Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
MBT Financial Corp. (the “Company”) is a bank holding company with one commercial bank subsidiary, Monroe Bank & Trust (the “Bank”). The Bank operates 14 branch offices in Monroe County, Michigan and 6 branch offices in Wayne County, Michigan, and 1 loan and wealth management office in Wayne County, Michigan.
The Bank’s primary source of income is Net Interest Income (interest income on loans and investments less interest expense on deposits and borrowings), and its primary expense is the compensation of its employees. The discussion and analysis should be read in conjunction with the accompanying consolidated statements and footnotes.
On October 9, 2018, the Company and First Merchants Corporation (“First Merchants”) signed an Agreement and Plan of Reorganization and Merger (the “Merger Agreement”), pursuant to which the Company will merge with and into First Merchants. Subject to the terms and conditions of the Merger Agreement, each share of the Company will be converted into 0.275 shares of First Merchants common stock. Consummation of the merger is expected to occur in the second quarter of 2019.
Executive Overview
The Bank is operated as a community bank, primarily providing loan, deposit, and wealth management products and services to the people, businesses, and communities in its market area. In addition to our commitment to our mission of serving the needs of our local communities, we are focused on improving asset quality, increasing net interest income, and improving non-interest income and expenses.
The net loss of $5,141,000 for the first quarter of 2019 was caused by losses totaling $11,646,000 on the sale of investment securities as the Company liquidated a substantial portion of its investment portfolio in anticipation of its merger with First Merchants. Excluding the securities losses, net profit would have been $4,059,000, an increase of $157,000 or 4.0% compared to the first quarter of 2018. The Net Interest Income increased $1,082,000, or 10.3% due to an improvement in the Net Interest Margin from 3.49% in the first quarter of 2018 to 3.83% in the first quarter of 2019. The effect of the improved margin was mitigated by an increase of $518,000 in non-interest expenses.
The national economic condition is good, and the economy in southeast Michigan is continuing to recover. State and local unemployment rates are holding steady near their lowest post-recession levels, and are now comparable to the national average. Commercial and residential development property values continue to improve, with most values reaching or exceeding their pre-recession levels. Our total classified assets, which include internal watch list loans, other real estate owned, and nonperforming and watch list investment securities, had been improving steadily since 2014, and stabilized recently. Net charge offs were $268,000, or 0.14% of loans, annualized, in the first quarter of 2019, compared to net recoveries of $319,000, or 0.18% of loans in the first quarter of 2018. Due to improving loan quality metrics, we were able to reduce our Allowance for Loan and Lease Losses (ALLL) as a percent of loans from 1.01% at December 31, 2018 to 0.98% as of March 31, 2019. The ALLL decreased $268,000 during the first quarter of 2019 due to the net charge offs of $268,000, as we did not record a provision during the quarter. We assess the adequacy of our ALLL each quarter, and adjust it as necessary by debiting or crediting the provision expense. The allowance includes $466,000 of specific allocations on $9.8 million of loans evaluated for impairment and $7.0 million of general allocations on the remainder of the portfolio. The general allocation is based on the historical charge off experience of the previous 20 quarters. The improvement in the historical loss rates is slowing and loan growth is continuing, so future provisions may be necessary.
The $1,082,000 increase in Net Interest Income in the first quarter of 2019 compared to the first quarter of 2018 was due to the increase in the net interest margin from 3.49% to 3.83%, and the increase of $5.0 million in the amount of average earning assets. The net interest margin increased because the yield on earnings assets increased 41 basis points while the cost of interest bearing liabilities only increased 9 basis points. Non-interest income for the quarter (excluding securities losses) decreased $126,000 and non-interest expenses increased $518,000.
Critical Accounting Policies
The Company’s Allowance for Loan Losses and Fair Value of Investment Securities are “critical accounting estimates” because they are estimates that are based on assumptions that are highly uncertain, and if different assumptions were used or if any of the assumptions used were to change, there could be a material impact on the presentation of the Company’s financial condition. These assumptions include, but are not limited to, collateral values, the effect of economic conditions on the financial condition of the borrowers, the Company, and the issuers of investment securities, market interest rates, and projected earnings for the Company.
To determine the Allowance for Loan Losses, the Company estimates losses on all loans that are not classified as non-accrual or renegotiated by applying historical loss rates, adjusted for current conditions, to those loans. In addition, all non-accrual loan relationships over $250,000 that are classified by Management as nonperforming as well as selected performing accounts and all renegotiated loans are individually tested for impairment. Any amount of monetary impairment is included in the Allowance for Loan Losses.
To determine the fair value of investment securities, the Company utilizes quoted prices in active markets for identical assets, quoted prices for similar assets in active markets, or discounted cash flow calculations for investments where there is little, if any, market activity for the asset.
Financial Condition
The regional economic conditions remained strong this quarter, with steady local unemployment rates and increasing property values. Management efforts remain focused on improving asset quality, increasing net interest income, and improving non-interest income and expenses.
With respect to asset quality, our nonperforming assets (“NPAs”) decreased 0.7% during the quarter, from $10.75 million to $10.67 million. Loan delinquencies increased from $6.9 million 30 days or more past due as of December 31, 2018 to $7.3 million as of March 31, 2019 and the delinquency percentage increased from 0.89% to 0.94% of the total loans. Over the last twelve months, NPAs decreased $2.3 million, or 17.7%, with nonperforming loans decreasing 9.6% from $11.7 million to $10.6 million, and Other Real Estate Owned (“OREO”) decreasing from $1.2 million to $58,000. The amount required in the Allowance for Loan and Lease Losses (“ALLL”) was decreased from $7.9 million a year ago to $7.5 million because the decreases required by the improvement in the quality of the assets and the historical loss rates exceeded the amount required by the increase in the size of the loan portfolio. The ALLL is now 0.98% of loans, down from 1.09% at March 31, 2018. The ALLL is 70.70% of nonperforming loans (“NPLs”), compared to 67.15% at March 31, 2018. In light of current economic conditions, we believe that this level of ALLL adequately estimates the potential losses in the loan portfolio.
Since December 31, 2018, total loans held for investment decreased $1.8 million as new loan activity was exceeded by payments received and other reductions in the period. Our pipeline of loans in process remained steady and our unfunded loan commitments increased, so we expect loans outstanding to increase in 2019.
Since December 31, 2018, deposits were unchanged at $1.183 billion, and borrowed funds were unchanged at $10.0 million, while other liabilities decreased $6.3 million and capital increased $2.6 million. As a result, our total assets decreased $3.4 million, or 0.3%. We will continue to price our deposit products competitively, but we have adequate liquidity on our balance sheet to fund our continued loan growth due to the investment sales. Capital increased and assets decreased, causing the capital to assets ratio to increase from 9.55% at December 31, 2018 to 9.77% at March 31, 2019.
Results of Operations –
First
Quarter 201
9
vs.
First
Quarter 201
8
Net Interest Income - A comparison of the income statements for the three months ended March 31, 2019 and 2018 shows an increase of $1,082,000, or 10.3%, in Net Interest Income. Interest income on loans increased $1,354,000, or 16.5% as the average loans outstanding increased $63.8 million and the average yield on loans increased from 4.72% to 5.04%. The average loans outstanding increased due to the purchases of consumer loans and syndicated commercial loans, and organic growth in our local markets. The interest income on investments, fed funds sold, and interest bearing balances due from banks decreased $60,000 even though the yield increased from 2.14% to 2.36% as the average amount of investments, fed funds sold, and interest bearing balances due from banks decreased $58.8 million. The Company continues to maintain a high level of liquidity, but some of that liquidity is being used by redeploying earning assets from low yielding short term investments and deposits in the Federal Reserve Bank into higher yielding loans. The interest expense on deposits increased $154,000, or 37.2% even though the average deposits decreased $4.0 million as the average cost of deposits increased from 0.14% to 0.19%. Due to the growth in loans and the decrease in deposit funding, average borrowed funds increased $8.5 million, and the cost of borrowed funds increased $58,000 compared to the first quarter of 2018. Average total interest bearing liabilities increased $7.9 million, and the cost of interest bearing liabilities increased from 0.19% in the first quarter of 2018 to 0.28% in the first quarter of 2019. As a result, interest expense increased $212,000, or 50.5%.
Provision for Loan Losses - The Company did not record a Provision for Loan Losses expense in the first quarter of 2019, which was an increase of $100,000 compared to the negative provision expense of $100,000 in the first quarter of 2018. We charged off $411,000 of principal while recovering $143,000 of previously charged off loans in the first quarter of 2019, for a net charge off total of $268,000, or 0.14% of average loans, annualized. Each quarter, the Company conducts a review and analysis of its ALLL to determine its adequacy. This analysis involves specific allocations for impaired credits and a general allocation for losses expected based on historical experience adjusted for current conditions. In the first quarter of 2019, the portfolio risk indicators improved and the amount of loans outstanding decreased slightly, resulting in the need for a decrease in the amount of ALLL required. The net charge offs of $268,000 enabled us to achieve the required ALLL without recording a negative provision expense. The allowance includes $466,000 of specific allocations and $7.0 million of general allocations. The general allocation is based on the historical charge off experience of the previous 20 quarters. The historical charge off rate is not expected to continue to improve significantly, and if loan growth continues as expected, provision expenses may be required in the future.
Other Income – Non interest income decreased $11,671,000, or 308.4% compared to the first quarter of 2018. Excluding securities losses in both periods, non-interest income decreased $126,000, or 3.2%. Wealth Management income, Service Charges on Deposit Accounts, Debit Card income, and Bank Owned Life Insurance income all decreased. Origination fees on mortgage loans sold and Other non-interest income increased slightly.
Other Expenses – Total non-interest expenses increased $518,000, or 5.3% compared to the first quarter of 2018. Salaries and Employee Benefits increased $102,000, or 1.7% mainly because workers’ compensation insurance increased due to a refund received in the first quarter of 2018. Professional fees increased $249,000, or 41.9% due to higher legal and accounting fees. Other insurance increased $297,000 primarily due to costs related to settling post retirement death benefits with former directors and officers.
As a result of the above activity, the Loss Before Income Taxes in the first quarter of 2019 was $6,579,000, a decrease of $11,207,000 compared to the pre-tax profit of $4,628,000 in the first quarter of 2018. The Company recorded a federal income tax benefit of $1,438,000 in the first quarter of 2019, reflecting an effective tax rate of 21.9%, compared to the tax expense of $726,000 in the first quarter of 2018, which reflected an effective rate of 15.7%. The Net Loss for the first quarter of 2019 was $5,141,000, a decrease of 231.8% compared to the net profit of $3,902,000 in the first quarter of 2018.
Cash Flows
Cash flows provided by operating activities decreased $7,444,000 compared to the first three months of 2018 mainly due to the large loss on the sale of investment securities in 2019. The cash flow from investing activities increased $409,049 compared to 2018 due to the sale of a substantial portion of the investment portfolio in the in the first three months of 2019. The securities were sold as the first part of a portfolio restructuring that is being completed in conjunction with our merger with First Merchants Bank, and the proceeds were still being held in cash as of the end of the first quarter of 2019. The amount of cash used for financing activities was $17.9 million lower in the first three months of 2019 than it was in the first three months of 2018 due to the large decrease in deposits and the special dividend paid in the first three months of 2018. In the first three months of 2019, the cash provided by investing activities greatly exceeded the cash used for operating and financing activities, and the amount of cash and cash equivalents increased by $381.0 million during the period. In the first three months of 2018, the cash used for investing and financing activities exceeded the cash provided by operating activities, resulting in a decrease of $38.5 million in cash and cash equivalents during the first three months of 2018. As we redeploy the proceeds from the investment securities sales in 2019 we expect cash flows from investing activities to exceed the cash provided by operating activities, resulting in a decrease from our current level of cash and cash equivalents.
Liquidity and Capital
The Company believes it has sufficient liquidity to fund its lending activity and allow for fluctuations in deposit levels. The high level of cash and cash equivalents ensures that the Company can meet its liquidity without utilizing any of its external sources of liquidity. External sources of liquidity include a Federal funds line that has been established with our correspondent bank and Repurchase Agreements with money center banks that allow us to pledge securities as collateral for borrowings. As of March 31, 2019, the Bank was utilizing $10 million of its authorized limit of $275 million with the Federal Home Loan Bank of Indianapolis, and none of its $25 million federal funds line with a correspondent bank. The Company periodically draws on its fed funds lines to ensure that funding will be available if needed.
The Company’s Funds Management Policy includes guidelines for desired amounts of liquidity and capital. The Funds Management Policy also includes contingency plans for liquidity and capital that specify actions to take if liquidity and capital ratios fall below the levels contained in the policy. Throughout the first three months of 2019 the Company was in compliance with its Funds Management Policy regarding liquidity and capital.
Total stockholders’ equity of the Company was $130.3 million at March 31, 2019 and $127.7 million at December 31, 2018. Retained earnings decreased $7.4 million due to the year to date loss of $5.1 million and the dividends paid of $2.3 million. The Accumulated Other Comprehensive Income (Loss) (“AOCI” or “AOCL”) increased because the unrealized losses on Available for Sale securities made up the largest portion of the AOCL as of December 31, 2018, and most of those losses were realized when the investment portfolio was sold. Total equity increased $2.6 million while total assets decreased $3.4 million, so the ratio of equity to assets increased from 9.55% at December 31, 2018 to 9.77% at March 31, 2019.
Federal bank regulatory agencies have set capital adequacy standards for Total Risk Based Capital, Tier 1 Risk Based Capital, and Leverage Capital. These standards require banks to maintain a Total Risk Based Capital ratio of at least 8%, a Tier 1 Risk Based Capital ratio of at least 6%, and a Tier 1 Leverage Ratio of at least 4% to be adequately capitalized. The regulatory agencies consider a bank to be well capitalized if its Total Risk Based Capital is at least 10% of Risk Weighted Assets, Tier 1 Risk Based Capital is at least 8% of Risk Weighted Assets, and the Tier 1 Leverage Capital ratio is at least 5%. Basel III implemented the new Common Equity Tier 1 Capital to Risk Weighted Assets ratio, with a minimum of 4.5% to be considered adequately capitalized and a minimum of 6.5% required to be considered well capitalized.
The following table summarizes the capital ratios of the Company and the Bank:
|
|
Actual
|
|
|
Minimum to Qualify as
Well Capitalized
|
|
|
|
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
As of March 31, 2019:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
$
|
137,880
|
|
|
|
15.80
|
%
|
|
$
|
87,258
|
|
|
|
10.0
|
%
|
Monroe Bank & Trust
|
|
|
136,149
|
|
|
|
15.63
|
%
|
|
|
87,120
|
|
|
|
10.0
|
%
|
Tier 1 Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
130,042
|
|
|
|
14.90
|
%
|
|
|
69,806
|
|
|
|
8.0
|
%
|
Monroe Bank & Trust
|
|
|
128,311
|
|
|
|
14.73
|
%
|
|
|
69,696
|
|
|
|
8.0
|
%
|
Common Equity Tier 1 Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
130,042
|
|
|
|
14.90
|
%
|
|
|
56,718
|
|
|
|
6.5
|
%
|
Monroe Bank & Trust
|
|
|
128,311
|
|
|
|
14.73
|
%
|
|
|
56,628
|
|
|
|
6.5
|
%
|
Tier 1 Capital to Average Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
130,042
|
|
|
|
9.66
|
%
|
|
|
67,292
|
|
|
|
5.0
|
%
|
Monroe Bank & Trust
|
|
|
128,311
|
|
|
|
9.55
|
%
|
|
|
67,211
|
|
|
|
5.0
|
%
|
|
|
Actual
|
|
|
Minimum to Qualify as
Well Capitalized
|
|
|
|
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
As of December 31, 2018:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
$
|
145,480
|
|
|
|
15.79
|
%
|
|
$
|
92,111
|
|
|
|
10.0
|
%
|
Monroe Bank & Trust
|
|
|
143,583
|
|
|
|
15.61
|
%
|
|
|
91,976
|
|
|
|
10.0
|
%
|
Tier 1 Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
137,374
|
|
|
|
14.91
|
%
|
|
|
73,689
|
|
|
|
8.0
|
%
|
Monroe Bank & Trust
|
|
|
135,477
|
|
|
|
14.73
|
%
|
|
|
73,580
|
|
|
|
8.0
|
%
|
Common Equity Tier 1 Capital to Risk-Weighted Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
137,374
|
|
|
|
14.91
|
%
|
|
|
59,872
|
|
|
|
6.5
|
%
|
Monroe Bank & Trust
|
|
|
135,477
|
|
|
|
14.73
|
%
|
|
|
59,784
|
|
|
|
6.5
|
%
|
Tier 1 Capital to Average Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
|
|
|
137,374
|
|
|
|
10.28
|
%
|
|
|
66,824
|
|
|
|
5.0
|
%
|
Monroe Bank & Trust
|
|
|
135,477
|
|
|
|
10.15
|
%
|
|
|
66,741
|
|
|
|
5.0
|
%
|
Market risk for the Bank, as is typical for most banks, consists mainly of interest rate risk and market price risk. The Bank’s earnings and the economic value of its equity are exposed to interest rate risk and market price risk, and monitoring this risk is the responsibility of the Asset/Liability Management Committee (ALCO) of the Bank. The Bank’s market risk is monitored quarterly by estimating the effect of changes in interest rates on its projected net interest income and the economic value of its equity. The sale of a large portion of its investment portfolio in the first quarter of 2019 significantly changed the Bank’s interest rate risk position.
Forward-Looking Statements
Certain statements contained herein are not based on historical facts and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements which are based on various assumptions (some of which are beyond the Company's control), may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "estimate," "anticipate," "continue," or similar terms or variations on those terms, or the negative of these terms. Actual results could differ materially from those set forth in forward-looking statements, due to a variety of factors, including, but not limited to, those related to the economic environment, particularly in the market areas in which the Company operates, competitive products and pricing, fiscal and monetary policies of the U.S. Government, changes in government regulations affecting financial institutions, including regulatory fees and capital requirements, changes in prevailing interest rates, acquisitions and the integration of acquired businesses, credit risk management, asset/liability management, changes in the financial and securities markets, including changes with respect to the market value of our financial assets, the availability of and costs associated with sources of liquidity, and the ability of the Company to resolve or dispose of problem loans.
The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.