions Bureau, Insurance Division. As a FHLMC, FNMA, and HUD Title 1 and Title 2 and HUD multifamily seller/servicer, the Bank's mortgage banking operation, and the Bank's mortgage operation subsidiaries, including Midwest Loan Services and Varsity Mortgage are subject to regulation and examination by FHLMC, FNMA and HUD.
Michigan BIDCO is also regulated and supervised by the FIB. The BIDCO is examined annually by the FIB, and is required to make annual filings of financial statements and to maintain a license from the Bureau. Licensing under the terms of the Michigan BIDCO Act conveys certain exemptions upon the BIDCO under Michigan law, which are beneficial to the operations and investment flexibility of the BIDCO. The BIDCO is also required to permit an observer from the Michigan Department of Commerce, Michigan Strategic Fund, BIDCO Program to attend its Board of Directors meetings, and is required to make regular reports and filings of its activities with this department, as a result of the terms of the loan agreement between the Michigan Strategic Fund and Michigan BIDCO.
ITEM 2.
ITEM 2. - PROPERTIES
In May 1995, the Bank purchased a building in Ann Arbor, Michigan for use as its main office. Beginning October 1, 1995 the Bank has leased a portion of the building to the University of Michigan. Currently 42% of the building is leased for approx. $68,000 (adjusted annually for inflation) plus a pro rata share of the building's expenses. The lease is renewable each year.
In mid-1996, the Bank leased a site which includes a registered historic landmark building in Ann Arbor, at the corner where Washtenaw Avenue and Stadium Boulevard merge. The Bank also loaned a limited liability company, Tuomy, L.L.C. (associated with non-affiliated third-parties), a sum sufficient to acquire the site, and earned a 1/3 L.L.C. membership interest in the L.L.C. as additional consideration for making the loan. The Bank uses the historic building as a multiple ATM drive-through location and an off-site storage facility.
The Bank leases an ATM location with an adjacent meeting room in Dexter, Michigan under a three year lease.
The Bank leases its former loan office in Sault Ste. Marie to an unrelated third-party. Management has listed the property with a local commercial realtor for sale.
Varsity Mortgage leases an office in Farmington Hills, Michigan under a one-year agreement. Varsity Mortgage's Retail Division leases a small office for retail origination branches in Columbus, Ohio under a short term rental agreement.
Midwest Loan Services leases an office in Houghton, Michigan under a year-to-year lease.
Management believes that its office facilities are adequate to support the anticipated level of future expansion of the Bank's business.
The following table sets forth certain information relating to real estate owned and leased at December 31, 1998. The Bank believes that the fair market value of the real estate which it owns exceeds the book value of such real estate. Based upon a recent appraisal and its assessment of current market conditions, management believes the 16-acre site where the former loan office is located has a fair market value substantially more than its carrying cost of $266,079 as of December 31, 1998. This property is carried as "other real estate owned" in the Company's financial statements as of December 31, 1998 since it is surplus to the Bank's requirements.
(1) The Bank owns a 1/3 L.L.C. membership interest in the L.L.C. which owns the site.
ITEM 3.
ITEM 3. - LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company or any of its subsidiaries is party to or to which any of their properties are subject.
ITEM 4.
ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II.
ITEM 5.
ITEM 5. - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
COMMON STOCK AND DIVIDEND INFORMATION
The Company's Common Stock trades on The NASDAQ Small-Cap Market under the symbol UNIB. As of the March 1, 1999 there were approximately 375 stockholders including approximately 240 beneficial owners of shares held by brokerage firms or other institutions. The high and low sales prices of the Company's common stock as quoted by NASDAQ, for each quarter of the two year period ended December 31, 1998 are listed below. The quotations represent interdealer prices only, without retail markups, markdowns or commissions, and may not necessarily represent actual retail transactions:
The Company effected a three for two stock split of its common stock (effected as a stock dividend) in February 1998 (see "Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations, Recent Events"). All per share and number of share amounts in this Report are adjusted to reflect the stock split. No cash dividends have been paid on the Company's Common Stock. The Company does not currently anticipate declaring or paying dividends.
CERTAIN SALES OF EQUITY SECURITIES
Not applicable.
ITEM 6.
ITEM 6. - SELECTED FINANCIAL DATA
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA (Dollars in Thousands Except Per Share Data)
[See the Note on the following page]
(1) The Bank sold three branches and associated loans and deposits on December 5, 1994. Income and expense associated with these branches are included up until the date of the sale. Net income includes a gain from the Branch Sale of $1.11 per share.
(2) Share and per share data have been retroactively restated to reflect a 3 for 2 stock split in February 1998.
ITEM 7.
ITEM 7. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The purpose of the following discussion and analysis is to assist the reader in understanding and evaluating the changes in financial position and results of operations over the past three years. The discussion should be read in conjunction with the consolidated financial statements, the related notes thereto, and statistical information presented elsewhere in this report.
This report contains certain forward looking statements which reflect the Company's expectation or belief containing future events that involve risks and uncertainties. Among others, certain forward looking statements relate to the continued growth of various aspects of the Company's community banking, mortgage banking and money management operations and the nature and adequacy of allowances for loan losses. The Company can give no assurance that the expectations reflected in its forward looking statements will prove to be correct. Various factors could cause results to differ materially from the Company's expectations.
Without intending to be exhaustive, these factors include:
NEW BUSINESS ENTERPRISE. The Company's Bank subsidiary operations were relocated to Ann Arbor in 1996, and are not yet profitable and has incurred substantial operating losses during the start-up phase. There is no assurance that the Ann Arbor operation will grow to a size that will enable it to become profitable.
RELIANCE ON KEY PERSONNEL. The success of the Company is dependent upon the services of certain of the senior executive officers. The loss of the services of one or more of such individuals could have an adverse affect on the Company. As the Company expands it will be necessary for the Company to continue to be able to attract and retain additional qualified senior executives. The unexpected loss of Stephen Lange Ranzini, President & CEO of the Company and the Bank or Joseph L. Ranzini, Chairman of the Board of the Company, or any other key executive of the Company or the inability to attract and retain qualified personnel in the future could have an adverse affect on the business and financial results of the Company. The Company does not maintain key man life insurance on any executive officer nor has it entered into non-compete agreements with any executive officer.
DIVIDEND HISTORY. The Company has not previously paid any cash dividends on its Common Stock, and the Company does not intend to pay dividends in the near future. The payment of any cash dividends by the Company in the future will depend to a large extent on the
receipt of dividends from the Bank. The ability of the Bank to pay cash dividends by the Bank to the Company and by the Company to its stockholders are both subject to certain statutory and regulatory restrictions.
COMPETITION FROM OTHER FINANCIAL INSTITUTIONS. There is significant competition among banks and bank holding companies, many of which have far greater assets and resources than the Company, in the areas in which the Company operates. The Company also encounters intense competition in its commercial banking business and mortgage banking business from savings and loan associations, credit unions, mortgage brokers, insurance companies, commercial and captive finance companies, and certain other types of financial institutions many of which are larger in terms of capital, resources and personnel than the Company. The Company believes that such competition will continue and increase in the future. In addition, the manner in which and the means by which financial services are delivered to customers have changed significantly in the past and can be expected to continue to change in the future. It is not possible to predict the manner in which existing technology, and changes in existing technology, will affect the Company. Changes in technology are likely to require additional capital investments to remain competitive. Although the Company has invested in new technology in the past, there can be no assurance that the Company will have sufficient financial resources or access to the proprietary technology which might be necessary to remain competitive in the future.
CREDIT RISK AND LOAN CONCENTRATIONS. The greatest risk facing lenders generally is credit risk, that is, the risk of losing principal and interest due to a borrower's failure to perform according to the terms of the loan agreement. As of December 31, 1998, the Company's total loan portfolio was $35,055,767, or 64% of total assets. The two largest components of the loan portfolio are residential mortgages held for sale to the secondary market, and portfolio loans. The Company's credit risk with respect to its portfolio loans relates principally to the collateral and the general creditworthiness of individuals and small businesses in the Ann Arbor area. Management believes that the allowance for possible loan losses is adequate. See Note 5 to the Company's consolidated financial statements, incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
CAPITALIZED MORTGAGE SERVICING RIGHTS. At December 31, 1998, the Company had an investment of $948,208 in capitalized mortgage servicing rights. Record low interest rates in 1998 were responsible for a surge in refinancing of mortgages. If interest rates were to drop back down to those levels, refinancings and payoffs would likely increase over recent experience since a significant portion of the fixed rate mortgages being serviced by the Company carry interest rates within 1.0% of the current market rate. Market interest rate conditions can quickly affect the value of mortgage servicing rights in a positive or negative fashion, as long term interest rates rise and fall. If interest rates were to decline to levels seen during 1998, the portfolio would experience significant refinancings and payoffs, which would hurt income.
GENERAL ECONOMIC CONDITIONS AND MONETARY POLICY. The operating income and net income of the Company depend to a substantial extent on "rate differentials", i.e., the difference between the income the Company receives from loans, securities and other earning assets, and the interest expense it pays to obtain deposits and other liabilities. These rates are highly sensitive to many factors which are beyond the control of the Company, including general economic conditions and the policies of various governmental and regulatory authorities. For example, in an expanding economy, loan demand usually increases and the interest rates charged on loans increase. Increases in the federal funds rate by the Federal Reserve System usually lead to rising interest rates, which affect the Company's interest income, interest expense and investment portfolio. Competition for deposits at banks can be increased or decreased by the relative attraction of competitive alternatives such as stocks or bonds, or by tax policy changes, such as changes in tax deductions for individual retirement accounts.
VOTING CONTROL. The total number of shares of Common Stock held by the Ranzini Group (Mr. Joseph L. Ranzini, Mr. Stephen Lange Ranzini, Mrs. Mildred Ranzini, the two Ranzini Family Trusts) and the ESOP shares beneficially owned by Stephen Lange Ranzini, is 1,313,362, or 66% of the issued and outstanding shares at December 31, 1998.
GOVERNMENT REGULATION AND SUPERVISION. The Company and the Bank are subject to extensive federal and state regulation and supervision, which is intended primarily for the protection of insured depositors and consumers. In addition, the Company and the Bank are subject to changes in federal and state law, as well as changes in regulations, governmental policies and accounting principles. There exist risks that regulatory examiners give negative examination ratings. The effects are any such potential changes or negative ratings cannot be predicted, but could adversely affect the business and operations of the Company and the Bank, or the Bank's subsidiaries.
REGULATION OF CONTROL. Individuals, alone or acting in concert with others, seeking to acquire more than 10% of any class of voting securities of the Company must comply with the Change in Bank Control Act. Entities seeking to acquire 5% or more of any class of voting securities of, or otherwise to control, the Company must comply with the Bank Holding Company Act. Accordingly, prospective investors need to be aware of these requirements and to comply with these requirements, if applicable, in connection with any purchase of shares of the Common Stock offered hereby.
TRADING MARKET FOR THE COMMON STOCK. Although the Common Stock is listed for trading on the NASDAQ Small-Cap Market, the trading market in the Company's Common Stock on such exchange historically has been less active than the average trading market for companies listed on such exchange. As a result, the price of the Company's Common Stock has ranged from $1.96875 to $5.484375 during 1998. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the
marketplace of willing buyers and sellers of Common Stock at any given time, which presence is dependent upon the individual decisions of investors and general economic and market conditions over which the Company has no control. There can be no assurance that the liquidity or volume of trading in the Common Stock will increase.
The above cautionary statement is for the purpose of qualifying for the "safe harbor" provisions of Section 21E of the Securities Exchange Act of 1934.
GENERAL
The discussion below must be considered in light of the fundamental changes resulting from 1) the opening in February 1996 of a new main office of the Bank in Ann Arbor, and 2) the closing on December 5, 1994 of the sale by the Bank of assets pertaining to its Newberry, Michigan headquarters office and its two branches in Sault Ste. Marie, Michigan, which included the sale of deposits and loan portfolios (the "Branch Sale"). Accordingly, historical results of operations of the commercial banking division are not indicative of future operations. In addition, results of operations for 1998, 1997, 1996, and 1995, were significantly affected by the opening in February 1996 of the Bank's office in Ann Arbor.
The operations of the Company and the banking industry in general are significantly influenced by general economic conditions, related monetary and fiscal policies of the federal government, and policies of financial institution regulatory authorities, including the Federal Reserve Board (FRB), the Michigan State Financial Institutions Bureau (FIB), and the Federal Deposit Insurance Corporation (FDIC). Deposit flows and cost of funds are influenced by interest rates in competing investments and general market rates of interest. Lending activities are affected by the demand for loan borrowing, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting the economy and the availability of funds.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Total assets of the Company at December 31, 1998 amounted to $54.54 million compared to $57.53 million at December 31, 1997. Loans receivable, net of reserves, decreased by $4.53 million to $23.19 million from $27.72 million. Cash and cash equivalents (including Federal Funds sold on an overnight basis) at the end of 1998 increased by $6.87 million from the prior year, while securities increased by $1.81 million. Loans held for sale in the Bank's mortgage banking division decreased by $6.30 million to $11.86 million from $18.16 million. During 1998, management of the Bank continued to pursue a policy of decreasing reliance on certain high cost deposits and borrowings and increasing the rate at which loans held for sale were sold to improve profitability. This policy has resulted in a reduction in total assets, loans held for sale and deposits.
University Bank, as an FDIC-insured bank, is subject to certain regulations which require the maintenance of minimum liquidity
levels of cash and eligible investments. The Bank has historically exceeded this minimum as a result of its investments in Federal Funds sold, U.S. Government and U.S. Agency securities and cash. In addition the bank holding company had $122,007 in cash and equity securities at the end of 1998 to meet cash needs, primarily operating expenses and interest and principal reductions on the holding company's bank loan. The balance of the loan was $826,000 and $922,688 at year end 1998 and 1997. The note was refinanced in late 1997, into a seven-year fully amortizing loan. In an effort to maintain the Bank's Tier 1 capital to assets ratio above 7% and to increase capital through retained earnings, management does not expect that the Bank will pay dividends to the Company during 1999. Management intends that the cash and securities on hand, together with cash from the sale of common stock and the exercise of stock options to be sufficient to cover the required principal reductions during 1999 on the holding company's loan.
Total stockholders' equity of the Company at December 31, 1998 was approximately $3.08 million (or 5.6% of total assets) compared to $3.40 million (or 5.9% of total assets) the year earlier. The Bank's regulatory capital at year end was $4.38 million or 8.02% of the Bank's total regulatory assets and the risk-adjusted capital ratio of 13.1% exceeded the minimum regulatory risk-based capital requirement of 8% of the risk-adjusted assets for the Bank. The following table provides additional information about the risk-adjusted assets of the Bank and the Company's actual capital percentages:
University Bank Risk-Based Capital Calculation December 31, 1998
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and the notes thereto have been prepared in accordance with generally accepted accounting principles which require the measurement of financial condition and operating results in terms of historical dollars (with the exception of the BIDCO, which uses the investment company method of accounting), without considering changes in the relative purchasing power of money over time due to inflation. The primary impact of inflation on operations is reflected in increased operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the prices of goods and services, since such prices are affected by inflation. In the current interest rate environment, where there are rapid increases and decreases of interest rates, liquidity and the maturity structure of the Bank's assets and liabilities are crucial determinants of the Bank's profitability.
ASSET/LIABILITY MANAGEMENT
All financial institutions are significantly affected by fluctuations in interest rates commonly referred to as "interest rate risk." The principal exposure of a financial institution's earnings to interest rate risk is the difference in time between interest rate adjustments or maturities on interest-earning assets compared to the time between interest rate adjustments or maturities on interest-bearing liabilities. Such difference is commonly referred to as a financial institution's "gap position." In periods when interest rates are increasing, a negative gap position will result in generally lower earnings as long-term assets are repricing upward slower than short-term liabilities. However during a declining rate environment, the opposite effect on earnings is true, with earnings rising due to long-term assets repricing downward slower than short-term liabilities.
The following table presents the Bank's interest sensitivity gap between interest-earning assets and interest-bearing liabilities at December 31, 1998. The table is based upon various assumptions of management which may not necessarily reflect future experience. The Bank performs a static gap analysis which has limited value as a simulation because of competitive and other influences that are beyond the control of the Bank. As a result, certain assets and liabilities indicated as maturing or re-pricing within a stated period may, in fact, mature or re-price in other periods or at different volumes. The one-year static gap position at December 31, 1998 was estimated to be ($8,424,000) or -15.46%:
UNIVERSITY BANK Asset/Liability Position Analysis ($ in 000's) Maturing or Repricing in
Notes: (1) Net of bad debt reserves.
The following additional information is provided with respect to the Bank's investment portfolio, at book value, as of December 31, 1998:
Investment Portfolio Maturities (in $000s) and Yield by Type:
Additional information regarding the Bank's investments as of December 31, 1998 and 1997 is set forth under note 3 to the Company's consolidated financial statements included with this report.
The following information pertaining to maturities and sensitivities of the Bank's loan portfolio to changes in interest rates is provided as of December 31, 1998:
Loan Portfolio Maturities by Type (in $000s):
(1) Excludes residential loans held for sale of $11,863, and the allowance for loan losses.
SUMMARY OF RESULTS OF OPERATIONS
The net loss from operations of the Company was $198,049 in 1998, $1,117,924 in 1997 and $536,758 in 1996. Earnings (loss) per share for 1998, 1997 and 1996 were $(0.10), $(0.58) and $(0.29), respectively.
The decreased loss in 1998 versus 1997 was principally due to decreased losses at the Bank's new Ann Arbor main office. During the year non-interest expenses at the retail bank division were decreased by $890,139, and certain aspects of underlying operating results including key indicators such as net interest income improved so that the Bank acheived a break-even result during the year from ongoing operations. Unusual or non-recurring expenses exceeded unusual or non-recurring profits and decreased the Bank's income by $342,000. The Bank's mortgage banking and other specialized financial subsidiaries had total increased profits of $581,381 in 1998, a 33% return on average investment and offset a portion of the losses from the retail banking operations.
The increased loss in 1997 versus 1996 was principally due to increased losses at the Bank's new Ann Arbor main office. During the year fixed costs were higher than revenues, and although certain aspects of underlying operating results including key indicators such as net interest income improved, the break-even point was only reached from ongoing operations in the fourth quarter. A change in management at the Bank also led to high severance and other expenses in the fourth quarter. The Bank's mortgage banking and other specialized financial subsidiaries had total increased profits of $245,292 in 1997, a 13% return on average investment and offset a portion of the losses from the community bank operations.
RECENT EVENTS
The Company recently received permission orally from the Michigan Financial Institutions Bureau for the BIDCO to repurchase the shares and convertible bonds held by certain minority shareholders of the BIDCO. Written permission is expected shortly. The transaction is contemplated to be effective in the near future. As a result of the transaction it is anticipated that the Company's ownership of the BIDCO will increase to 80% from 44.1%, and that the BIDCO will then become part of the Company's tax filing group for federal income tax purposes. As a result, certain deferred tax assets are expected to be realized during 1999, as the BIDCO's taxable income is sheltered by the Company's net operating tax loss carryforward. Since the purchase price for the shares is at a discount to the BIDCO's per share book value, the transaction is anticipated to generate an immediate gain for the Company of approximately $70,000.
NET INTEREST INCOME
Net interest income represents the dollar amount by which interest income generated by interest-earning assets exceeds the cost of funds. Interest-earning assets consist primarily of loans, short term investments and investment securities, and the principal cost of
funds is the interest paid on deposit accounts and other borrowings. Net interest income is affected by (i) the difference between the average rate of interest earned on the Bank's interest-earning assets and the average rate paid on its interest-bearing liabilities ("interest rate spread") and (ii) the relative amounts of its average interest-earning assets and interest-bearing liabilities. In order to maintain and increase earnings during periods of fluctuating interest rates, it is imperative that interest-earning assets and interest-bearing liabilities be managed effectively. Trends in net interest income provide a measure of the effectiveness by which a financial institution manages its interest rate sensitivity.
In each period, net interest income on a consolidated basis was reduced by interest expense associated with the holding company's bank loan indebtedness. Such interest expense was $0.09 million in 1998, $0.11 million in 1997 and $0.09 million in 1996.
In the following table, non-accrual loans are included in the average balances. The table presents, for the periods and dates indicated, the average balances (all averages are calculated using monthly averages) of, the interest earned or paid on, and the weighted average yield earned or rate paid on, the Company's interest-bearing assets and liabilities:
(1) Actual yields; not adjusted to take into account tax-equivalent yields resulting from tax-free municipal income and includes bank deposits.
The table above does not specify the average level of non-interest bearing demand deposits, which were $2,626,160, $3,510,337 and $3,377,101 for the years ended December 31, 1998, 1997 and 1996, respectively, as computed using month-end balances for such years.
Net interest income of the Bank increased to $1.65 million in 1998 from $1.53 million in 1997, mainly as a result of a larger decrease in interest-earning liabilities than the decrease in interest-earning assets, which was only partially offset by a decline in the yield on interest-earning assets, which fell faster than the decline in the cost of interest-earning liabilities. During the year ended December 31, 1998, the Bank's average interest-earning asset base fell by $2.32 million or 4.7% over 1997, while average interest-bearing liabilities decreased by $9.71 million or 18.8%. Due to a restructuring of the interest rate earned on loans held for sale charged to the Bank's Varsity subsidiaries, the average yield on interest-earning assets decreased to 8.45% from 9.52% in 1997. Due to the decrease of wholesale deposits in the mix of interest-earning liabilities, the average cost of deposits decreased from 5.99% in 1997 to 5.40 in 1998. As a result of the decrease in yield on interest-earning assets in an amount greater than the decline in the cost of interest-earning liabilities, which more than offset an expansion in interest-earning assets relative to interest-earning liabilities, the net interest margin decreased to 2.96% in 1998 from 3.43% in 1997. Interest rates were mostly stable until September 1998, and short term interest rates declined for the balance of the year.
Net interest income of the Bank increased to $1.53 million in 1997 from $0.99 million in 1996, mainly as a result of an increase in both yield on interest-earning assets, and an increase in average interest-earning assets, which was only partially offset by the rise in interest-earning liabilities. During the year ended December 31, 1997, the Bank's average interest-earning asset base rose by $4.04 million or 8.8% over 1996, while average interest-bearing liabilities increased by $7.62 million or 17.3%. Due to the growth of loans versus securities in the mix of interest-earning assets, the average yield on interest-earning assets increased to 9.52% from 8.14% in 1996. Due to the increase of retail deposits versus wholesale funds in the mix of interest-earning liabilities, the average cost of deposits decreased from 6.00% in 1996 to 5.99% in 1997. As a result of an expansion in loans and retail deposits, the net interest margin increased to 3.43% in 1997 from 2.09% in 1996. Interest rates were mostly stable for the entire year, and had a minor impact on net interest margins during 1997.
At December 31, 1998, the net yield on the Bank's interest-earning assets was 3.64% up from the average net spread for the 1998 year of 3.48%, principally as a result of lower cost retail deposits. Fee income from the Bank's mortgage banking originations, income from the Bank's portfolio of mortgage servicing rights and the Bank's investment in its subsidiaries are not included in these calculations.
The following table presents information regarding fluctuations in interest income and interest expense of the Company
for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume); with the rate/volume variance allocated to changes in rate:
LOAN PORTFOLIO
Information regarding the Bank's loan portfolio as of December 31, 1998 and 1997 is set forth under Note 5 to the Company's consolidated financial statements included with this report.
PROVISION FOR LOAN LOSSES
The Bank charges to operations a provision for possible loan losses which is intended to create an allowance for future loan losses inherent in the Bank's portfolio. Each year's provision reflects management's analysis of the amount necessary to maintain the allowance for possible loan losses at a level adequate to absorb anticipated losses. In its evaluation, management considers such factors as historical loan loss experience, specifically identified problem loans, composition and growth of the loan portfolio, current and projected economic conditions, and other pertinent factors. A loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur.
Non-performing loans are defined as loans which have been placed on non-accrual status and loans over 90 days past due as to principal or interest and still in an accrual status. Where serious doubt exists as to the collectibility of a loan, the accrual of interest is discontinued. See Notes 5 and 6 of the Consolidated Financial Statements for additional information regarding impaired and past due loans.
Non-performing loans amounted to $471,832 and $1,121,605 at December 31, 1998 and 1997, respectively. The decrease in non-performing loans during 1998 is the result of an improvement in the Bank's non-residential loan portfolio, and the transfer to REO of some non-performing residential properties that were foreclosed on during the year.
The provision for loan losses in 1998 was $118,433, a decrease of $141,567 from the 1997 level, which in turn was an increase of $69,500 from the 1996 level of $190,500. Loans charged off net of recoveries were $180,385, $36,830 and $209,432 in 1998, 1997 and 1996, respectively. The allowance for possible loan losses totaled $459,001, $520,953 and $297,783 at the end of 1998, 1997, and 1996, respectively.
A summary of loan loss expense for the Bank for the years indicated is presented below:
Analysis of the Allowance for Loan Losses ($ in thousands)
Analysis of the Allowance for Loan Losses ($ in thousands)
(1) Excludes loans held for sale.
The monthly provision for loan loss remained at $7,500 during 1998, although management added a special provision of $35,933 in the third quarter of 1998 to create a new allowance for loan losses at Varsity Funding and Midwest Loan Services for portfolio loans at these subsidiaries.
The Bank's overall loan portfolio is geographically concentrated in Ann Arbor and the future performance of these loans is dependent upon the performance of relatively limited geographical areas.
Management believes that the current reserve level is adequate to absorb losses inherent in the loan portfolio, although the ultimate adequacy of the allowance for loan losses is dependent upon future economic factors beyond the Company's control. A downturn in the general nationwide economy will tend to aggravate, for example, the problems of local loan customers currently facing some
difficulties. A general nationwide business expansion could conversely tend to diminish the severity of any such difficulties.
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
There were several one-time, non-recurring losses and gains included in the retail banking division's 1998 results. For example, the financial results of the Bank in December 1998 included a one-time, non-recurring loss of $121,224 which was related to the sale a substantial majority of the Bank's mortgage servicing rights. Management expects this sale of the Bank's mortgage servicing rights to end a drain (a loss of $286,000 in 1998) on the retail bank division's profitability. During 1998 the Bank also sold its Newberry and Saline offices at a profit and consolidated all Bank operations (excluding offsite ATMs) into the Ann Arbor site.
Non-interest income. Non-interest income in 1998 rose to $5,973,899 from $5,189,104 in 1997, an increase of $784,795, or 15.1%. The increase in 1998 was mainly the result of mortgage banking income, which increased 7.4%, or $364,807, but all categories increased, including increased gains from securities sales, gains from the sale of excess property, increased service charges and fees, and net income from Michigan BIDCO.
Non-interest income in 1997 rose to $5,189,104 from $3,219,520 in 1996, an increase of $1,969,584, or 61.2%. The increase in 1997 was mainly the result of mortgage banking income, which increased 108%, or $2,563,735, partially offset by decreased gains from securities sales and sales of portfolio mortgage servicing rights.
Mortgage Banking. Mortgage banking, servicing and origination fees increased to $5,291,622 in 1998 from $4,926,815 in 1997. The increase in mortgage banking fee income was the result of a 31% increase in loan purchase and origination volumes during 1998 and profits from the Bank's mortgage banking subsidiaries, Varsity Mortgage and Midwest Loan Services.
The servicing rights portfolio totaled $95,588,808 of FHLMC and FNMA mortgages for others at December 31, 1998, versus $124,719,166 at December 31, 1997. All servicing done in 1998 was done by Midwest Loan Services. The amount decreased as a result of a portfolio sale of servicing rights by the Bank in December 1998, and payoff and refinancing of existing rights throughout the year. The following table summarizes the portfolio by type and mortgage note rate:
Interest Rate Stratification of the Bank's Servicing
Mortgage interest rates declined during late 1998 to levels briefly seen during the Summer of 1993 and the Winter of 1995, and as a result, the portfolio experienced increased refinancings and payoffs. The Bank in particular amortized $286,000 in 1998 of servicing rights, in addition to a $121,224 loss on the sale of the bulk of the Bank's remaining portfolio of servicing rights in December 1998.
Based on recent comparable sales and indications of market value from industry brokers, management believes that the current market value of the Bank's portfolio of mortgage servicing rights approximates cost. Market interest rate conditions can quickly affect the value of mortgage servicing rights in a positive or negative fashion, as long term interest rates rise and fall.
(1) Assumes a price based upon market transactions at December 31, 1998 of 4.3x (4.3 times the servicing fee) for 30-year servicing, 3.6x for 15-year servicing, 2.6x for Balloon servicing and 1.8x for ARM servicing. The market value of servicing at December 31, 1997 [Footnotes continued on following page]
was based on a price of 4.6x for 30-year servicing, 3.5x for 15-year servicing, 1.9x for Balloon servicing and 2.0x for ARM servicing. Excess servicing is discounted from these amounts at a multiple of one times the servicing fee. (2) Uses net present value analysis of future cash flows, discounted back at rates ranging from 10 to 12% in 1998 and 1997. (3) Range based upon the two methods used in (1) and (2), above. During 1998 purchases and sales of mortgage servicing rights by third-parties evidenced a declining trend in price as long term interest rates declined in towards the end of the year.
Additional information regarding the Bank's mortgage banking activities for the past three years is set forth in Note 4 to the Company's consolidated financial statements.
Michigan BIDCO. Michigan BIDCO (the "BIDCO"), an equity affiliate, invests in businesses in Michigan with the objective of fostering job growth and economic development. As of December 31, 1998, the BIDCO had made twenty-seven such investments, amounting to a total of $13,413,600 at original cost (before repayments or participations sold). At December 31, 1998, Michigan BIDCO had total assets of $5,327,697 versus $5,683,808 at December 31, 1997. As discussed above under "ITEM 1.- Business, Lines of Business, Michigan BIDCO", the financial statements of the BIDCO are presented using the investment company method, and, accordingly, investments in stocks, stock warrants, limited liability companies and loans ("BIDCO Investments") are reported at fair value.
The BIDCO's financial results for 1998 reflect net income in the amount of $259,238 versus a net loss of 163,539 in 1997. Operating expenses declined $167,637 or 38.9%, as expenses were well controlled and the expense reimbursement from Northern Michigan Foundation increased $80,000 to $190,000. Net interest income recovered to $13,310, an increase of $233,698 from the prior year. Realized gains on the sale of two major investments in the amount of $720,000 had no impact on income as the valuations had been taken into account in the year-end 1997 valuation. Additional market value provisions were recorded on the mixed office recycled paper pulp mill investment, because continued record low paper prices decreased the revenue that had been anticipated from a royalty on sales.
The BIDCO's financial results for 1997 reflect a loss in the amount of $163,539 as a result of a negative market value adjustment on securities and loans of $309,144 for the year and a write-off of accrued but unpaid interest that resulting in negative net interest income for the year of ($220,388). Two BIDCO investments run into financial difficuly during 1997 and the carrying value was decreased. One was restructured during 1997, with the BIDCO's investment reduced in value by approximately half. The second was still in the process of being restructured, and the BIDCO took a substantial write-down on its investment there.
At December 31, 1998, the BIDCO had no outstanding conditional commitments to lend.
Securities. Proceeds from sales of marketable equity securities (included in proceeds from sales of investment securities) were $121,037, $166,498 and $631,278 for the years ended December 31, 1998, 1997 and 1996, respectively. Gross gains of approximately $97,993, $41,155 and $346,495 and no gross losses were realized on 1998, 1997 and 1996 sales, respectively.
Proceeds from sales of available for sale securities were $140,449, $5,740,991 and $10,888,145 for the years ended December 31, 1998, 1997 and 1996, respectively (including sales of marketable equity securities and excluding sales associated with the Bank's mortgage banking operation). There was no gain or loss on 1998 sales. Gross gains of approximately $29,726 and gross losses of approximately $63,166 were realized on 1997 sales. Gross gains of approximately $433,222 and gross losses of approximately $33,940 were realized on 1996 sales.
At December 31, 1998, gross unrealized losses in the Bank's available-for-sale securities were $156,993 and gross unrealized gains were $3,776. At December 31, 1997 gross unrealized losses in the Company's available-for-sale securities were $27,961 and gross unrealized gains were $46,549. At December 31, 1996 gross unrealized losses in the Company's available-for-sale securities were $68,000 and gross unrealized gains were $60,000. Sales of loans pooled into mortgage backed securities in connection with the Bank's mortgage banking activities were $48,236,448 in 1998, 171,639,196 in 1997 and $54,137,028 in 1996.
Non-interest expense. Non-interest expense for the Company increased by $36,156 or 0.5% in 1998. During the year non-interest expenses at the retail bank division were decreased by $890,139 as a result of a variety of cost cutbacks in an effort to streamline the operation. During the year, the Newberry and Saline operation centers were sold and all operations centralized in the Ann Arbor main office. Excess personnel costs were reduced, and a variety of other efficiencies realized. This decrease was offset by ongoing growth at the Bank's mortgage subsidiaries, Varsity and Midwest Loan Services. In addition, legal and audit expenses remained high as a result of various projects including approximately $75,000 spent on the unsuccessful litigation against the RTC, and a variety of Year 2000 expenses were incurred and expensed. Holding company total expense decreased $13,963 primarily as a result of decreases in public listing expense and audit and legal expense as certain projects finished in 1997. Partially offsetting this decrease at the holding company was an increase in ESOP benefits expense and salary and expenses reimbursed to a consultant in connection with a special project.
Non-interest expense for the Company increased by $2,952,525 or 60.0% in 1997 to $7,867,874 from $4,915,349 in 1996. Increased personnel, occupancy and state income tax expense resulting from the development of the Bank's new full-service branch office in Ann Arbor and the Varsity Funding and Varsity Mortgage mortgage banking subsidiaries during 1997 was the major factor in the increase. Legal and audit expense remained unusually high as a result of various projects and loan collection legal expense. Bonuses and severance pay
to the Bank's former President added $405,000 in salary expense. As a result of a variety of actions, in late 1997 and January 1998, management reduced the Bank's ongoing non-interest expenses by a total of $850,000 per year, when compared to the annualized rate during the first nine months of 1997. Holding company total expense increased $45,470 primarily as a result of increases in public listing expense and legal expense associated with various projects.
Year 2000 Readiness. The following statements are Year 2000 Readiness Disclosures for purposes of the Federal Year 2000 Information and Readiness Disclosure Act, and you are entitled to protection in accordance with that act. The Year 2000 issue concerns the potential impact of computer software code that only utilizes two digits to represent the calendar year (e.g. "99" for "1999"). Software of this type, if not corrected, could produce inaccurate or unpredictable results at any time, and especially after January 1, 2000, when current and future dates have a lower two digit year number than dates in this century. The Company, similar to most financial services providers, is significantly subject to the potential of the Year 2000 issue due, among other matters, to the nature of financial information. Potential impacts to the Company may arise from software, computer hardware, and other equipment both within the Company's direct control and outside of the Company's ownership, yet with which the Company electronically or operationally interfaces. Financial institution regulators have focused intensively on Year 2000 exposures in the institutions they regulate, issuing guidance concerning the responsibilities of senior management and directors. Year 2000 testing and certification is being addressed as a key safety and soundness issue in conjunction with regulatory exams. The failure to implement an adequate Year 2000 program can be identified as an unsafe and unsound banking practice.
In order to address the Year 2000 issue, the Bank has formed a Year 2000 coordination committee with key members of management from the Bank and each operating subsidiary and appointed its Compliance Officer as Year 2000 Coordinator. The Bank and Midwest rely on mainframe computers, which are IBM A/S 400s, and are certified and tested as Year 2000 compliant. The Bank's main bank software application is a product of Peerless Group, which has also been upgraded to a Year 2000 compliant version which has been tested and certified as Year 2000 compliant. Midwest's main application software is LSAMS servicing software which has been upgraded to a Year 2000 compliant version which has been tested and certified as Year 2000 compliant. The Bank, Varsity Mortgage and Varsity Funding also rely on Novell Local Area Networks, which have been upgraded to a Year 2000 certified version of Novell Local Area Network software, which has also been tested and certified as Year 2000 compliant. All PC systems and PC software at the Bank and its subsidiaries have been tested and certified as Year 2000 compliant.
Approximately all of the $93,000 Year 2000 readiness budget has been spent in the process of upgrading and certifying the systems as being Year 2000 compliant. The bulk of the Year 2000 budget was allocated to capital expenditures for software upgrades for software updates and hardware updates and Year 2000 testing which was expensed
in 1998. At this point in time, the Company and its subsidiaries have renovated, tested and certified as Year 2000 compliant all systems identified as mission critical. The focus of the Company's Year 2000 effort is now shifting towards less critical systems and contingency planning to deal with unforseen events external to the Company.
Actual and budgeted Year 2000 readiness costs do not include the implicit costs associated with the reallocation of internal staff hours to Year 2000 readiness related efforts. These costs are not included because the Bank does not separately track those expenses. Budgeted costs also do not include normal ongoing costs for computer hardware and software that would be replaced even without the presence of the Year 2000 issue in conjunction with the Company's ongoing programs for updating its infrastructure. Additional Year 2000 costs may be incurred as the Company progresses in its Year 2000 program and obtains additional information and conducts further testing regarding the Year 2000 readiness of third parties.
The Company has communicated and will continue to communicate with various significant suppliers and major borrowers and customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 issues. The Company is requesting that such third party vendors indicate whether their products and services are Year 2000 compliant, whether they have a program to test for that compliance, and the status of the program. However, the activities of third parties in responding to the Year 2000 issue is beyond the control of the Company.
Despite the Company's activities to address the Year 2000 issue, there is no assurance that certain mission critical vendors such as the Federal Reserve Bank of Chicago, the Bank's correspondent banks (Bank One, the Federal Home Loan Bank of Indianapolis and Associated Bank), the Bank's credit card processor (Equifax), the Bank's ATM processor (Magic Line), or local power (Detroit Edison Electric) and phone utilities (Ameritech and ATT) will be Year 2000 compliant by year-end 1999, and if not this could have a material adverse effect on the Company's operations, and the Company's borrowers and customers. There can also be no assurance that partial or total systems interruptions or the costs necessary to implement contingency plans, or Year 2000 systems failures affecting borrowers, customers or third party vendors would not have a material adverse effect on the Company's operations and business prospects. Further, the Company cannot estimate the additional cost, if any, of implementing any such contingency plan.
The Bank has evaluated the Year 2000 readiness of its major borrowers and determined that it has a below average risk (relative to its peer group) from Year 2000 related potential loan losses, due to its primary focus on real estate secured lending. All business loans and loan renewals by the Bank are being evaluated in the context of the Year 2000 readiness of each business. However, it is impossible for the Company to know with any certainty that the Bank or its subsidiaries will not sustain Year 2000 related credit losses, and whether or not such losses would be material.
The Bank and its subsidiaries have established back-up contingency plans to continue operations in the event of a Year 2000 systems failure, based on the assumption that all mission critical computer systems are Year 2000 certified and tested but that non-traditional power sources may be required for a short period of time. In addition, a final contingency plan has been established to conduct manual operations using paper forms until such time as a systems failure can be corrected. A full scale live contingency plan test is currently planned to occur in April. Management believes that as a temporary measure, it is feasible with the volume of current activity to continue operations in this manner, but there is no assurance that it is possible or that the cost would not be material.
INCOME TAXES
Income tax expense (benefit) in 1998 was $(198,592) versus $(292,818) in 1997 and $(358,758) in 1996. The effective tax (benefit) rate was (50.1)% in 1998, (33.9)% in 1997 and (40.1)% in 1996. A tax benefit was realized in 1998, 1997 and 1996 for net operating loss carryforwards as a result of the net losses from operations.
In February 1996, the Bank, through its 98%-owned subsidiary, Arbor Street LLC, purchased $1,000,000 in federal low income housing tax credits through a partnership investment in Michigan Capital Fund for Housing Limited Partnership I, a Michigan limited partnership (the "Partnership"). The initial investment consisted of a $50,000 equity purchase and the execution by Arbor Street LLC of a $950,000 promissory note held by the Partnership (the "Note"). Additional capital contributions are made over time. The purchase of the tax credits increased the Company's deferred federal income tax assets in 1998, 1997 and 1996 and is expected to decrease the amount of federal income taxes the Company would otherwise pay annually through 2005.
At December 31, 1998, the Company had available federal income tax loss carryforwards that could be utilized to shelter approximately $2,100,000 in taxable income, and carried a deferred tax asset on its books of $377,088, net of a deferred tax asset reserve of $360,000. If the Company is able to generate sufficient taxable income in future years, the reserve against the Company's deferred tax asset could be reversed, resulting in an increase in future net income. However, if the Company does not generate income in the future to utilize the existing deferred tax assets, the amount of the reserve could be increased, resulting in a decrease in future net income. See above, "Recent Events".
UNIVERSITY BANCORP, INC.
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CONSOLIDATED FINANCIAL STATEMENTS
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DECEMBER 31, 1998, 1997, 1996
REPORT OF INDEPENDENT AUDITORS
Board of Directors And Shareholders University Bancorp, Inc. Ann Arbor, Michigan
We have audited the accompanying consolidated balance sheets of University Bancorp, Inc. as of December 31, 1998, and 1997 and the related consolidated statements of operations, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. 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 generally accepted auditing standards. 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 the above present fairly, in all material respects, the financial position of University Bancorp, Inc. as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
/s/ Crowe Chizek and Company LLP Crowe Chizek and Company LLP
Grand Rapids, Michigan March 18, 1999
Part 1. - Financial Information Item 1.- Financial Statements
UNIVERSITY BANCORP, INC. Consolidated Balance Sheets December 31,1998 and 1997
-Continued-
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Consolidated Balance Sheets (continued) December 31,1998 and 1997
The accompanying notes are an integral part of the consolidated financial statements.
UNIVERSITY BANCORP, INC. Consolidated Statements of Operations For the Years Ended December 31, 1998, 1997 and 1996
-Continued-
UNIVERSITY BANCORP, INC. Consolidated Statements of Operations (continued) For the Years Ended December 31, 1998, 1997 and 1996
UNIVERSITY BANCORP, INC. Statement of Comprehensive Income For the Years Ended December 31, 1998, 1997 and 1996
The accompanying notes are an integral part of the consolidated financial statements.
UNIVERSITY BANCORP, INC. Consolidated Statements of Stockholders' Equity For the years ended December 31, 1998, 1997, and 1996
UNIVERSITY BANCORP, INC. Consolidated Statements of Cash Flows For the years ended December 31, 1998, 1997 and 1996
The accompanying notes are an integral part of the financial statements.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
1. Summary of significant accounting policies
Principles of Consolidation and Nature of Operations The consolidated financial statements of University Bancorp, Inc. (the Company) include the operations of its wholly-owned subsidiary, University Bank (the Bank), the Bank's wholly-owned subsidiaries, Varsity Funding Services, L.L.C. (Varsity Funding), Varsity Mortgage, L.L.C. (Varsity Mortgage), and University Insurance & Investment Services, Inc. (Agency), 98% owned subsidiary, Arbor Street, L.L.C. (Arbor) and 80% owned subsidiary, Midwest Loan Services, Inc. (Midwest). The accounts are maintained on an accrual basis in accordance with generally accepted accounting principles and predominant practices within the banking industry. All significant intercompany balances and transactions have been eliminated in preparing the consolidated financial statements.
The Company is a bank holding company. The subsidiary Bank, which is located in Michigan, is a full service community bank, which offers all customary banking services, including the acceptance of checking, savings and time deposits. The Bank also makes commercial, real estate, personal, home improvement, automotive and other installment, credit card and consumer loans, and provides fee based services such as annuity and mutual fund sales, life insurance and foreign currency exchange. The Bank considers its customer base to be primarily located in the Ann Arbor, Michigan area. The Bank established its main office in Ann Arbor in February 1996, by relocating from the eastern Upper Peninsula of Michigan. The Ann Arbor office is the focus of the Bank's future business development plan. The consolidated assets of the Company of $54,535,558 as of December 31, 1998, primarily represent commercial and retail banking activity. Mortgage loans which were sold into the secondary market and are being serviced by the Bank and Midwest for others of $95,000,000 as of December 31, 1998, are not included in the Company's consolidated balance sheet. The Bank uses brokers to arrange time deposits, and during 1998, a significant portion of the Bank's time deposits were brokered deposits (See Note 8).
The Bank's operating subsidiaries, Midwest, Varsity Funding and Varsity Mortgage, are engaged in the residential home "mortgage banking" business. Midwest Loans Services began operations in 1992 and was acquired by University Bank in December, 1995. Midwest Loan Services is based in Houghton, Michigan, and is a specialist in servicing residential mortgage loans for itself and other financial institutions, including the Bank (See Note 4.) Varsity Funding commenced operations in October 1995 and Varsity Mortgage commenced operations in March 1996 (See Note 4). Varsity Funding and Varsity Mortgage which are based in Farmington Hills, Michigan, specialize in the purchase, from correspondents, and the sale to the secondary market, of nonconforming and conforming residential loans, respectively.
The consolidated financial statements include operating results of the Agency since its acquisition on December 31, 1996. The Agency is engaged in the sale of insurance products including life and health, and investment products including annuities and mutual funds. The Agency is located in the Bank's Ann Arbor main office.
The Bank's 98%-owned subsidiary, Arbor Street LLC, has purchased $1,000,000 in low income housing tax credits through Michigan Capital Fund for Housing Limited Partnership I with the assistance of $950,000 in initial financing in the form of a loan from the Michigan Housing Development Authority.
The Company's loan portfolio is concentrated in Ann Arbor and Washtenaw County, Michigan. While the loan portfolio is diversified, the customers' ability to honor their debts is partially dependent on the local economy. The Ann Arbor area is primarily dependent on the education, healthcare, services, and manufacturing (automotive and other) industries. Most real estate loans are secured by federal agency guarantees and residential or commercial real estate and most business loans are secured by business assets. Generally, installment loans are secured by various items of personal property. A large portion of time deposits consist of certificates of deposit obtained through brokers and are subject to withdrawal (with penalties for early withdrawal) should the Company's credit worthiness downgrade.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
1. Summary of significant accounting policies (continued)
Michigan BIDCO, Inc. The Bank's investment in Michigan BIDCO, Inc. (the BIDCO) is accounted for under the equity method of accounting. The Bank owns 44.1% of the outstanding shares of the BIDCO at December 31, 1998, which began operations in May, 1993. At December 31, 1998, the Company owned $67,977 in bonds issued by the BIDCO. If there were a conversion of outstanding convertible bonds, the Bank and the Company would together own 12.17% and 15.61% at December 31, 1998 and 1997. In addition, upon conversion, certain Corporation officers and directors and their immediate family (two of whom serve as President and Chairman of the Corporation) would have an ownership interest in the BIDCO of 29.4%. The conversion may take place, at the election of the BIDCO, subsequent to any time that the BIDCO's equity pursuant to an audit performed using generally accepted auditing standards exceeds $1,500,000. The financial statements of Michigan BIDCO, Inc. are stated using the prescribed accounting practices of investment companies. As a result, investments made by the BIDCO are evaluated by management and carried at estimated fair value. Total equity of the BIDCO was $1,486,239 at December 31, 1998.
Use of Estimates in Preparing Financial Statements: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions based upon available information. These estimates and assumptions affect the reported amounts and disclosures. Actual results could differ from those estimates.
The significant estimates incorporated into these consolidated financial statements which are more susceptible to change in the near term include the value of mortgage servicing rights, the allowance for loan losses, the identification and valuation of impaired loans, the equity interest in the fair value and the change in the fair value of investments made by the BIDCO, the fair value of financial instruments, and the valuation of deferred tax assets.
Cash flow reporting For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents is defined to include the cash on hand, non-interest bearing deposits in other institutions, federal funds sold and other investments with a maturity of three months or less when purchased. Net cash flows are reported for customer loan and deposit transactions and interest bearing deposits with other banks.
Securities Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately in stockholders' equity, net of tax. Realized gains are based on specific identification of amortized cost. Securities are written down to fair value when a decline in fair value is not temporary. Interest income includes amortization of purchase premium or discount. Trading securities are carried at fair value, with changes in unrealized holding gains and losses included in income. Other securities such as Federal Home Loan Bank stock are carried at cost.
Loans Loans 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. Payments received on such loans are reported as principal reductions, unless all interest and principal payments in arrears are paid in full.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
1. Summary of significant accounting policies (continued)
Mortgage banking activities Mortgage banking activities include the purchase of loans from correspondents. The agreements with the correspondents and the degree of underwriting the Bank performs on the loans determine whether the loans are purchased with or without recourse. Mortgage loans held for sale as part of the Bank's mortgage banking activities are valued at the lower of cost or market as determined by bid prices for loans in the secondary market. Certain loans are securitized into mortgage backed trading securities. Upon securitization, the loans are transferred at market value to trading securities, and a gain or loss on securitization of loans is recorded.
Allowance for loan losses The allowance for loan losses is a valuation allowance for probable credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required based on past loan loss experience, known and inherent risks in 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 impairment is reported 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, consumer, and credit card 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. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when it is probable that all principal and interest amounts will not be collected according to the original terms of the loan.
Premises and equipment Bank premises and equipment are stated at cost less accumulated depreciation. Provisions for depreciation are computed primarily on the straight-line method for bank premises and the accelerated methods for equipment and land improvements over their estimated useful lives. These assets are reviewed for impairment when events indicate the carrying amount may not be recoverable.
Other real estate owned Real estate properties acquired in collection of a loan are recorded at fair value at the acquisition. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in other expenses.
Servicing rights Servicing rights represent both purchased rights and 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 grouping of the underlying loans as to type, term and interest rates. Any impairment of a grouping is reported as a valuation allowance.
Income taxes Income tax expense is the sum of the current year estimated tax obligation or refund per the income tax return, and the change in the estimated future tax effects of temporary differences and carryforwards. Deferred tax assets or liabilities are computed by applying enacted income tax rates to the expected reversals of temporary differences between financial reporting and income tax reporting, and by considering carryforwards for operating losses and tax credits. A valuation allowance, if needed, adjusts deferred tax assets to the net amount that is more likely than not to be realized.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
1. Summary of significant accounting policies (continued)
Retirement plan The Bank replaced a SEP IRA plan with a 401-K Plan, effective January 1, 1996, which allows an employee to contribute up to 15% of salary pre-tax, to the allowable limit prescribed by the Internal Revenue Service. Management has discretion to make matching contributions to the Plan. However, no matching contributions were made by the Bank for the years ended December 31, 1998, 1997 and 1996.
Employees Stock Ownership Plan (ESOP) The Corporation has a noncontributory ESOP covering all full-time employees who have met certain service requirements. The employees' share in the Corporation's contribution is based on their current compensation as a percentage of the total employee compensation. As shares are contributed to the plan they are allocated to employees and compensation expense is recorded at the shares' fair value.
Stock options No expense for stock options is recorded, as the grant price equals the market price of the stock at grant date. Pro-forma disclosures show the effect on income and earnings per share had the options' fair value been recorded using an option pricing model. The pro-forma effect is expected to increase in the future.
Dividend restriction Banking regulations require the maintenance of certain capital levels and may limit the amount of dividends which may be paid by the bank to the holding company or by the holding company to shareholders. In addition, the Bank cannot pay a dividend until it has net retained earnings. The retained earnings deficit of the Bank at December 31,1998 and 1997 was $624,615 and $490,509 respectively.
Earnings per share Basic earnings per share is based on weighted-average common shares outstanding. Diluted earnings per share further assumes issue of any dilutive potential common shares. The accounting standard for computing earnings per share was revised for 1997, and all earnings per share previously reported are restated to follow the new standard. Earnings per share and share amounts are restated for all subsequent stock dividends and splits.
Fair Values of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. 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.
Comprehensive Income (Loss): Under a new accounting standard, comprehensive income is now reported for all periods. Comprehensive income (loss) includes both net income and other comprehensive income. Other comprehensive income includes the change in unrealized gains and losses on securities available for sale.
Reclassifications Certain amounts for 1997 and 1996 have been reclassified to conform with the 1998 presentation.
Segment Reporting
The Corporation's segments are determined by the products and services offered, primarily distinguished between banking and mortgage banking operations. Loans, investments, and deposits provide the revenues in the banking operation, and servicing fees, underwriting fees and loan sales provide the revenues in mortgage banking. All operations are domestic.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
2. Sale of branches and associated loans
On December 5, 1994 the Bank sold three branches, certain deposits and associated loans to another bank. A portion of the sales price, $175,000, was allocated to deferred income attributable to the non-compete agreement. This deferred income is being amortized into income over the five year term of the agreement.
3. Securities available for sale
The following is a summary of the amortized cost and fair value of securities available for sale at December 31, 1998 and 1997:
Investment securities with an amortized cost of approximately $3,077,000 at December 31, 1998 and $1,068,000 at December 31, 1997 were pledged to secure certain borrowings.
The scheduled maturity date of the securities available for sale at December 31, 1998 is:
Since mortgage-backed securities have variable payments, they are not reported by specific maturity grouping.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
4. Secondary mortgage market operations
The Bank, and its subsidiaries Midwest Loan Services, Varsity Mortgage and Varsity Funding, originate, purchase, sell and service single family mortgage loans. The following summarizes the secondary market activities of the Bank, Midwest, Varsity Funding and Varsity Mortgage, for the years ended:
Certain assumptions were used to calculate the profit and loss from secondary market activities. Interest income was calculated using the average annual balance of loans held for sale at the Bank's average yield on mortgage loans. Interest expense was calculated using the average annual balance of loans held for sale, net of escrow balances, at the Bank's average cost of funds rate.
Operating expenses included certain direct costs, but a significant portion is based upon management's estimates using the best available information.
The bank and third parties will alternatively provide funding sources for the mortgage banking pipeline. Included within other liabilities at December 31, 1998 and 1997 are $5,065,281 and $3,300,000 of recently closed loans which the Bank is funding internally.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
4. Secondary mortgage market operations (continued) The aggregate market value of the loans held for sale exceeded the cost at December 31, 1998, 1997 and 1996, thus no reserve was required.
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. Such mortgage loans have been sold predominately without recourse or with limited recourse. The unpaid principal balances of these loans, including loans acquired from the acquisition of Midwest, were $95,000,000, $125,000,000, and $214,000,000 at December 31, 1998, 1997 and 1996, respectively.
Midwest also provides sub-servicing of loans for other financial institutions. At December 31, the principal balance of loans for which sub-servicing was provided was $116,179,291 in 1998 and $321,896,000 in 1997.
Custodial balances maintained in connection with the foregoing loan servicing were $1,670,138, $425,756, and $1,064,650 at December 31, 1998, 1997 and 1996, respectively.
Following is an analysis of the change in the asset balance of mortgage servicing rights:
There was no valuation allowance necessary at December 31, 1998, 1997 or 1996. Additions to mortgage servicing rights in 1998 consisted of purchased rights of $0 and originated rights of $48,484. Additions to mortgage servicing rights in 1997 consisted of purchased rights of $113,905 and originated rights capitalized of $161,775. Additions to mortgage servicing rights in 1996 consisted of purchased rights of $319,715 and originated rights capitalized of $296,721.
5. Loans Major classifications of loans are as follows as of December 31, 1998 and 1997:
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
5. Loans (continued) Changes in the allowance for loan losses were as follows:
Past due and non accrual loans are as follows:
6. Impaired Loans Information regarding impaired loans for the years ended December 31, is as follows:
7. Premises and equipment Premises and equipment classifications at December 31, 1998 and 1997 are summarized as follows:
Depreciation expense amounted to $269,698, $242,376, and $279,807 for the years ended December 31, 1998, 1997 and 1996, respectively.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
7. Premises and equipment (continued)
The Bank leases its ATM Drive-thru location in Ann Arbor for $24,000 per year. Varsity Funding and Varsity Mortgage lease space for their offices for $44,771 and $61,533 per year, respectively, and Midwest leases its space for a nominal amount from the city of Houghton. Total rental expense for the operating leases was $156,633 in 1998, $131,774 in 1997, and $74,831 in 1996. As of December 31, 1998, the Corporation had no minimum rental commitments under noncancelable operating leases. The Bank had an annual minimum rent as of December 31, 1998 of $24,000, with a total minimum amount of future rent payable over the next 7 years of $168,000. Varsity had an annual minimum rent as of December 31, 1998 of $106,304, with a total minimum amount of future rent payable over the next two years of $174,182.
The Bank remains contingently liable in the event that the purchaser of one of its branch locations in Sault Ste. Marie does not meet its future obligations to the lessor. As of December 31, 1998, management believes that the purchaser was in compliance with these lease terms. The annual base rent for such branch is currently $32,000, and the future minimum rent due is $154,000.
In May 1995, the Bank purchased a building in Ann Arbor, Michigan. The Bank leases 42% of the building to the University of Michigan. The lease calls for minimum payments of $68,000 (adjusted annually for inflation) plus the pro rata share of the building's expenses. The lease was renewed in 1998 for another three years.
8. Time deposits
Time deposit liabilities issued in denominations of $100,000 or more at December 31, 1998 and 1997, were $15,445,336 and $12,208,952, respectively.
At year-end 1998, stated maturities of time deposits were:
At December 31, 1998 and 1997, the Bank had issued through brokers $10,687,000 and $5,334,000 of time deposits with a maturity of 1-60 months which are included in the table above.
Related party deposits totaled $278,003 and $473,978 at year-end 1998 and 1997.
9. Stock options
Director Stock Options In 1993, the Board of Directors approved the grant of options to purchase 15,000 shares of common stock to each of the four non-executive directors, in lieu of compensation. The exercise price of options granted was set at $2.08 per share, which was the then current bid price per share as reported by NASDAQ. The options are immediately exercisable and expire July 19, 2003. No options were exercised in 1998. Options covering 15,000 shares were exercised during 1997. Options granted on 45,000 shares remain outstanding under this plan at December 31, 1998.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
1995 Stock Plan In 1995, the Corporation adopted a stock option and stock award plan (the 1995 Stock Plan), which provides for the grant of incentive stock options, as defined in Section 422(b) of the Internal Revenue Code of 1986, as amended, as well as the grant of non-qualified stock options and other stock awards. The plan provides for the grant to officers, directors and key employees of the Corporation, and independent contractors providing services to the Corporation, of options to purchase and other awards of common stock. The exercise price of options granted under the plan shall be as determined by the Board of Directors, or a compensation committee thereof. Options shall expire on the date specified by the Board of Directors or such committee, but not more than 10 years from the date of grant (or five years from the date of grant for incentive stock options if the grantee owned 10% of the Corporation's voting stock at the date of grant). Unless amended, the 1995 Stock Plan will terminate on November 15, 2005.
The following table summarizes the activity relating to options to purchase the Corporation's common stock:
Options outstanding have been restated for a 3 for 2 stock split in 1998. Options allowable for grant under the plan are not adjusted without shareholder approval. Due to forfeitures in 1998 prior to the split, the number of shares allowable for grant did not require adjustment, and the number of options has remained within allowable amounts.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
9. Stock options (continued) SFAS No. 123, which became effective for 1996, requires pro forma disclosures for companies that do not adopt its fair value accounting method for stock-based employee compensation. Accordingly, the following pro forma information presents net income and earnings per share had the Standard's fair value method been used to measure compensation cost for stock options granted in 1996. Compensation cost recognized for stock options under APB No. 25 was $0 for 1998 and 1997, because options were granted at exercise prices equal to the underlying stock prices at date of grant. At year-end 1998, 169,370 shares were authorized for future grants.
10. Employee stock ownership plan The employees allocation of ESOP assets is based on their current compensation, after 1 year of service and upon reaching the age of twenty one. The annual contribution to the ESOP is at the discretion of the Corporation. The assets of the ESOP are held in trust and were valued at approximately $144,000 and $205,000 as of December 31, 1998 and 1997, respectively. The assets of the plan are comprised entirely of shares of the Corporation, 67,800 and 63,074 shares at December 31, 1998 and 1997, respectively, all of which were fully allocated at December 31, 1998. Upon retirement from the plan, participants have distributed to them their allocated shares of the Corporation's stock. The Corporation made an additional contribution to the plan for the years ended December 31, 1998, 1997 and 1996 of 16,445, 9,906, and 4,050 shares of common stock with an approximate fair market value at the time of the contribution of $53,445, $36,322, and $15,056, respectively.
11. Commitments and contingencies The Bank and Varsity Mortgage are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to make loans and to sell loans, letters of credit and unused lines of credit. The Bank and Varsity Mortgage's exposure to credit loss in the event of non-performance is equal to or less than the contractual amount of these instruments. The Bank follows the same credit policy to make such commitments as is followed by those loans recorded in the consolidated financial statements.
The following is a summary of commitments as of December 31, 1998 and 1997:
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
12. Related party transactions The Company's Chairman and President also serve as officers and directors of BIDCO. As such, the Chairman and President are actively involved in BIDCO operations, including investment activity and estimation of the fair value of investments. In addition, in the ordinary course of business the BIDCO has invested in several limited liability companies (LLCs), and the Chairman and President have also personally purchased participations from the BIDCO and invested in certain of the same LLCs.
In connection with the Arbor Street investment of $1,000,000 in federal low income housing tax credits through a partnership, the Bank was not permitted by regulation to guarantee a $950,000 loan from the Michigan Housing Development Authority to Arbor Street. Such loan was instead personally guaranteed by the Chairman of the Company, and common stock of the Company held by a trust for the benefit of the President of the Company was pledged as additional security for the loan. In exchange, the Chairman and President of the Company were each granted a 1% membership interest in Arbor Street and the Bank's ownership reduced to 98%.
13. Income taxes The provision for federal income taxes is composed of the following amounts:
The net deferred tax asset at December 31, 1998 and 1997 is comprised of the following:
The Company has net operating loss carryforwards of approximately $620,000 which expire 2017; and general business credit carryforwards of approximately $320,000 which expire in 2017. In addition, the Company has an alternative minimum tax (AMT) credit carryforward of approximately $83,000. Under current tax regulations, the AMT credit can be carried forward indefinitely. Management has established an allowance for deferred tax assets that are not considered realizable at both December 31, 1997 and 1998.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
The difference between the financial statement tax expense and amounts computed by applying the statutory federal tax rate of 34% to pretax income is reconciled as follows:
14. Short and Long-Term Borrowings The Corporation has a note payable to North Country Bank & Trust (NCB&T) secured by the stock of the Bank with a balance of $826,000 and $922,688 at December 31, 1998 and 1997. The note has a maturity date of February 15, 2005. Interest is payable quarterly at the prime rate of NCB&T plus 1.00 percent. Required principal payments under the loan for the next five years are:
Dividends by the Bank to the holding company in excess of the prior year's annual net income are not permitted without prior permission from NCB&T under the terms of the Corporation's credit facility.
Arbor Street, LLC has an obligation of $647,097 at December 31, 1998 payable to the Michigan Housing Development Authority in connection with its investment in a low income housing limited partnership. Payments are due on demand, but are expected to be funded as follows:
15. Federal Home Loan Bank advances At December 31, 1998, the Bank has a line of credit from the Federal Home Loan Bank (the FHLB) in the amount of $6,500,000. There were no outstanding advances from the FHLB at December 31, 1998.
Advances are secured by the pledge of specific mortgage loans held for investment with unpaid principal balances of $4,880,656 and available-for-sale securities with a balance of $3,076,709.
16. Earnings per share Due to the net losses in 1998, 1997, and 1996, the stock options outstanding were considered anti-dilutive and are not included in earnings per share calculations. As a result, both basic and diluted earnings per share are equal to net loss divided by weighted average common shares outstanding.
In February of 1998, the Company declared a 3 for 2 share stock split in the form of a dividend. Calculated fractional shares were paid in whole share amounts. All weighted average share numbers have been adjusted for this stock split.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
17. Regulatory matters The Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and 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 about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.
The prompt corrective action regulations provide five classifications, including 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 minimum requirements are:
The Bank presently has an agreement with its regulators that no dividends will be declared without prior regulatory approval, and the tier 1 to average assets be at 7% or more.
At year end, actual capital levels of the bank (in millions) and minimum required levels were:
At year-end 1998, the Bank was categorized as well capitalized.
18. Fair Value of Financial Instruments
The following methods and assumptions were used to estimate fair values for financial instruments. The carrying amount is considered to estimate fair value for cash and short-term instruments, demand 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 loan or deposits with infrequent repricing or repricing limits, the fair value is estimated by the 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 are estimated using discounted cash flows based on current market interest rates net of estimated costs of servicing loans. The fair value of debt is based on currently available rates for similar financing. The fair value of off-balance sheet items is based on the fees or cost that would normally be charged to enter into or terminate such agreements.
Unrecognized financial instruments: The fair value of commitments to extend credit and the fair value of letters of credit are considered immaterial.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
18. Fair Value of Financial Instruments (continued)
The carrying amounts and fair values of the Company's financial instruments were as follows:
19. Segment Reporting
The Corporation's operations include two primary segments: banking and mortgage banking. Through its banking subsidiary's branch in Ann Arbor, the Corporation provides traditional community banking services such as accepting deposits, making loans, and providing cash management services to individuals and local businesses. Mortgage banking activities include the origination and purchase of residential mortgage loans for sale to various investors as well as providing servicing of mortgage loans for others.
UNIVERSITY BANCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1998
19. Segment Reporting (continued)
The Corporation's two reportable segments are strategic business units that are separately managed as they offer different products and services and have different marketing strategies. In addition, the mortgage banking segment services a different customer base than the banking segment.
The segment financial information provided below has been derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Corporation. The accounting policies of the two segments are the same as those described in the summary of significant accounting principles. The Corporation evaluates segment performance based on profit or loss before income taxes, not including nonrecurring gains and losses. Certain indirect expenses have been allocated based on actual volume measurements and other criteria, as appropriate. The Corporation accounts for intersegment revenue and transfers at current market prices.
Operating Segment Data Information about reportable segments follows.
Amounts presented in the "other" column reflect the Corporation's investment in Michigan BIDCO. Segment profit is measured before allocation of corporate overhead and income tax expense. Transactions between segments are reported at cost (fair value.) Refer to note 4 for mortgage banking segment information provided for prior periods.
20. University Bancorp (Parent Company Only) Condensed Financial Information
CONDENSED BALANCE SHEET
CONDENSED STATEMENTS OF INCOME
20. University Bancorp (Parent Company Only) Condensed Financial Information (continued)
UNIVERSITY BANCORP, INC. (The Parent)
Condensed Statement of Cash Flows
ITEM 8.
ITEM 8. - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements provided pursuant to this item are listed under Item 14(a) below and appear beginning on page 43.
ITEM 9.
ITEM 9. - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
None.
PART III.
ITEM 10.
ITEM 10. - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated by reference herein from the portions of the Company's Proxy Statement for its 1999 Annual Meeting (the "Proxy Statement") to be under the captions:
Election of Directors Executive Officers Section 16(a) Beneficial Ownership Reporting Compliance
ITEM 11.
ITEM 11. - EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference herein from the portions of the Company's Proxy Statement to be under the captions:
Executive Compensation Compensation Plans
ITEM 12.
ITEM 12. - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference herein from the portion of the Company's Proxy Statement to be under the caption:
Security Ownership of Certain Beneficial Owners and Management
ITEM 13.
ITEM 13. - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference herein from the portion of the Company's Proxy Statement to be under the caption:
Certain Relationships and Related Transactions
PART IV.
ITEM 14.
ITEM 14. - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORT ON FORM 8-K
(a) (1) Index of Financial Statements: The following financial statements are filed as part of this Report:
Audited consolidated balance sheets as of December 31, 1998 and December 31, 1997, and consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 1998, 1997 and 1996, of the Company.
(b) Reports on Form 8-K. None.
(c) Exhibits:
(3) Certificate of Incorporation and By-laws:
3.1 Composite Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (the "June 30, 1996 10-Q")).
3.1.1 Certificate of Amendment, dated June 10, 1998, of the Company's Certificate of Incorporation (incorporated by reference to Exhibit 3.1.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998 (the "June 30, 1998 10-Q"))
3.2 Composite By-laws of the Company (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989 (the "1989 10-K")).
(10) Material Contracts.
10.1 Loan Agreement and Promissory Note dated December 31, 1997 issued to North Country Bank & Trust (incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 10-K")).
10.2 University Bancorp, Inc. Employee Stock Ownership Plan (the "ESOP"), as amended November 27, 1990 (incorporated by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 10-K). *
10.2.1 Amendment to the ESOP, effective as of December 31, 1991 (incorporated by reference to Exhibit 10.2.A to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 10-K. *
10.3 University Bank 401(k) Profit Sharing Plan, adopted August 1, 1996, effective as of January 1, 1996 (incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 10-K")). *
10.4 Letter regarding grant of options to outside directors, dated as of July 20, 1993 (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993 (the "1993 10-K")). *
10.5 1995 Stock Plan of the Company (incorporated by reference to Exhibit A to the definitive Proxy Statement of the Company for 1996 Annual Meeting of Stockholders (the "1996 Proxy")). *
10.5.1 Form of Stock Option Agreement related to the 1995 Stock Plan (incorporated by reference to Exhibit 10.7.1 to the Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 10-K")). *
10.6 Letter, dated December 1, 1989, from Federal Reserve Bank of Minneapolis (incorporated by reference to Exhibit 10.9 to the 1989 10-K).
10.7 Lease Agreement (the "Cascade Lease Agreement") between RG Properties, Inc., as agent for Sault Associates, a Michigan Limited Partnership, and University Bank, dated September 30, 1992 (incorporated by reference to exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K").
10.7.1 First Amendment to the Cascade Lease Agreement, dated January 5, 1993 (incorporated by reference exhibit 10.9.1 to the 1992 10-K).
10.8 Federal Income Tax Allocation Agreement Between Newberry State Bank and Newberry Holding Inc. dated March 21, 1992 (incorporated by reference to Exhibit 10.11 to the 1991 10-K).
10.8.1 Federal Income Tax Allocation Agreement Between Newberry Holding Inc. and University Bancorp, Inc. dated May 21, 1991 (incorporated by reference to Exhibit 10.11.1 to the 1991 10-K).
10.9 Noncompetition Agreement Between First Northern Bank & Trust and University Bank dated December 3, 1994 (incorporated by reference to Exhibit 10.12.4 to the 1994 10-K).
10.9.1 Mortgage Origination Agreement Between First Northern Bank & Trust and University Bank dated December 3, 1994 (incorporated by reference to Exhibit 10.12.5 to the 1994 10-K).
10.9.2 Branch Services Agreement Between First Northern Bank & Trust and University Bank dated December 5, 1994 (incorporated by reference to Exhibit 10.12.6 to the 1994 10-K).
10.10 Employment Agreement, between Mark Ouimet and University Bank and Newberry Bancorp, Inc., as amended (incorporated by reference to Exhibit 10.13 to the 1995 10-K). *
10.10.1 Stock Option Agreement, dated as of December 15, 1995, between Mark Ouimet and Newberry Bancorp, Inc. (incorporated by reference to Exhibit 10.13.1 to the 1995 10-K). *
10.11 Revised Net Branch Agreement, dated October 1, 1997, regarding Varsity Funding Services, L.L.C., among University Bank, Jess Monticello and William Cook (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 10-K")). *
10.12 Revised Operating Agreement for Varsity Mortgage LLC and related Net Branch Agreement Modification, dated as of April 1, 1997, among University Bank and the LLC Managers (incorporated by reference to Exhibit 10.13 to the Company's Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1997 (the "June 30, 1997 10-Q"). *
10.13 Purchase and Sale Agreement, dated November 1, 1995, concerning Common Stock of Midwest Loan Services, Inc., among its shareholders and University Bank and Newberry Bancorp, Inc (incorporated by reference to Exhibit 10.16 of the 1995 10-K).
* Each of the exhibits noted by an "*" is a management compensatory plan or arrangement.
(21) Subsidiaries of Registrant: List of subsidiaries filed herewith.
(27) Financial Data Schedule (EDGAR version only)
SIGNATURES
Pursuant to the requirements of Sections 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.
UNIVERSITY BANCORP, INC.
By: /s/Stephen Lange Ranzini ----------------------------------- Stephen Lange Ranzini, President, Chief Executive Officer and Chief Accounting Officer
Date: March 30, 1999 --------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Index of Exhibits