Taylor Capital Group Inc. CEO CAPITAL LLC SECOND CURVE bought 75000 shares on 1-14-2010 at $9.87
BUSINESS OVERVIEW
Our Business
We are a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago, and we derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank. Cole Taylor Bank was founded in 1929 by forefathers of the Taylor family and has served the Chicago metropolitan area for almost 80 years. Taylor Capital Group, Inc. was formed in 1996 and acquired Cole Taylor Bank in 1997. We provide a range of products and services primarily to closely-held commercial customers and their owner operators in the Chicago metropolitan area. At December 31, 2008, we had assets of $4.4 billion, deposits of $3.1 billion, and stockholders’ equity of $307.1 million.
Our primary business is commercial banking and, as of December 31, 2008, over 95% of our loan portfolio was comprised of commercial loans. Our targeted commercial lending customers are closely-held businesses in industries such as manufacturing, wholesale and retail distribution, transportation, construction contracting and professional services. Our commercial lending activities primarily consist of providing loans for working capital, business expansion or acquisition, owner-occupied commercial real estate financing, revolving lines of credit and stand-by and commercial letters of credit. In addition to our lending activities, we offer deposit products such as checking, savings and money market accounts, time deposits and repurchase agreements to our business customers and community-based customers, typically individuals and small, local businesses, located near our banking centers. We offer corporate treasury cash management services to our commercial customers, which include internet balance reporting, remote deposit capture, automated clearing house products, imaged lock-box processing, controlled disbursement, and account reconciliation. We also cross-sell products and services to the owners and executives of our business customers designed to help them meet their personal financial goals. Our product offerings currently include personal customized credit and wealth management services. We use third-party providers to augment our offerings to include investment management, and brokerage services. Our products and services consist of commercial banking credit and deposit products delivered by a single operations area. We do not have separate and discrete operating segments.
Our Strategy
Our strategy to build stockholder value is based on a focused plan to be the commercial banking specialists for closely-held businesses and the people who own and manage them. Providing commercial banking services to this market niche has been an integral part of Cole Taylor Bank’s strategy since it was founded in 1929. Our strategy is comprised of the following elements:
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Relationship-oriented customer experience . Our customers are the center of what we do, so we partner with our customers to understand the dynamics of the businesses that we serve. Speed and responsiveness are critical elements of the customer experience and we do our utmost to be available anytime and any place to meet their needs. We believe closely-held business owners value a long-term relationship with a quality banker who provides innovative advice and creative ideas and understands the challenges and opportunities they face. For this reason, we believe our relationship managers are the number one “product” we bring to the market and that our customers value their access to our top management.
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Focus on our targeted customers. We focus our time and resources on closely-held businesses and the owners and managers of these businesses. We identify and pursue customer niches as a natural extension of our focused strategy. We also seek to leverage our commercial relationships by cross-selling products and services to address the personal financial needs of these business owners and managers. Expanding on the relationships we have built with these key decision-makers by helping
them meet their personal financial goals through products such as personal customized credit, financial planning and wealth management services, in addition to our array of deposit products, is an opportunity for us.
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Optimal position in our market. We believe we are well positioned to meet the needs of our target market. We are large enough to handle more complex credit facilities and treasury cash management services, yet small enough to provide more personalized customer service. We also believe it is important to our customers to have access to senior management who understand what it means to run an owner-operated business. This relationship banking approach, coupled with our ability to offer customized products and financial solutions, is what we believe sets us apart from our competition.
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Efficient growth. Historically, we have increased our total loans through organic growth and we expect to continue to grow our business and develop new customer relationships and cross-sell other products and services to our commercial customers and the owners and managers of those businesses. One of our strategies has been our ongoing recruitment of additional talented relationship managers. We actively pursue high quality relationship managers to extend our reach in the market place. In addition, in furtherance of our growth strategy, we may also seek to acquire other financial institutions or parts of those institutions.
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Effective credit risk management . A disciplined underwriting and credit administration and monitoring process is critical to our success. Credit risk is the primary risk we face in our business model, and therefore, significant resources are dedicated to monitoring and protecting our asset quality. The current downturn in the real estate market will continue to require greater attention from senior management to minimize potential losses arising from that collateral category.
Overview of 2008
The year ended December 31, 2008 was dynamic and challenging and we underwent significant change. The following is an overview of the more significant events:
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Our senior management team changed with the hiring of a new President, Chief Operating Officer, Chief Financial Officer, Chief Credit Officer and Chief Lending Officer.
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We hired over 50 new commercial bankers and embarked on a significant growth strategy. During 2008, our commercial loan portfolio increased $714.6 million, or 30%. Our loan growth was focused on lending to operating companies and we increased the percentage of our loan portfolio not secured by commercial real estate to 46% at December 31, 2008 from 34% at the end of 2007.
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We hired an Executive Vice President to lead an expanded asset-based lending initiative, and opened offices in Kansas City, Houston, Milwaukee and Baltimore from which we provide asset-backed lending services.
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Our asset quality deteriorated with nonperforming assets increasing to $213.6 million at December 31, 2008, or 4.87% of total assets, and net charge-offs in 2008 totaling $70.3 million, or 2.52% of total loans.
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Our operating results deteriorated with a net loss to common stockholders of $143.4 million for the year ended December 31, 2008. Our net loss included the establishment of a $46.4 million valuation reserve for deferred taxes.
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Our adverse operating results and deterioration in asset quality caused a number of our counterparties to reduce or withdraw our borrowing lines with them.
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We raised $219.9 million, net of additional regulatory capital with the issuance of two series of preferred stock, common stock warrants and subordinated debt.
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Our private placement in September 2008 included the issuance of $60 million of Series A convertible preferred stock, $60 million of subordinated bank debt and warrants to purchase up to 1,400,000 shares of our common stock. Net proceeds from these transactions totaled $115.1 million.
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Our participation in the U.S. Treasury Department’s TARP Capital Purchase Program in November 2008 resulted in the issuance of 104,823 shares of our Series B preferred stock and warrants to purchase up to 1,462,647 shares of our common stock for net proceeds of $104.8 million.
Competition
We encounter intense competition for all of our products and services, including substantial competition in attracting and retaining deposits and in obtaining loan customers. The principal competitive factors in the banking and financial services industry are quality of services to customers, ease of access to services and pricing of services, including interest rates paid on deposits, interest rates charged on loans, as well as credit terms and underwriting criteria, and fees charged for trust, investment and other professional services. Our principal competitors are numerous and include other commercial banks, savings and loan associations, mutual funds, money market funds, finance companies, credit unions, mortgage companies, the United States Government, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms. We may also face a competitive disadvantage as a result of our smaller size, limited branch network or narrower product offerings. Many of our competitors are significantly larger than us and have access to greater financial and other resources. In addition, many of our non-bank competitors are not subject to the same federal regulations that govern bank holding companies and federally insured banks or the state regulations governing state chartered banks. As a result, our non-bank competitors may have advantages over us in providing some services.
Employees
Together with the Bank, we had approximately 451 full-time equivalent employees as of December 31, 2008. None of our employees is subject to a collective bargaining agreement. We consider our relationships with our employees to be good.
Supervision and Regulation
General
Financial institutions, their holding companies and their affiliates are regulated under federal and state law and by the regulations and policies of various bank regulatory authorities, including the Illinois Department of Financial and Professional Regulation (the “DFPR”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC”). These laws, regulations and policies address, among other things, the scope of business, the kinds and amounts of investments, reserve requirements, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers and consolidations and the payment of dividends. This system of supervision and regulation establishes a comprehensive framework for our operations and those of our subsidiaries and is intended primarily for the protection of the FDIC-insured deposits and depositors of the Bank, rather than stockholders.
The following is a summary of the material elements of the regulatory framework that applies to us and our banking subsidiary. It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of those that are described. As such, the following is qualified in its entirety by reference to applicable law. Any change in statutes, regulations or regulatory policies may have a material effect on our business and the business of our subsidiaries.
The Company
General. We, as the sole stockholder of the Bank, are a bank holding company. As a bank holding company, we are registered with, and are subject to regulation by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHCA”). In accordance with Federal Reserve policy, we are expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where we might not otherwise do so. Under the BHCA, we are subject to periodic examination by the Federal Reserve. We are required to file with the Federal Reserve periodic reports of our operations and such additional information regarding us and our subsidiaries as the Federal Reserve may require. We are also subject to regulation by the DFPR under Illinois law.
Current Economic Environment . In response to the current national and international economic condition, the U.S. government has taken a variety of actions intended to stimulate the national economy, including the passage of legislation, such as the Emergency Economic Stabilization Act of 2008 (the “EESA”) and the American Recovery and Reinvestment Act of 2009 (the “ARRA”, although known commonly as the economic stimulus bill), and the implementation of certain programs by federal agencies, including the Federal Reserve, the FDIC and the U.S. Treasury Department.
Last Fall, pursuant to its authority under the EESA, the U.S. Treasury announced the Troubled Assets Relief Program’s Capital Purchase Program (the “CPP”), in which the U.S. Treasury would invest up to $250 billion in preferred stock and warrants to purchase common stock of qualified financial institutions that applied to participate. We applied to participate in the CPP and on November 21, 2008, the U.S. Treasury invested $104.8 million, equal to 3% of our risk-weighted assets as of September 30, 2008, in our Series B preferred stock. The terms of our Series B preferred stock, and the accompanying warrants to purchase shares of our common stock, are described later in this Annual Report under the caption “Management’s Discussion and Analysis of Results of Operations and Financial Condition.”
As a result of this investment by the U.S. Treasury, we are required to certify to the U.S. Treasury that we have complied with statutory, Treasury and contractual executive compensation restrictions imposed as part of this program. We will be required to re-certify this attestation on an annual basis so long as any of the shares of Series B preferred stock remain outstanding. Our compensation committee also must provide the U.S. Treasury with an explanation of our senior executive compensation arrangements and how such arrangements are designed to ensure that they do not encourage unnecessary or excessive risk-taking.
In addition, pursuant to the ARRA, we are subject to restrictions on executive compensation so long as any of our shares of Series B preferred stock remain outstanding, including a prohibition on paying or accruing any bonus, retention award or incentive compensation to certain senior executive officers, other than limited exceptions for restricted stock grants and pre-existing contractual requirements and a prohibition on any severance payments to any of our senior executive officers or any of our next five most highly-compensated employees. Our Board of Directors also will be required to adopt a company-wide policy regarding excessive or luxury expenditures and we are required to permit an advisory stockholder vote to approve executive compensation, as disclosed in our proxy statement, at each annual meeting of stockholders so long as any of the shares of Series B preferred stock remain outstanding.
The FDIC established a temporary liquidity guarantee program that had both a debt guarantee component, whereby the FDIC agreed to guarantee certain senior unsecured debt issued by eligible financial institutions between October 14, 2008 and June 30, 2009, and a transaction account guarantee component, whereby the FDIC agreed to insure 100% of non-interest bearing deposit transaction accounts at eligible financial institutions, such as lawyers’ trust accounts, payment processing accounts, payroll accounts and working capital accounts, through December 31, 2009. On February 27, 2009, the FDIC’s Board modified the temporary liquidity guarantee program to allow participating entities, with the FDIC’s permission, to issue mandatory convertible debt. The Bank is participating in both of these programs and paying the premiums related to such participation to the FDIC.
The FDIC has also provided for a temporary increase in deposit insurance coverage. Pursuant to the EESA, the FDIC temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The EESA provides that the basic deposit insurance limit will return to $100,000 after December 31, 2009. (Other changes related to the regulation of deposit insurance are discussed below under “ Deposit Insurance”) .
Another recently implemented program intended to stabilize the nation’s banking system is the Term Asset-Backed Securities Loan Facility (the “TALF”) promulgated by the Federal Reserve. The program is intended to increase credit availability and support economic activities by facilitating renewed issuance of consumer and small business asset-backed securities as well as commercial mortgage-backed securities, private-label residential mortgage-backed securities, and other asset-backed securities (collectively, “ABS”). According to the Federal Reserve, a newly announced expansion of the TALF could increase its size to as much as $1 trillion. Under TALF, the Federal Reserve Bank of New York will finance the purchase of eligible ABS by investors that own eligible collateral so long as such investor maintains an account relationship with a primary dealer.
Acquisitions, Activities and Change in Control. The primary purpose of a bank holding company is to control and manage banks. The BHCA generally requires the prior approval of the Federal Reserve for any merger involving a bank holding company or any acquisition by a bank holding company of another bank or bank holding company. Subject to certain conditions (including deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States. In approving interstate acquisitions, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws that require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.
The BHCA generally prohibits us from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking … as to be a proper incident thereto.” This authority would permit us to engage in a variety of banking-related businesses, including the operation of a thrift, consumer finance, equipment leasing, the operation of a computer service bureau (including software development), and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.
Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of nonbanking activities, including securities and insurance underwriting and sales, merchant banking and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. As of the date of this filing, we have not applied for approval to operate as a financial holding company.
Federal law also prohibits any person or company from acquiring “control” of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator. “Control” is conclusively presumed to exist upon the acquisition of 25% or more of the outstanding voting securities of a bank or bank holding company, but may arise under certain circumstances at 10% ownership.
Capital Requirements. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital levels fall below the minimum required levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses.
The Federal Reserve’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: (i) a risk-based requirement expressed as a percentage of total assets weighted according to risk; and (ii) a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others. For purposes of these capital standards, Tier 1 capital consists primarily of permanent stockholders’ equity less intangible assets (other than certain loan servicing rights and purchased credit card relationships). Total capital consists primarily of Tier 1 capital plus certain other debt and equity instruments that do not qualify as Tier 1 capital and a portion of the company’s allowance for loan and lease losses.
The risk-based and leverage standards described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions ( i.e. , Tier 1 capital less all intangible assets), well above the minimum levels. As of December 31, 2008, we had regulatory capital in excess of the Federal Reserve’s minimum requirements.
Dividend Payments . Our ability to pay dividends to our stockholders may be affected by both general corporate law considerations and policies of the Federal Reserve applicable to bank holding companies, as well as limitations contained in the documents governing our trust preferred securities and Series A and Series B preferred stock. As a Delaware corporation, we are subject to the limitations of the Delaware General Corporation Law (the “DGCL”). The DGCL allows us to pay dividends only out of our surplus (as defined and computed in accordance with the provisions of the DGCL) or if we have no such surplus, out of our net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Additionally, policies of the Federal Reserve caution that a bank holding company should not pay cash dividends that exceed its net income or that can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.
Federal Securities Regulation. Our common stock is registered with the SEC under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Consequently, we are subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.
The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance and accounting measures to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of disclosures under federal securities laws. We are subject to Sarbanes-Oxley because we are required to file periodic reports with the SEC under the Exchange Act. Among other things, Sarbanes-Oxley and/or its implementing regulations established membership requirements and additional responsibilities for our audit committee, imposed restrictions on the relationship between us and our outside auditors (including restrictions on the types of non-audit services our auditors may provide to us), imposed additional responsibilities for external financial statements on our chief executive officer and chief financial officer, expanded the disclosure requirements for corporate insiders, required management to evaluate our disclosure controls and procedures and our internal controls over financial reporting and required auditors to issue a report on our internal control over financial reporting.
The Bank
General. The Bank is an Illinois-chartered bank, the deposit accounts of which are insured by the FDIC’s Deposit Insurance Fund (“DIF”). The Bank is also a member of the Federal Reserve System (“member bank”). As an Illinois-chartered, FDIC-insured member bank, the Bank is presently subject to the examination, supervision, reporting and enforcement requirements of the DFPR, as the chartering authority for Illinois banks; the Federal Reserve, as the primary federal regulator of member banks; and the FDIC, as administrator of the DIF.
Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of four risk categories and assessed insurance premiums based upon their capital group and supervisory group designations within such category. Institutions classified in the highest capital group (i.e., those with a “well capitalized” capital group designation) and in the highest supervisory group (i.e., those with CAMELS ratings of 1 or 2) pay the lowest premium while institutions that are in the lowest (i.e., undercapitalized) capital group and lowest supervisory group (i.e., those with CAMELS ratings of 4 or 5) pay the highest premium. Capital group assignments are made by the FDIC quarterly. During the year ended December 31, 2008, DIF assessments ranged from 5 cents to 43 cents per $100 of assessable deposits. The FDIC announced in the 4 th quarter of 2008, however, that risk-based deposit insurance premiums for insured institutions were to be uniformly increased by 7 basis points for the first quarter of 2009 (annualized). As such, for first quarter 2009, deposit insurance premiums ranged between 12 cents and 50 cents per $100 of assessable deposits.
On February 27, 2009, the FDIC’s Board of Directors voted to amend the current restoration plan for the DIF. Under the revised restoration plan, the schedule to raise the DIF reserve ratio to 1.15% was extended from five to seven years in recognition of the current strain on banks and the country’s economic environment. At the same meeting, the FDIC proposed a 20 point special assessment on all FDIC-insured institutions to be assessed on June 30, 2009, and paid to the FDIC on September 30, 2009. Related to the proposed special assessment, the FDIC also proposed the imposition of an emergency special assessment on FDIC-insured institutions after June 30, 2009 of up to 10 basis points if necessary to support public confidence in the federal deposit insurance system. Comments on both special assessment proposals are currently being sought by the FDIC. Finally, at the same meeting, the Board approved a final rule that sets forth revised deposit insurance assessment rates. Prior to the adoption of this final rule, most banks paid between 12 cents and 14 cents per $100 of assessable deposits to the FDIC for deposit insurance. Under the new rule, most banks will pay initial base assessment rates between 12 cents and 16 cents per $100 of assessable deposits beginning April 1, 2009 (with a maximum of 45 cents per $100 of assessable deposits). Higher rates will also be imposed on banks that present additional risks to the DIF as well as those that rely significantly on secured liabilities, which increase the risk to the FDIC without providing additional assessment revenue to the agency. In some instances, the final rule will also impose increased assessments on insured institutions that use brokered deposits for rapid asset growth.
FICO Assessments. DIF members are subject to assessments to cover the interest payments on outstanding Financing Corporation (“FICO”) obligations until the final maturity of such bond obligations in 2019. These FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. For fourth quarter of 2008, the assessment for these obligations was 1.14 basis points.
Supervisory Assessments. All Illinois banks are required to pay supervisory assessments to the DFPR to fund the operations of the DFPR. The amount of the assessment is calculated on the basis of the bank’s total assets. During the year ended December 31, 2008, the Bank paid supervisory assessments to the DFPR totaling $425,000.
CEO BACKGROUND
Nominees for Election
The names of the persons nominated for election as directors of our company, together with certain information concerning the nominees as of April 6, 2009, are set forth below:
Name Age
Position With Company
Bruce W. Taylor
53 Chairman, Chief Executive Officer, Director and member of Executive Committee
Mark A. Hoppe
55 President, Director and member of Executive Committee
Harrison I. Steans
73 Director and Chairman of Executive Committee
Ronald L. Bliwas
66 Director
Ronald D. Emanuel
62 Director
M. Hill Hammock
63 Director
Michael H. Moskow
71 Director
Louise O’Sullivan
63 Director
Melvin E. Pearl
73 Director
Shepherd G. Pryor, IV
62 Director
Jennifer W. Steans
45 Director
Jeffrey W. Taylor
56 Vice Chairman and Director
Richard W. Tinberg
58 Director
MANAGEMENT DISCUSSION FROM LATEST 10K
Introduction
We are a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago. We derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank. We provide a range of banking services to our customers, with a primary focus on serving closely-held businesses in the Chicago metropolitan area and the people who own and manage those businesses.
The following discussion and analysis presents our consolidated financial condition at December 31, 2008 and 2007 and the results of operations for the years ended December 31, 2008, 2007 and 2006. This discussion should be read together with the “Selected Consolidated Financial Data,” our audited consolidated financial statements and the notes thereto and other financial data contained elsewhere in this annual report. In addition to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and forward-looking statements as a result of certain factors, including those discussed in the section captioned “Risk Factors” and elsewhere in this Annual Report on Form 10-K.
2008 Overview
Results of Operations
We reported a net loss applicable to common shareholders for the year ended December 31, 2008 of $143.4 million, or ($13.72) per common share, compared with a net loss of $9.6 million, or ($0.89) per common share, for the year ended December 31, 2007. The largest component of the net loss in 2008 was a $144.2 million provision for loan losses, compared with a provision of $31.9 million in 2007. The net loss in 2008 was also impacted by the establishment of a $46.4 million, or $4.44 per common share, valuation reserve against our deferred tax assets and preferred stock dividends of $18.8 million in 2008. The net loss in 2007 included a non-cash, after-tax charge of $23.2 million, or $2.14 per share, for the write-off of our goodwill.
Our total assets increased $832.4 million, or 23.4%, during 2008 to $4.39 billion at December 31, 2008, compared to $3.56 billion at December 31, 2007. Total loans increased $699.9 million, or 27.6%, to $3.2 billion at December 31, 2008, with the increase attributable to primarily commercial and industrial loans (C&I loans). C&I loans increased $635.5 million, or 74.7% during 2008, as we hired over 50 new commercial bankers and embarked on a significant growth strategy. Our new commercial bankers established 180 new commercial banking relationships and originated more than $750 million in new commercial loans.
Our senior management team changed beginning with the hiring of a new President in February 2008. During 2008, we recruited a new Chief Credit Officer, Chief Lending Officer, Chief Operating Officer and Chief Financial Officer. We also hired an Executive Vice President to lead an expanded asset-based lending capability. We launched our asset-based lending initiative, which operates under the name Cole Taylor Business Capital, and opened offices in Kansas City, Milwaukee, Houston and Baltimore to support these operations. All of our new executives’ previous experience was with a substantially larger banking organization and included many years of experience in the Chicago banking market.
Series A Preferred Stock Issuance
On September 29, 2008, we completed a private placement of $60 million of 8% non-cumulative convertible perpetual preferred stock, Series A, to certain institutional and individual accredited investors. The preferred stock private placement included a total of 2.4 million shares of 8% non-cumulative convertible perpetual preferred stock, Series A, with a purchase price and liquidation preference of $25.00 per share. The preferred stock pays non-cumulative dividends at an annual rate of 8% of the liquidation preference beginning in January 2009. Each share of the preferred stock can be converted into 2.5 shares of our common stock at a conversion price of $10.00 per common share. The preferred stock is convertible into an aggregate of 6.0 million shares of our common stock at the option of the preferred stockholders at any time, and will be convertible at our option on or after September 29, 2013. The preferred stock will cease to pay dividends after September 29, 2010, if the volume weighted average price of our common stock on the Nasdaq Global Select Market exceeds 200% of the then applicable conversion price ($20.00) for at least 20 trading days in any consecutive 30-day period, or after September 29, 2011, if the volume weighted average price of our common stock on the Nasdaq Global Select Market exceeds 130% ($13.00) of the then-applicable conversion price for at least 20 trading days in any consecutive 30-day period.
Issuance of Subordinated Bank Notes and Common Stock Warrants
Simultaneously with the issuance of the Series A preferred stock, we closed a sale of $60 million in principal amount of 10% subordinated notes issued by our Bank which included detachable warrants to purchase shares of our Company’s common stock. The subordinated notes issued by the Bank bear interest at an annual rate of 10% and mature on September 29, 2016, but may be prepaid at the Bank’s option after September 29, 2011. For every $1,000 in principal amount of the subordinated notes, investors in this transaction also received a warrant to purchase 15 shares of our common stock at an exercise price of $10.00 per share, which represents an aggregate of 900,000 shares of common stock. The warrants are not exercisable until March 29, 2009 and expire on September 29, 2013.
In connection with the private placement of Series A preferred stock, we also issued to Financial Investments Corporation (“FIC”) warrants to purchase up to 500,000 shares of our common stock at an exercise price of $20.00 per share. The FIC warrants are not transferable or assignable after their initial issuance, and are exercisable anytime up to the September 29, 2018 expiration date.
Participation in U.S. Treasury Department’s TARP Capital Purchase Program
On November 21, 2008, we received $104.8 million from the U.S. Treasury Department in exchange for the issuance of 104,823 shares of our Series B preferred stock and warrants to purchase 1,462,647 shares of our common stock as part of the federal government’s TARP Capital Purchase Program. The Series B preferred shares pay a dividend of 5% per year for the first five years and reset to 9% per year thereafter. The Series B preferred shares are callable at par after three years and can be redeemed prior to then at 100% of the issue price, subject to the approval of our federal regulator. The warrants have a term of ten years and an exercise price of $10.75 per share.
Counterparty Borrowing Lines
During 2008, our pre-approved borrowing lines for federal funds purchased and repurchase agreements declined. Our approved overnight federal funds borrowing lines have declined to $95 million at December 31, 2008 from $260 million at December 31, 2007. Our pre-approved repurchase agreement lines have declined to $390 million at December 31, 2008 from $610 million at December 31, 2007. In response, we have increased our pledge of qualifying commercial loan collateral under the Federal Reserve Bank’s Borrower-in-Custody Program, which increased our borrowing capacity to $640 million at December 31, 2008 from $307 million at December 31, 2007. Subsequent to year end, the Bank has increased its pre-approved borrowing lines for federal funds purchased by $35 million. The Bank has further increased its ability to purchase federal funds by cultivating relationships with a growing group of correspondent banking customers who may sell Federal Funds to the Bank in order to manage their excess liquidity.
In addition, an independent debt rating agency, Fitch Ratings, downgraded its ratings of the holding company and the Bank during 2008. Fitch reduced the long and short-term debt and deposit ratings from investment grade to non-investment grade and revised their ratings outlook to negative from stable. We have also experienced a decline in our ratings from entities such as IDC, LACE, and Bankrate.com. The Bank has not experienced any difficulty acquiring deposits at market rates. However, these ratings declines could negatively impact our acquisition or retention of deposits in the future.
2007 Overview
We reported a net loss for the year ended December 31, 2007 of $9.6 million, or ($0.89) per share, compared with net income of $46.2 million, or $4.15 per diluted common share, for the year ended December 31, 2006. The net loss in 2007 included a non-cash, after-tax charge of $23.2 million, or $2.14 per share, for the write-off of our goodwill. In addition, the provision for loan losses was $31.9 million in 2007, compared with a provision of $6.0 million in 2006. Net income in 2006 included $15.5 million, or $1.39 per share, of tax benefits associated with the resolution of particular tax uncertainties. These tax benefits were recognized in the second half of 2006 because of the expiration of the statute of limitations on our 2002 income tax return and the completion of certain taxing authority examinations. Total assets at December 31, 2007 were $3.56 billion, compared to $3.38 billion at December 31, 2006, an increase of $176.8 million, or 5.2%.
Application of Critical Accounting Policies
Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America and general reporting practices within the financial services industry. Our accounting policies are described in the section of this annual report captioned “Notes to Consolidated Financial Statements–Summary of Significant Accounting and Reporting Policies.”
The preparation of financial statements in conformity with these accounting principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available to us as of the date of the consolidated financial statements and, accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. The estimates, assumptions and judgments made by us are based upon historical experience or other factors that we believe to be reasonable under the circumstances. Certain accounting policies inherently have greater reliance on the use of estimates, assumptions and judgments and as such, have a greater possibility of producing results that could be materially different than originally reported. We consider our policies for the allowance for loan losses, the valuation of deferred tax assets and establishment of tax liabilities and the valuation of financial instruments such as investment securities and derivatives to be critical accounting policies. In 2008, we revised which of our accounting policies we consider critical. We added as a critical accounting policy the valuation of investment securities, specifically our policy regarding other than temporary impairment. In addition, our policy regarding goodwill impairment was no longer critical as all of our goodwill was written off at the end of 2007.
The following accounting policies materially affect our reported earnings and financial condition and require significant estimates, assumptions and judgments.
Allowance for Loan Losses
We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in our loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include a general allowance computed by applying loss factors to categories of loans outstanding in the portfolio, specific allowances for identified problem loans and portfolio segments, and an unallocated allowance. We maintain our allowance for loan losses at a level considered adequate to absorb probable losses inherent in our portfolio as of the balance sheet date. In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including historical charge-off experience, growth of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent and criticized loans. In addition, we use information about specific borrower situations, including their financial position, work-out plans and estimated collateral values under various liquidation scenarios to estimate the risk and amount of loss on loans to those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of risk of loss and amount of loss on any loan are complicated by the uncertainties surrounding not only our borrowers’ probability of default, but also the fair value of the underlying collateral. The current illiquidity in the real estate market has increased the uncertainty with respect to real estate values. Because of the degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding holding period until sale and the collateral liquidation method, our actual losses may materially vary from our current estimates.
As a business bank, our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have higher potential losses on an individual loan basis. The individually larger commercial loans can cause greater volatility in our reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate with respect to a single sizable loan can have a material impact on our reported impaired loans and related loss estimates. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of any one or a few of these loans can cause a significant increase in uncollectible loans and, therefore, our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, our allowance for loan losses is adjusted through the recording of a provision for loan losses.
Income Taxes
We have maintained significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan losses. For income tax return purposes, only net charge-offs are deductible, not the provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of the current and future economic and business conditions. We consider both positive and negative evidence regarding the ultimate realizability of our deferred tax assets. Positive evidence includes the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods, while negative evidence includes a cumulative loss in the current year and prior two years and general business and economic trends. At December 31, 2008, we recorded a valuation allowance relating to our deferred tax asset. This determination was based, largely, on the negative evidence of a cumulative loss in the most recent three year period caused primarily by the significant loan loss provisions made during 2008. In addition, general uncertainty surrounding the future economic and business conditions have increased the likelihood of volatility in our future earnings. We believe, based on our internal earnings projections, that we will generate future taxable income that will result in the realization of this deferred tax asset. However, this positive evidence was not sufficient to overcome the negative evidence of our recent cumulative loss.
At times, we apply different tax treatment for selected transactions for tax return purposes than for income tax financial reporting purposes. The different positions result from the varying application of statutes, rules, regulations, and interpretations, and our accruals for income taxes include reserves for these differences in position. Our estimate of the value of these reserves contains assumptions based upon our past experience and judgments about potential actions by taxing authorities, and we believe that the level of these reserves is reasonable. We initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examinations. Subsequently, the reserves are then utilized or reversed when we determine the more likely than not threshold is no longer met, once the statute of limitations has expired, or the tax matter is effectively settled. However, because reserve balances are estimates that are subject to uncertainties, the ultimate resolution of these matters may be greater or less than the amounts we have accrued.
Derivative Financial Instruments
We use derivative financial instruments (derivatives), including interest rate exchange and floor and collar agreements, to accommodate individual customer needs and to assist in our interest rate risk management. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), all derivatives are measured and reported at fair value on our consolidated balance sheet as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the effective portion of the hedged risk, are recognized in current earnings during the period of the change in the fair values. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value. Similarly, the changes in the fair value of derivatives that do not qualify for hedge accounting under SFAS 133 or are not designated as an accounting hedge are also reported currently in earnings.
At the inception of a hedge and quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivatives have been highly effective in offsetting the changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. If it is determined that derivatives are not highly effective as a hedge, hedge accounting is discontinued for the period. Once hedge accounting is terminated, all changes in fair value of the derivatives flow through the consolidated statements of operations in other noninterest income, which results in greater volatility in our earnings.
The estimates of fair values of our derivatives are calculated using independent valuation models to estimate market-based valuations. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both us and our counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in volatility in our statement of operations.
Valuation of Investment Securities
Each quarter we review our investment securities portfolio to determine whether unrealized losses are temporary or other than temporary, based on an evaluation of the creditworthiness of the issuers/guarantors, as well as the underlying collateral, if applicable. Our analysis includes an evaluation of the type of security, the length of time and extent to which the fair value has been less than the security’s carrying value, the characteristics of the underlying collateral, the degree of credit support provided by subordinate tranches within the total issuance, independent credit ratings and discounted cash flow analysis. We utilize various independent pricing sources to obtain fair values and perform discounted cash flow analysis for selected securities. When the discounted cash flow analysis we obtain from those independent pricing sources indicates that it is probable that all future principal and interest payments would be received in accordance with their original contractual terms and we have both the intent and ability to hold the investment security until maturity, the unrealized loss is deemed temporary. Our assessments of creditworthiness and the resultant expected cash flows are complicated by the significant uncertainties surrounding not only the specific security and its underlying collateral but also the severity of the current overall economic downturn. Our cash flow estimates for mortgage-backed securities are based on estimates of mortgage default rates and future housing prices, which are difficult to predict. Changes in assumptions can result in material changes in expected cash flows. Therefore, unrealized losses that we have determined to be temporary may at a later date be determined to be other than temporary and have a material impact on our statement of operations.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Introduction
We are a bank holding company headquartered in Rosemont, Illinois, a suburb of Chicago. We derive substantially all of our revenue from our wholly-owned subsidiary, Cole Taylor Bank. We provide a range of banking services to our customers, with a primary focus on serving closely-held businesses in the Chicago metropolitan area and the people who own and manage them.
The following discussion and analysis presents our consolidated financial condition and results of operations as of and for the dates and periods indicated. This discussion should be read in conjunction with our consolidated financial statements and the notes thereto appearing elsewhere in this document. In addition to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and forward-looking statements as a result of certain factors, including those discussed in the section captioned “Risk Factors” in our 2008 Annual Report on Form 10-K filed with the SEC on March 11, 2009.
Application of Critical Accounting Policies
Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America and general reporting practices within the financial services industry. Our accounting policies are described in the section captioned “Notes to Consolidated Financial Statements–Summary of Significant Accounting and Reporting Policies” in our 2008 Annual Report on Form 10-K.
The preparation of financial statements in conformity with these accounting principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available to us as of the date of the consolidated financial statements and, accordingly, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. The estimates, assumptions and judgments made by us are based upon historical experience or other factors that we believe to be reasonable under the circumstances. Certain accounting policies inherently have greater reliance on the use of estimates, assumptions and judgments and as such, have a greater possibility of producing results that could be materially different than originally reported. We consider our policies for the allowance for loan losses, the valuation of deferred tax assets and establishment of tax liabilities and the valuation of financial instruments such as investment securities and derivatives to be critical accounting policies.
The following accounting policies materially affect our reported earnings and financial condition and require significant estimates, assumptions and judgments.
Allowance for Loan Losses
We have established an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in our loan portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include a general allowance computed by applying loss factors to categories of loans outstanding in the portfolio, specific allowances for identified problem loans and portfolio segments, and an unallocated allowance. We maintain our allowance for loan losses at a level considered adequate to absorb probable losses inherent in our portfolio as of the balance sheet date. In evaluating the adequacy of our allowance for loan losses, we consider numerous quantitative factors, including historical charge-off experience, growth of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent and criticized loans. In addition, we use information about specific borrower situations, including their financial position, work-out plans and estimated collateral values under various liquidation scenarios to estimate the risk and amount of loss on loans to those borrowers. Finally, we also consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, the impact of competition on our underwriting terms, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature more subjective and fluid. Our estimates of risk of loss and amount of loss on any loan are complicated by the uncertainties surrounding not only our borrowers’ probability of default, but also the fair value of the underlying collateral. The current illiquidity in the real estate market has increased the uncertainty with respect to real estate values. Because of the degree of uncertainty and the sensitivity of valuations to the underlying assumptions regarding holding period until sale and the collateral liquidation method, our actual losses may materially vary from our current estimates.
As a business bank, our loan portfolio is comprised primarily of commercial loans to businesses. These loans are inherently larger in amount than loans to individual consumers and, therefore, have higher potential losses on an individual loan basis. The individually larger commercial loans can cause greater volatility in our reported credit quality performance measures, such as total impaired or nonperforming loans. Our current credit risk rating and loss estimate with respect to a single sizable loan can have a material impact on our reported impaired loans and related loss estimates. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of any one or a few of these loans can cause a significant increase in uncollectible loans and, therefore, our allowance for loan losses. We review our estimates on a quarterly basis and, as we identify changes in estimates, our allowance for loan losses is adjusted through the recording of a provision for loan losses.
Income Taxes
We have maintained significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan losses. For income tax return purposes, only net charge-offs are deductible, not the provision for loan losses. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more
likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of the current and future economic and business conditions. We consider both positive and negative evidence regarding the ultimate realizability of our deferred tax assets. Positive evidence includes the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods, while negative evidence includes a cumulative loss in the current year and prior two years and general business and economic trends. We currently maintain a valuation allowance against significantly all of our deferred tax asset because it is more likely than not that all of this deferred tax asset will not be realized. This determination was based, largely, on the negative evidence of a cumulative loss in the most recent three year period caused primarily by the significant loan loss provisions made during recent periods. In addition, general uncertainty surrounding future economic and business conditions have increased the likelihood of volatility in our future earnings.
At times, we apply different tax treatment for selected transactions for tax return purposes than for income tax financial reporting purposes. The different positions result from the varying application of statutes, rules, regulations, and interpretations, and our accruals for income taxes include reserves for these differences in position. Our estimate of the value of these reserves contains assumptions based upon our past experience and judgments about potential actions by taxing authorities, and we believe that the level of these reserves is reasonable. We initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examinations. Subsequently, the reserves are then utilized or reversed when we determine the more likely than not threshold is no longer met, once the statute of limitations has expired, or the tax matter is effectively settled. However, because reserve balances are estimates that are subject to uncertainties, the ultimate resolution of these matters may be greater or less than the amounts we have accrued.
Derivative Financial Instruments
We use derivative financial instruments (derivatives), including interest rate exchange, floor and collar agreements, and forward loan sale commitments to either accommodate individual customer needs or to assist in our interest rate risk management. All derivatives are measured and reported at fair value on our consolidated balance sheet as either an asset or a liability. For derivatives that are designated and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the effective portion of the hedged risk, are recognized in current earnings during the period of the change in the fair values. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. For all hedging relationships, derivative gains and losses that are not effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings during the period of the change in fair value. Similarly, the changes in the fair value of derivatives that do not qualify for hedge accounting or are not designated as an accounting hedge are also reported currently in earnings.
At the inception of a hedge and quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivatives have been highly effective in offsetting the changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. If it is determined that derivatives are not highly effective as a hedge, hedge accounting is discontinued for the period. Once hedge accounting is terminated, all changes in fair value of the derivatives flow through the consolidated statements of operations in other noninterest income, which results in greater volatility in our earnings.
The estimates of fair values of our interest rate swap, floors, and collar derivatives are calculated using independent valuation models to estimate market-based valuations. The valuations are determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flow of each derivative. This analysis reflects the contractual terms of the derivative and uses observable market-based inputs, including interest rate curves and implied volatilities. In addition, the fair value estimate also incorporates a credit valuation adjustment to reflect the risk of nonperformance by both us and our counterparties in the fair value measurement. The resulting fair values produced by these proprietary valuation models are in part theoretical and, therefore, can vary between derivative dealers and are not necessarily reflective of the actual price at which the derivative contract could be traded. Small changes in assumptions can result in significant changes in valuation. The risks inherent in the determination of the fair value of a derivative may result in volatility in our statement of operations.
Valuation of Investment Securities
The fair value of our investment portfolio is determined in accordance with generally accepted accounting principals, which requires that we classify financial assets and liabilities measured at fair value into a three-level fair value hierarchy. The determination of fair value is highly subjective and requires management to rely on estimates, assumptions, and judgments that can affect amounts reported in our financial statements. We obtain the fair value of investment securities from an independent pricing service. We review the pricing methodology for each significant class of assets used by this third party pricing service to assess the compliance with accounting standards for fair value measurement and classification in the fair value measurement hierarchy. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current rating from credit rating agencies, and the bond’s terms and conditions, among other things. We have determined that these valuations are classified in Level 2 of the fair value hierarchy.
While we use an independent pricing service to obtain the fair values of our investment portfolio, we do employ certain control procedures to determine the reasonableness of the valuations. We validate the overall reasonableness of the fair values by comparing information obtained from our independent pricing service to other third party valuation sources for selected assets and review the valuations and any differences in valuations with members of management who have the relevant technical expertise to assess the results. We do not alter the fair values provided by our independent pricing service.
Our investment portfolio includes $1.08 billion of mortgage related investment securities which consisted of mortgage-backed securities and collateralized mortgage obligations. We do not have subprime loans in this portfolio. Of the total mortgage related investment securities, $1.05 billion, or 97.5%, were issued by government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. The mortgage related portfolio included $27.5 million of private-label mortgage related securities that has received heightened monitoring because the Company believe the fair values of these securities have been impacted by illiquidity in the market place because of a lack of active trading in these securities. While none of these securities contain subprime mortgage loans, the portfolio does include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. While the fair value of these securities has been impacted by market illiquidity, the Company does not modify the fair value determined by the independent pricing but takes additional steps to review for other-than-temporary impairment.
Each quarter we review our investment securities portfolio to determine whether unrealized losses are temporary or other than temporary, based on an evaluation of the creditworthiness of the issuers/guarantors, as well as the underlying collateral, if applicable. Our analysis includes an evaluation of the type of security, the length of time and extent to which the fair value has been less than the security’s carrying value, the characteristics of the underlying collateral, the degree of credit support provided by subordinate tranches within the total issuance, independent credit ratings, changes in credit ratings and a cash flow analysis, considering default rates, loss severities based upon the location of the collateral, and estimated prepayments. Those securities with unrealized losses for more than 12 months and for more than 10% of their carrying value are subjected to further analysis to determine if we expect to receive all the contractual cash flows. We utilize other independent pricing sources to obtain fair values and perform discounted cash flow analysis for selected securities. When the discounted cash flow analysis we obtain from those independent pricing sources indicates that we expect all future principal and interest payments would be received in accordance with their original contractual terms, we do not intend to sell the security, and we more-likely-than-not will not be required to sell the security before recovery, the unrealized loss is deemed temporary. If such analysis shows that we expect not to be able to recover our entire investment, then an other-than-temporary impairment charge would be recorded in current earnings for the amount of the credit loss. The amount of impairment that related to factors other than the credit loss is recognized in other comprehensive income. Our assessments of creditworthiness and the resultant expected cash flows are complicated by the significant uncertainties surrounding not only the specific security and its underlying collateral but also the severity of the current overall economic downturn. Our cash flow estimates for mortgage related securities are based on estimates of mortgage default rates, severity of loss, and prepayments, which are difficult to predict. Changes in assumptions can result in material changes in expected cash flows. Therefore, unrealized losses that we have determined to be temporary may at a later date be determined to be other-than-temporary and have a material impact on our statement of operations.
CONF CALL
Bruce Taylor
Thank you. Good morning everyone. With me today is our Chief Financial Officer, Robin VanCastle, who will review the financial highlights of the first quarter. I am also excited to introduce Mark Hoppe who joined us earlier this year as President of Taylor Capital Group and CEO of Cole Taylor Bank. Mark is here to provide his perspectives on the market and the opportunities that we have.
The first quarter's performance reflects two major factors impacting the company. The first is the consummation of the most significant external growth transaction in our core business since the last bank acquisition we made in 1984. Second is the ongoing challenge being faced by homebuilders in the market. We do not foresee any near term improvement in the housing market conditions which will continue to cause stress amongst our borrowers in that business.
It is no secret that a key component of building our company's long-term value is the growth of our business with closely-held companies. Continuing to build a force of talented, experienced and well-known commercial bankers is a prerequisite to accomplishing this. During the first quarter in addition to Mark joining us as President and CEO of Cole Taylor Bank, we hired Larry Ryan, a 27 year veteran over LaSalle Bank N.A. as our Executive Vice President of Commercial Banking and Mike Morton, formerly one of the top risk officers of LaSalle Bank as our Chief Credit Officer.
In late March and early April we hired 29 other commercial bankers and related support staff including six Group Senior Vice Presidents and our new head of asset-based lending. We made a substantial investment to recruit these people and will incur an increase in ongoing expense.
Robin will provide more details about the financial impact in her remarks.
I would like to note that some of the newly added expense is offset by our ongoing efficiency efforts. Some of the new personnel are filling vacant positions. We also eliminated some positions late last year and early this year as our ongoing planning and efficiency management which resulted in our recognizing severance expense during the quarter.
The business focus, cultural alignment and tactical execution of our growth strategy could not be more tightly aligned to our core business. This builds on our strong heritage in commercial banking and an infrastructure that's in place to support the needs of the companies we bank. Our efforts are now focused on quickly integrating our new staff and accelerating our growth in the relationships.
At the same time that we are planting these seeds for our future growth we've not lost sight of the importance of effectively working through the downturn in the residential market, improving asset quality and mitigating our exposure to potential losses. We are fortunate to have a strong capital base and substantial allowance for loan losses to help absorb losses we may face from the decline in home sales and related real estate values.
The first quarter loss provision of $11.8 million was half of what we provided in the fourth quarter. Non-performing assets now stand at 2.9% of total assets. This is a historically high amount and the result of the quick and sharp downturn in home sales.
First quarter new home sales in the Chicago area were 61% or what they were a year ago with only about 2,100 homes sold. As of March 31, residential real estate and related land exposures make up approximately 79% of our non-accrual loan totals. The majority of our non-accruals are represented by floor borrowers, including our single largest exposure that was put on non-accrual status during the first quarter.
We continue to add strength and experience to our staff charged with credit risk management. In addition to Mike Morton, Chief Credit Officer, we have added three other credit professionals to our staff since the beginning of the year. They include our head of loan reviews, Senior Vice President, a Senior Vice President in our special assets division, and also a Senior Vice President in commercial real estate administrative management. All of these individuals will add strength and experience to our credit support functions and allow us to work through the current economic environment while building the foundation needed to support our growth.
Mark will talk more about this in his comments. I will now turn the call over to Robin VanCastle who will provide more detail on our financial results for the quarter.
Robin VanCastle
Thank you, Bruce and good morning everyone. Continued weakness in the residential real estate market resulted in $11.8 million provision for loan losses in the first quarter. This provision represented a three-fold increase from the first quarter of last year, but was half the level we have provided last quarter.
Net charge-offs for the first quarter were $2.2 million or 36 basis points of average loans on an annualized basis compared with $2.8 million in the first quarter last year and $8.7 million in the fourth quarter. Non-performing loans increased $23.8 million or 31.5% primarily based on our assessment of a single borrower involved in residential real estate development with loans from us totaling $26.7 million.
These loans were current on interest and principle however the developer's obligations to other banks and the performance of the projects financed by those other banks was sufficient in our judgment to stop accruing interest and recognize the entire relationship as non-performing. Our accounting treatment for this loan is an example of how we are proactively recognizing and aggressively addressing weakness in the residential construction part of our portfolio.
While average non-accrual loan balances increased during the first quarter that impact was offset by interest we collected on a loan that we have placed on non-accrual last year. The interest we received when the non-accrual loan paid off during the first quarter more than offset the amount of interest reversals we recognized. As a result, the net effect of the non-accruals to our total loan yield was unchanged between the first and fourth quarters another example of how our proactive approach to recognizing potential credit weakness.
Our net interest margin in the first quarter declined 13 basis points on a linked quarter basis. We moved quickly during the quarter to reduce our funding costs and step with the declining prime rate and that supported our net interest spread which remained flat from the last quarter. One of the actions we took to reduce funding costs in the first quarter was to call above market rate brokered CD. We called approximately $70 million in CDs with average remaining terms of over three years and coupons between 4.85% and 6% and recognized early debt extinguishment expenses of $810,000. That early debt extinguishment expense is separately reported in non-interest expense. We funded the calls with additional brokered CDs.
Our net interest margin declined in spite of our flat net interest spread because the calculation for net interest margin factors in the effects of interest earning assets that are being supported by non-interest bearing funding, our so called free-funding. The lower average interest bearing liability cost reduces the value attributed to the free funding in the margin calculation.
CNI lending continues to increase as a percentage of our portfolio. While our real estate construction loan portfolio continues to decline on both the real and proportional basis. CNI loans increased $29 million or 3.4% in the first quarter, 14% on an annualized basis to comprise 35% of our total portfolio at March 31. Our real estate construction loans decreased $61.5 million or 9%, declining to 24% of our portfolio. In total our loan portfolio decreased $21 million or about 1% during the first quarter.
Non-interest expense was higher in the first quarter on both a linked quarter and year-over-year basis. The provision for losses and other real estate FDIC insurance and early debt extinguishment expenses and easily identified in our earnings release. The impact of our significant recruiting however is less apparent. So let me break that down for you.
Since mid March, we have recruited 22 commercial banking officers dedicated to business development and 7 new credit professionals, including our new Chief Credit Officer. Including our new President, Mark Hoppe and our Executive Vice President of Commercial Lending, Larry Ryan, incremental compensation expense for the first quarter totaled $1.1 million. Because approximately half of our new hires started with us after March 31, the estimated impact in future quarters is expected to be higher. Based on our recruiting to date, we estimate that the incremental recurring compensation expense will approximate $2 million per quarter.
Both the holding company and Cole Taylor Bank remain well-capitalized with total capital to risk weighted rated assets of 12.67% and 11.92% respectively at quarter end. Given the current economy and our strategic growth initiative we believe it is prudent to preserve capital and liquidity. Therefore, in spite of our stock trading at a significant discount to book value, we did not repurchase any shares during the quarter.
I look forward to your questions and now, I will hand off our conference call to Mark.
Mark Hoppe
Thank you, Robin. Good morning, everyone. First, I would like to express that I am really excited about joining Cole Taylor. What drew me to the company is its unwavering commitment to middle market commercial banking strategy and commitment to closely held business orders. I have been here for about 90 days now, which is long enough to confirm what I have always thought about Cole Taylor. This is a strong company with talented people and it is as competitive as any bank in our existing markets.
The commercial banking market in Chicago is very dynamic right now. Relationships are shifting and clients and commercial bankers as well are considering their options. My first priority is to position the bank to move quickly and to capture as many opportunities as possible during this period of market disruption.
We have the advantage of working from a position of strength. Cole Taylor has the strategic focus, a full suite of competitive products, an engaged and accessible management team and talented bankers. As a further description of that as Bruce mentioned, last month, we hired Larry Ryan, who is a well-known middle market commercial banker in the Chicago area. Larry had a 27 year career at LaSalle Bank dealing primarily with closely-held businesses.
In the 30 days that Larry has been here, he has done a great job of ramping up our commercial banking team with experienced relationship driven producers who have middle market banking skills and strong deep client relationships.
Our commercial banking business unit has doubled in size over the past few months and today there are a total of 41 relationship managers in commercial banking. Larry may hire a few more people going forward but for now, his senior commercial banking team is in place and they are focused on market development. The strong, strategic, and cultural fit of the new hires makes it possible for us to become quickly and efficiently as a unified team working toward a common goal, winning in the marketplace.
In addition I've been assessing our infrastructure. We have to make sure that our bankers have the support and products they need to maximize our new business opportunities. I am pleased to say that with some modest enhancements to our existing products we can improve our delivery capability in treasury management, foreign exchange, international services, as well as interest rate risk management products.
We are committed to provide these products to our clients in an efficient and cost effective manner which will increase our fee income. I have also taken this opportunity to enhance our credit operations in ways that will support our commercial banking growth strategy. Commercial lending, particularly in the relationship banking model, must balance underwriting with an appreciation for getting deals done along with credit administration processes that protect against the risk of loss.
Mike Morton, who joined Cole Taylor from LaSalle where he was a Senior Vice President and one of the Senior Credit Officers, was a commercial banking lender before becoming a credit officer a number of years ago. He has the benefit of hands on experience working with clients and has seen a wide range of scenarios. Also, Mike has worked with most of the new RMs who have joined Cole Taylor and this familiarity should increase underwriting and credit administration efficiency and effectiveness.
In credit monitoring as Bruce alluded to before, we've added senior staff in loan review special assets and commercial real estate administration. When I arrived at Cole Taylor, I found sound underwriting and practices that are common in banking. That said, we are building a credit management infrastructure that will support the accelerated growth we expect to experience over the next several quarters.
The individuals we have recruited are experienced and successful credit professionals who are familiar working in a larger environment. Their skills will not only enhance our current practices, but also put in place those processes required to manage a larger, more diverse and complex portfolio.
I look forward to your questions and will hand the mic back to Bruce.
Bruce Taylor
Thank you very much, Mark. During the first quarter, we took advantage of a unique, maybe once in a lifetime opportunity in the market. Net-net, we made an $8 million annual investment in our company's core business and future growth. We are not the only bank in the market seeking this opportunity and yet our success in attracting this talent to our company exceeded our expectations. I expect the successful execution of this phase of our growth plan will lead into successfully executing the next phase, building our market share.
In turn, this will improve our competitive position, diversify our portfolio, improve financial performance and build long-term value.
I will ask the operator to open up the line for your questions. Thank you.
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Fund Letters
