Note 4.  Loans

 

Geographic distributions of loans were as follows:

 

 

 

(1) Loans held for sale are included in retail real estate.

 

 

 

(1) Loans held for sale are included in retail real estate.

 

Net deferred loan origination costs included in the tables above were $0.6 million as of December 31, 2014 and insignificant as of December 31, 2013.

 

The Company believes that making sound loans are a necessary and desirable means of employing funds available for investment. Recognizing the Company’s obligations to its stockholders, depositors, and to the communities it serves, authorized personnel are expected to seek to develop and make sound, profitable loans that resources permit and that opportunity affords. The Company maintains lending policies and procedures designed to focus lending efforts on the types, locations and duration of loans most appropriate for its business model and markets.  While not specifically limited, the Company attempts to focus its lending on short to intermediate-term (0-7 years) loans in geographies within 125 miles of its lending offices.  The Company attempts to utilize government-assisted lending programs, such as the Small Business Administration and United States Department of Agriculture lending programs, when prudent. Generally, loans are collateralized by assets, primarily real estate, of the borrowers and guaranteed by individuals.  The loans are expected to be repaid primarily from cash flows of the borrowers, or from proceeds from the sale of selected assets of the borrowers.

 

Management reviews and approves the Company’s lending policies and procedures on a routine basis.  Management routinely (at least quarterly) reviews the Company’s allowance for loan losses and reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. The Company’s underwriting standards are designed to encourage relationship banking rather than transactional banking.  Relationship banking implies a primary banking relationship with the borrower that includes, at a minimum, an active deposit banking relationship in addition to the lending relationship.  The integrity and character of the borrower are significant factors in the Company’s loan underwriting.  As a part of underwriting, tangible positive or negative evidence of the borrower’s integrity and character are sought out.  Additional significant underwriting factors beyond location, duration, a sound and profitable cash flow basis and the borrower’s character are the quality of the borrower’s financial history, the liquidity of the underlying collateral and the reliability of the valuation of the underlying collateral.

 

Total borrowing relationships, including direct and indirect debt, are generally limited to $20 million, which is significantly less than the Company’s regulatory lending limit.  Borrowing relationships exceeding $20 million are reviewed by the Company’s board of directors at least annually and more frequently by management.  At no time is a borrower’s total borrowing relationship permitted to exceed the Company’s regulatory lending limit.  Loans to related parties, including executive officers and the Company’s various directorates, are reviewed for compliance with regulatory guidelines by the Company’s board of directors at least annually.

 

The Company maintains an independent loan review department that reviews the loans for compliance with the Company’s loan policy on a periodic basis.  In addition to compliance with this policy, the loan review process reviews the risk assessments made by the Company’s credit department, lenders and loan committees. Results of these reviews are presented to management and the audit committee at least quarterly.

 

The Company’s lending can be summarized into five primary areas: commercial loans, commercial real estate loans, real estate construction loans, retail real estate loans, and retail other loans. The significant majority of the lending activity occurs in the Company’s Illinois and Indiana markets, with the remainder in the Florida market.  Due to the small scale of the Indiana loan portfolio and its geographical proximity to the Illinois portfolio, the Company believes that quantitative or qualitative segregation between Illinois and Indiana is not material or warranted.

 

Commercial Loans

 

Commercial loans typically comprise working capital loans or business expansion loans, including loans for asset purchases and other business loans.  Commercial loans will generally be guaranteed in full or a significant amount by the primary owners of the business. Commercial loans are made based primarily on the historical and projected cash flow of the underlying borrower and secondarily on the underlying assets pledged as collateral by the borrower.  The cash flows of the underlying borrower, however, may not perform consistently with historical or projected information.  Further, the collateral securing loans may fluctuate in value due to individual economic or other factors.  The Company has established minimum standards and underwriting guidelines for all commercial loan types.

 

Commercial Real Estate Loans

 

The Company is primarily located in markets with significant academic presence.  The academic presence in addition to the commercial environment provides for the majority of the Company’s commercial lending opportunities to be commercial real estate related, including multi-unit housing.  As the majority of the Company’s loan portfolio is within the commercial real estate class, the Company’s goal is to maintain a high quality, geographically diverse portfolio of commercial real estate loans. Commercial real estate loans are subject to underwriting standards and guidelines similar to commercial loans.  Commercial real estate loans will generally be guaranteed in full or a significant amount by the primary owners of the business. The repayment of these loans is primarily dependent on the cash flows of the underlying property. However, the commercial real estate loan generally must be supported by an adequate underlying collateral value.  The performance and the value of the underlying property may be adversely affected by economic factors or geographical and/or industry specific factors.  These loans are subject to other industry guidelines that are closely monitored by the Company.

 

Real Estate Construction Loans

 

Real estate construction loans are typically commercial in nature. The loan proceeds are controlled by the Company and distributed for the improvement of real estate in which the Company holds a mortgage.  Real estate construction loans will generally be guaranteed in full or a significant amount by the developer or primary owners of the business. These loans are subject to underwriting standards and guidelines similar to commercial loans. The loan generally must be supported by an adequate “as completed” value of the underlying project. In addition to the underlying project, the financial history of the developer and business owners weighs significantly in determining approval. The repayment of these loans is typically through permanent financing following completion of the construction.  Real estate construction loans are inherently more risky than loans on completed properties as the unimproved nature and the financial risks of construction significantly enhance the risks of commercial real estate loans.  These loans are closely monitored and subject to other industry guidelines.

 

Retail Real Estate Loans

 

Retail real estate loans are comprised of direct consumer loans that include residential real estate, residential real estate construction loans, home equity lines of credit and home equity loans.  The Company sells substantially all of its fixed rate long-term (over 15 years) retail real estate loans to secondary market purchasers.  The Company does retain fixed rate retail real estate loans having terms typically 15 years or less.  As retail real estate loan underwriting is subject to specific regulations, the Company typically underwrites its retail real estate loans to conform to widely accepted standards.  Several factors are considered in underwriting including the value of the underlying real estate and the debt to income and credit history of the borrower.

 

Retail Other Loans

 

Retail other loans consist of installment loans to individuals, including automotive loans.  These loans are centrally underwritten utilizing the borrower’s financial history, including the Fair Isaac Corporation (FICO) credit scoring and information as to the underlying collateral. Repayment is expected from the cash flow of the borrower.

 

The Company utilizes a loan grading scale to assign a risk grade to all of its loans.  Loans are graded on a scale of 1 through 10 with grades 2, 4 & 5 unused.  A description of the general characteristics of the grades is as follows:

 

 

 

 

 

 

All loans are graded at the inception of the loan.  All commercial loans that are $1.0 million or less are processed through an expedited underwriting process.  If the credit receives a pass grade it is aggregated into a homogenous pool of either:  $0.35 million or less or $0.35 million to $1.0 million.  These pools are monitored on a quarterly basis for the first year, semiannually in the second year and annually thereafter.  Homogenous pool credits which are subsequently downgraded to a grading of 7 or worse are subject to the same portfolio review as loans over $1.0 million.  All commercial loans greater than $1.0 million receive a portfolio review at least annually.  Commercial loans greater than $1.0 million that have a grading of 7 receive a portfolio review twice per year.  Commercial loans greater than $1.0 million that have a grading of 8 or worse receive a portfolio review on a quarterly basis.  Interim grade reviews may take place if circumstances of the borrower warrant a more timely review.

 

Loans in the highest grades, represented by grades 1, 3, 6 and 7, totaled $2.28 billion at December 31, 2014 and grew by $160.9 million from $2.12 billion at December 31, 2013.  Loans in the lowest grades, represented by grades 8, 9 and 10, totaled $124.0 million at December 31, 2014 and declined by $37.9 million from $161.9 million at December 31, 2013.  The positive change in mix of loan grades began in 2012 and suggests a declining level of overall risk in the total loan portfolio.

 

The following table presents weighted average risk grades segregated by category of loans (excluding held for sale, non-posted and clearings) and geography:

 

 

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.  Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions.  Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due.  When interest accrual is discontinued, all unpaid accrued interest is reversed.  Interest income is subsequently recognized only to the extent cash payments are received in excess of the principal due.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

An age analysis of past due loans still accruing and non-accrual loans is as follows:

 

 

 

A loan is impaired when, based on current information and events, it is probable the Company will be unable to collect scheduled principal and interest payments when due according to the terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.  The following loans are assessed for impairment by the Company: loans 60 days or more past due and over $0.25 million, loans graded 8 over $0.5 million and loans graded 9 or 10.

 

Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.  Large groups of smaller balance homogenous loans are collectively evaluated for impairment.  Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures unless such loans are the subject of a restructuring agreement.

 

The Company actively seeks to reduce its investment in impaired loans.  The primary tools to work through impaired loans are settlement with the borrowers or guarantors, foreclosure of the underlying collateral, loan sales to outside parties or restructuring.  During the years ended December 31, 2014 and 2013, the Company sold problem loans from its portfolio, net of charge-offs, of $3.8 million and $7.6 million, respectively.

 

The gross interest income that would have been recorded in the years ended December 31, 2014, 2013 and 2012 if impaired loans had been current in accordance with their original terms was $0.8 million, $1.3 million, and $3.4 million, respectively.  The amount of interest collected on those loans and recognized on a cash basis that was included in interest income was insignificant in 2014, 2013 and 2012.

 

The Company’s loan portfolio includes certain loans that have been modified in a troubled debt restructuring (“TDR”), where concessions have been granted to borrowers who have experienced financial difficulties. The Company will restructure loans for its customers who appear to be able to meet the terms of their loan over the long term, but who may be unable to meet the terms of the loan in the near term due to individual circumstances.

 

The Company considers the customer’s past performance, previous and current credit history, the individual circumstances surrounding the current difficulties and the customer’s plan to meet the terms of the loan in the future prior to restructuring the terms of the loan.  Generally, all five primary areas of lending are restructured through short-term interest rate relief, short-term principal payment relief, short-term principal and interest payment relief, or forbearance (debt forgiveness).  Once a restructured loan has gone 90+ days past due or is placed on non-accrual status, it is included in the non-performing loan totals. A summary of restructured loans as of December 31, 2014 and 2013 is as follows:

 

 

All TDRs are considered to be impaired for purposes of assessing the adequacy of the allowance for loan losses and for financial reporting purposes.  When the Company modifies a loan in a TDR, it evaluates any possible impairment similar to other impaired loans based on present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.  If the Company determines that the value of the TDR is less than the recorded investment in the loan, impairment is recognized through an allowance estimate in the period of the modification and in periods subsequent to the modification.

 

Performing loans classified as TDRs during the three and twelve months ended December 31, 2014 included one commercial real estate modification in Florida for short-term principal payment relief, with a recorded investment of $2.0 million.  Other performing loans classified as TDRs during the twelve months ended December 31, 2014 were insignificant.

 

Performing loans classified as TDRs during the three and twelve months ended December 31, 2013 included one commercial modification in Illinois/Indiana for short-term principal payment relief, with a recorded investment of $0.1 million.  Further, one commercial real estate modification in Illinois/Indiana for the three and twelve months ended December 31, 2013 consisted of a modification for short-term principal payment relief, with a recorded investment of $0.2 million. Commercial real estate modifications for the twelve months ended December 31, 2013 also consisted of one modification in Illinois/Indiana for short-term principal payment relief, with a recorded investment of $0.2 million and one modification in Florida for short-term interest rate relief, with a recorded investment of $0.1 million.  Other performing loans classified as TDRs during the three and twelve months ended December 31, 2013 were insignificant.

 

The gross interest income that would have been recorded in the three and twelve months ended December 31, 2014 and 2013 if performing TDRs had been in accordance with their original terms instead of modified terms was insignificant.

 

TDRs that were classified as non-performing and had payment defaults (a default occurs when a loan is 90 days or more past due or transferred to non-accrual) during the three and twelve months ended December 31, 2014 consisted of one Illinois/Indiana commercial modification totaling $0.3 million.

 

There were no TDRs that were classified as non-performing and had payment defaults during the three months ended December 31, 2013.  TDRs that were classified as non-performing and had payment defaults during the twelve months ended December 31, 2013 consisted of one Illinois/Indiana commercial real estate modification totaling $1.7 million, one Illinois/Indiana real estate construction modification totaling $0.2 million and one Illinois/Indiana retail real estate modification totaling $0.5 million.

 

The following tables provide details of impaired loans, segregated by category and geography. The unpaid contractual principal balance represents the recorded balance prior to any partial charge-offs.  The recorded investment represents customer balances net of any partial charge-offs recognized on the loan.  The average recorded investment is calculated using the most recent four quarters.

 

 

 

Management’s opinion as to the ultimate collectability of loans is subject to estimates regarding future cash flows from operations and the value of property, real and personal, pledged as collateral.  These estimates are affected by changing economic conditions and the economic prospects of borrowers.

 

Allowance for Loan Losses

 

The allowance for loan losses represents an estimate of the amount of losses believed inherent in the Company’s loan portfolio at the balance sheet date.  The allowance for loan losses is evaluated geographically, by class of loans.  The allowance calculation involves a high degree of estimation that management attempts to mitigate through the use of objective historical data where available. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of the loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.  Overall, the Company believes the allowance methodology is consistent with prior periods and the balance was adequate to cover the estimated losses in the Company’s loan portfolio at December 31, 2014 and 2013.

 

The general portion of the Company’s allowance contains two components: (i) a component for historical loss ratios, and (ii) a component for adversely graded loans.  The historical loss ratio component is an annualized loss rate calculated using a sum-of-years digits weighted 20-quarter historical average.

 

The Company’s component for adversely graded loans attempts to quantify the additional risk of loss inherent in the grade 8 and grade 9 portfolios.  The grade 9 portfolio has an additional allocation placed on those loans determined by a one-year charge-off percentage for the respective loan type/geography.  The minimum additional reserve on a grade 9 loan was 3.00% as of December 31, 2014 and 2013, which is an estimate of the additional loss inherent in these loan grades based upon a review of overall historical charge-offs.  As of December 31, 2014, the Company believed this minimum reserve remained adequate.

 

Grade 8 loans have an additional allocation placed on them determined by the trend difference of the respective loan type/geography’s rolling 12- and 20-quarter historical loss trends. If the rolling 12-quarter average is higher (more current information) than the rolling 20-quarter average, the Company adds the additional amount to the allocation.  The minimum additional amount for grade 8 loans was 1.00% as of December 31, 2014 and 2013, based upon a review of the differences between the rolling 12 and 20 quarter historical loss averages by region.  As of December 31, 2014, the Company believed this minimum additional amount remained adequate.

 

The specific portion of the Company’s allowance relates to loans that are impaired, which includes non-performing loans, TDRs and other loans determined to be impaired.  The impaired loans are subtracted from the general loans and are allocated specific reserves as discussed above.

 

Impaired loans are reported at the fair value of the underlying collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Collateral values are estimated using a combination of observable inputs, including recent appraisals discounted for collateral specific changes and current market conditions, and unobservable inputs based on customized discounting criteria.

 

The general quantitative allocation based upon historical charge off rates is adjusted for qualitative factors based on current general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things:  (i) Management & Staff; (ii) Loan Underwriting, Policy and Procedures; (iii) Internal/External Audit & Loan Review; (iv) Valuation of Underlying Collateral; (v) Macro and Local Economic Factor; (vi) Impact of Competition, Legal & Regulatory Issues; (vii) Nature and Volume of Loan Portfolio; (viii) Concentrations of Credit; (ix) Net Charge-Off Trend; and (x) Non-Accrual, Past Due and Classified Trend.  Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis.  Based on each component’s risk factor, a qualitative adjustment to the reserve may be applied to the appropriate loan categories.

 

During the fourth quarter of 2014, the Company adjusted the Illinois/Indiana and Florida qualitative factors relating to Macro and Local Economic Factor and a Florida qualitative factor relating to Net Charge-Off Trend.  The adjustment of these factors increased our allowance requirements by $1.3 million at December 31, 2014 compared to the method used for September 30, 2014.  Earlier in 2014, the Company adjusted Illinois/Indiana qualitative factors relating to Loan Underwriting, Policy and Procedures, Macro and Local Economic Factor, Nature and Volume of Loan Portfolio, and Net Charge-Off Trend compared to the method used for December 31, 2013.  Additionally, the Company adjusted Florida qualitative factors relating to Loan Underwriting, Policy and Procedures, Macro and Local Economic Factor, and Net Charge-Off Trend compared to the method used for December 31, 2013.  Adjustments to increase these qualitative factors were made throughout 2014 to recognize perceived changing degrees of risk, offset decreasing quantitative factors and reflect management’s evaluation of risk.  The Company will continue to monitor its qualitative factors on a quarterly basis.

 

Changes in the allowance for loan losses were as follows:

 

 

The following table details activity on the allowance for loan losses.  Allocation of a portion of the allowance to one category does not preclude its availability to absorb losses in other categories.

 

 

 

 

The following table presents the allowance for loan losses and recorded investments in loans by category and geography: