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MB FINANCIAL INC /MD - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following is a discussion and analysis of MB Financial, Inc.'s financial condition and results of operations and should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. The words "the Company," "we," "our" and "us" refer to MB Financial, Inc. and its consolidated subsidiaries, unless we indicate otherwise. Overview The profitability of our operations depends primarily on our net interest income after provision for credit losses, which is the difference between interest earned on interest earning assets and interest paid on interest bearing liabilities less provision for credit losses. The provision for credit losses is dependent on changes in our loan portfolio and management's assessment of the collectability of our loan portfolio as well as prevailing economic and market conditions. Our net income is also affected by non-interest income and non-interest expenses. During the periods under report, non-interest income included revenue from our key fee initiatives: capital markets and international banking fees, commercial deposit and treasury management fees, net lease financing income, trust and asset management fees, and card fees. Non-interest income also included loan service fees, consumer and other deposit service fees, brokerage fees, net gain (loss) on investment securities, increase in cash surrender value of life insurance, net gain (loss) on sale of assets, accretion of the FDIC indemnification asset, net gains on sale of loans and other operating income. During the periods under report, non-interest expenses included salaries and employee benefits, occupancy and equipment expense, computer services and telecommunication expense, advertising and marketing expense, professional and legal expense, other intangibles amortization expense, net loss on other real estate owned, other real estate expenses (net of rental income) and other operating expenses. Net interest income is affected by changes in the volume and mix of interest earning assets, interest earned on those assets, the volume and mix of interest bearing liabilities and interest paid on interest bearing liabilities. Non-interest income and non-interest expenses are impacted by growth of banking and leasing operations and growth in the number of loan and deposit accounts through both acquisitions and core banking and leasing business growth. Growth in operations affects other expenses primarily as a result of additional employee, branch facility and promotional marketing expense. Growth in the number of loan and deposit accounts affects other income, including service fees as well as other expenses such as computer services, supplies, postage, telecommunications and other miscellaneous expenses. Non-performing asset levels impact salaries and benefits, legal expenses and other real estate owned expenses. The Company had net income of $23.1 million for the three months ended June 30, 2014 compared to net income of $25.3 million for the three months ended June 30, 2013. Fully diluted earnings per common share were $0.42 for the three months ended June 30, 2014 compared to $0.46 per common share for the three months ended June 30, 2013. The Company had net income of $43.1 million for the six months ended June 30, 2014 compared to net income of $50.2 million for the six months ended June 30, 2013. Fully diluted earnings per common share were $0.78 for the six months ended June 30, 2014 compared to $0.92 per common share for the six months ended June 30, 2013. 49 --------------------------------------------------------------------------------Critical Accounting Policies Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industries in which we operate. This preparation requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a 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. Management believes the following policies are both important to the portrayal of our financial condition and results of operations and require subjective or complex judgments; therefore, management considers the following to be critical accounting policies. Management has reviewed the application of these polices with the Compliance and Audit Committee of our Board of Directors. Allowance for Loan Losses. The allowance for loan losses is subject to the use of estimates, assumptions, and judgments in management's evaluation process used to determine the adequacy of the allowance for loan losses, which combines several factors: management's ongoing review and grading of the loan portfolio, consideration of past loan loss experience, trends in past due and non-performing loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require that certain loan balances be charged off when their credit evaluations differ from those of management or require that adjustments be made to the allowance for loan losses, based on their judgments about information available to them at the time of their examination. We believe the allowance for loan losses is appropriate and properly recorded in the financial statements. See "Allowance for Loan Losses" section below for further analysis. Residual Value of Our Direct Finance, Leveraged, and Operating Leases. Lease residual value represents the present value of the estimated fair value of the leased equipment at the termination date of the lease. Realization of these residual values depends on many factors, including management's use of estimates, assumptions, and judgment to determine such values. Several other factors outside of management's control may reduce the residual values realized, including general market conditions at the time of expiration of the lease, whether there has been technological or economic obsolescence or unusual wear and tear on, or use of, the equipment and the cost of comparable equipment. If, upon the expiration of a lease, we sell the equipment and the amount realized is less than the recorded value of the residual interest in the equipment, we will recognize a loss reflecting the difference. On a quarterly basis, management reviews the lease residuals for potential impairment. If we fail to realize our aggregate recorded residual values, our financial condition and profitability could be adversely affected. At June 30, 2014, the aggregate residual value of the equipment leased under our direct finance, leveraged, and operating leases totaled $76.4 million. See Note 1 and Note 6 of our December 31, 2013 audited consolidated financial statements contained in our Annual Report Form 10-K for the year ended December 31, 2013 for additional information. Income Tax Accounting. ASC Topic 740 provides guidance on accounting for income taxes by prescribing the minimum recognition threshold that a tax position must meet to be recognized in the financial statements. ASC Topic 740 also provides guidance on measurement, recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As of June 30, 2014, the Company had $82 thousand of uncertain tax positions. The Company elects to treat interest and penalties recognized for the underpayment of income taxes as income tax expense. However, interest and penalties imposed by taxing authorities on issues specifically addressed in ASC Topic 740 will be taken out of the tax reserves up to the amount allocated to interest and penalties. The amount of interest and penalties exceeding the amount allocated in the tax reserves will be treated as income tax expense. As of June 30, 2014, the Company had approximately $9 thousand of accrued interest related to tax reserves. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. As such, we are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of, and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of income. Fair Value of Assets and Liabilities. ASC Topic 820 defines fair value as the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of assets and liabilities is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not fully available, management judgment is necessary to estimate fair value. In addition, changes in 50 -------------------------------------------------------------------------------- market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. Therefore, when market data is not available, the Company would use valuation techniques requiring more management judgment to estimate the appropriate fair value measurement. See Note 13 to the consolidated financial statements for a complete discussion on the Company's use of fair valuation of assets and liabilities and the related measurement techniques. Goodwill. The excess of the cost of an acquisition over the fair value of the net assets acquired consists of goodwill, and core deposit and client relationship intangibles. See Note 8 of our December 31, 2013 audited consolidated financial statements contained in our Annual Report Form 10-K for the year ended December 31, 2013 for further information regarding core deposit and client relationship intangibles. The Company reviews goodwill to determine potential impairment annually, or more frequently if events and circumstances indicate that goodwill might be impaired, by comparing the carrying value of the reporting units with the fair value of the reporting units. The Company's annual assessment date for goodwill impairment testing is as of December 31. Goodwill is tested for impairment at the reporting unit level. The Company has two reporting units: banking and leasing. No impairment losses were recognized during the three or six months ended June 30, 2014 and 2013. We are not aware of any events or circumstances subsequent to our annual goodwill impairment testing date of December 31, 2013 that would indicate impairment of goodwill at June 30, 2014. Recent Accounting Pronouncements. Refer to Note 2 of our consolidated financial statements for a description of recent accounting pronouncements including the respective dates of adoption and effects on results of operations and financial condition. Net Interest Income The following tables present, for the periods indicated, the total dollar amount of interest income from average interest earning assets and the related yields, as well as the interest expense on average interest bearing liabilities, and the related costs, expressed both in dollars and rates (dollars in thousands). The tables below and the discussion that follows contain presentations of net interest income and net interest margin on a tax-equivalent basis, which is adjusted for the tax-favored status of income from certain loans and investments. We believe this measure to be the preferred industry measurement of net interest income, as it provides a relevant comparison between taxable and non-taxable amounts. Reconciliations of net interest income and net interest margin on a tax-equivalent basis to net interest income and net interest margin in accordance with accounting principles generally accepted in the United States of America are provided in the table. 51 -------------------------------------------------------------------------------- Three Months Ended June 30, (dollars in thousands) 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Interest Earning Assets: Loans (1) (2) (3) $ 5,199,981 $ 53,649 4.18 % $ 5,320,472 $ 57,356 4.32 % Loans exempt from federal income taxes (4) 317,251 3,470 4.33 310,751 3,423 4.36 Taxable investment securities 1,434,300 8,794 2.45 1,377,369 6,280 1.82 Investment securities exempt from federal income taxes (4) 966,518 12,748 5.28 933,442 12,559 5.38 Federal funds sold 4,359 4 0.36 2,879 2 0.27 Other interest earning deposits 448,173 277 0.25 183,010 92 0.20 Total interest earning assets 8,370,582 $ 78,942 3.78 8,127,923 $ 79,712 3.93 Non-interest earning assets 1,205,314 1,161,459 Total assets $ 9,575,896 $ 9,289,382 Interest Bearing Liabilities: Deposits: NOW and money market deposit $ 2,880,910 $ 899 0.13 % $ 2,675,189 $ 833 0.12 % Savings deposit 868,694 97 0.04 840,154 136 0.06 Time deposits 1,378,201 2,758 0.80 1,700,970 4,163 0.98 Short-term borrowings 184,204 95 0.21 189,029 116 0.24 Long-term borrowings and junior subordinated notes 236,266 1,344 2.25 214,839 1,390 2.56 Total interest bearing liabilities 5,548,275 $ 5,193 0.38 5,620,181 $ 6,638 0.47 Non-interest bearing deposits 2,476,396 2,179,284 Other non-interest bearing liabilities 199,621 192,553 Stockholders' equity 1,351,604 1,297,364 Total liabilities and stockholders' equity $ 9,575,896 $ 9,289,382 Net interest income/interest rate spread (5) $ 73,749 3.40 % $ 73,074 3.46 % Less: taxable equivalent adjustment 5,677 5,594 Net interest income, as reported $ 68,072 $ 67,480 Net interest margin (6) 3.26 % 3.33 % Tax equivalent effect 0.27 % 0.28 % Net interest margin on a fully tax equivalent basis (6) 3.53 % 3.61 % (1) Non-accrual loans are included in average loans. (2) Interest income includes amortization of net deferred loan origination fees of $28 thousand and $817 thousand for the three months ended June 30, 2014 and 2013, respectively. (3) Loans held for sale are included in the average loan balance listed. Related interest income is included in loan interest income. (4) Non-taxable loan and investment income is presented on a fully tax equivalent basis assuming a 35% tax rate. (5) Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis. (6) Net interest margin represents net interest income as a percentage of average interest earning assets. Net interest income on a fully tax equivalent basis increased $675 thousand during the three months ended June 30, 2014 compared to the three months ended June 30, 2013, primarily due to higher yields on taxable investment securities partly offset by lower loan yields. The net interest margin, expressed on a fully tax equivalent basis, was 3.53% for the second quarter of 2014 and 3.61% for the second quarter of 2013. This eight basis point decrease was primarily due to higher cash balances held during the second quarter of 2014 as a result of the strong deposit inflows. Higher deposits and cash balances had minimal impact on net interest income. 52 -------------------------------------------------------------------------------- Six Months Ended June 30, (dollars in thousands) 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Interest Earning Assets: Loans (1) (2) (3) $ 5,241,582 $ 107,595 4.14 % $ 5,341,062 $ 115,892 4.38 % Loans exempt from federal income taxes (4) 320,371 7,006 4.35 311,128 6,895 4.41 Taxable investment securities 1,409,473 16,940 2.40 1,430,539 12,419 1.74 Investment securities exempt from federal income taxes (4) 951,275 25,158 5.29 922,652 24,960 5.41 Federal funds sold 5,120 9 0.35 1,448 2 0.27 Other interest bearing deposits 318,332 390 0.25 189,994 227 0.24 Total interest earning assets 8,246,153 $ 157,098 3.84 8,196,823 $ 160,395 3.95 Non-interest earning assets 1,226,340 1,172,219 Total assets $ 9,472,493 $ 9,369,042 Interest Bearing Liabilities: Deposits: NOW and money market deposit $ 2,804,688 $ 1,747 0.13 % $ 2,706,170 $ 1,759 0.13 % Savings deposit 865,463 206 0.05 831,233 272 0.07 Time deposits 1,406,003 5,570 0.80 1,753,640 8,810 1.01 Short-term borrowings 192,346 195 0.20 190,458 283 0.30 Long-term borrowings and junior subordinated notes 229,021 2,722 2.36 231,770 2,957 2.54 Total interest bearing liabilities 5,497,521 $ 10,440 0.38 5,713,271 $ 14,081 0.50 Non-interest bearing deposits 2,424,917 2,162,266 Other non-interest bearing liabilities 206,597 204,318 Stockholders' equity 1,343,458 1,289,187 Total liabilities and stockholders' equity $ 9,472,493 $ 9,369,042 Net interest income/interest rate spread (5) $ 146,658 3.46 % $ 146,314 3.45 % Less: taxable equivalent adjustment 11,258 11,149 Net interest income, as reported $ 135,400 $ 135,165 Net interest margin (6) 3.31 % 3.33 % Tax equivalent effect 0.28 % 0.27 % Net interest margin on a fully tax equivalent basis (6) 3.59 % 3.60 % (1) Non-accrual loans are included in average loans. (2) Interest income includes amortization of net deferred loan origination costs of $27 thousand for the six months ended June 30, 2014 compared to net deferred loan origination fees of $1.8 million for the six months ended June 30, 2013. (3) Loans held for sale are included in the average loan balance listed. Related interest income is included in loan interest income. (4) Non-taxable loan and investment income is presented on a fully tax equivalent basis assuming a 35% tax rate. (5) Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis. (6) Net interest margin represents net interest income as a percentage of average interest earning assets. Net interest income on a fully tax equivalent basis increased $344 thousand during the six months ended June 30, 2014 compared to the six months ended June 30, 2013, primarily due to improved taxable investment securities yields and a lower cost of funds, partially offset by lower loan yields. The net interest margin, expressed on a fully tax equivalent basis, was 3.59% for the six months ended June 30, 2014 and 3.60% for the six months ended June 30, 2013. 53 -------------------------------------------------------------------------------- Non-interest Income Three Months Ended June 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest income (in thousands): Capital markets and international banking fees $ 1,360 $ 939 $ 421 44.8 % Commercial deposit and treasury management fees 7,106 6,029 1,077 17.9 Lease financing, net 14,853 15,102 (249 ) (1.6 ) Trust and asset management fees 5,405 4,874 531 10.9 Card fees 3,304 2,735 569 20.8 Loan service fees 916 1,911 (995 ) (52.1 ) Consumer and other deposit service fees 3,156 3,593 (437 ) (12.2 ) Brokerage fees 1,356 1,234 122 9.9 Net (loss) gain on investment securities (87 ) 14 (101 ) (721.4 ) Increase in cash surrender value of life insurance 834 842 (8 ) (1.0 ) Net loss on sale of assets (24 ) - (24 ) (100.0 ) Accretion of FDIC indemnification asset 28 100 (72 ) (72.0 ) Net gain on sale of loans 187 506 (319 ) (63.0 ) Other operating income 1,534 1,060 474 44.7 Total non-interest income $ 39,928 $ 38,939 $ 989 2.5 % NM - not meaningful Non-interest income increased by $1.0 million, or 2.5%, for the three months ended June 30, 2014 compared to the three months ended June 30, 2013. • Commercial deposit and treasury management fees increased due to robust new customer activity. • Card fees increased due to a new payroll prepaid card program. • Trust and asset management fees increased due to the growth in investment management fees as a result of new customers added and the impact of higher equity values on assets under management and related fee revenue. • Capital markets and international banking service fees increased due to higher M&A advisory and syndication fees. • Loan service fees decreased due to lower late, prepayment and miscellaneous loan fees collected. • Consumer and other deposit service fees decreased due to lower demand deposit service and overdraft charges. • Net gain on sale of loans decreased as a result of less mortgage origination activity. 54 -------------------------------------------------------------------------------- Six Months Ended June 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest income (in thousands): Capital markets and international banking fees $ 2,338 $ 1,747 $ 591 33.8 % Commercial deposit and treasury management fees 14,250 11,995 2,255 18.8 Lease financing, net 28,049 31,365 (3,316 ) (10.6 ) Trust and asset management fees 10,612 9,368 1,244 13.3 Card fees 6,005 5,430 575 10.6 Loan service fees 1,881 2,922 (1,041 ) (35.6 ) Consumer and other deposit service fees 6,091 6,839 (748 ) (10.9 ) Brokerage fees 2,681 2,391 290 12.1 Net gain on investment securities 230 13 217 NM Increase in cash surrender value of life insurance 1,661 1,686 (25 ) (1.5 ) Net loss on sale of assets (17 ) - (17 ) (100.0 ) Accretion of FDIC indemnification asset 59 243 (184 ) (75.7 ) Net gain on sale of loans 246 1,145 (899 ) (78.5 ) Other operating income 2,454 2,498 (44 ) (1.8 ) Total non-interest income $ 76,540 $ 77,642 $ (1,102 ) (1.4 )% NM - Note meaningful Non-interest income decreased by $1.1 million, or 1.4%, for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. • Commercial deposit and treasury management fees increased in the first half of 2014 due to robust new customer activity. • Capital markets and international banking service fees increased due to higher M&A advisory and syndication fees. • Trust and asset management fees increased due to the growth in investment management fees as a result of new customers added and the impact of higher equity values on assets under management and related fee revenue. • Card fees increased due to a new payroll prepaid card program as well as higher ATM and debit card fees. • Leasing revenues declined due to lower equipment remarketing gains and lower fees from the sale of third-party equipment maintenance contracts. • Loan service fees decreased due to lower late, prepayment and miscellaneous loan fees collected. • Consumer and other deposit service fees decreased due to lower demand deposit service and overdraft charges. • Net gain on sale of loans decreased as a result of less mortgage origination activity. 55 -------------------------------------------------------------------------------- Non-interest Expenses Three Months Ended June 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest expenses (in thousands): Salaries and employee benefits $ 46,622 $ 43,909 $ 2,713 6.2 % Occupancy and equipment expense 9,518 9,408 110 1.2 Computer services and telecommunication expense 5,079 4,617 462 10.0 Advertising and marketing expense 2,221 2,167 54 2.5 Professional and legal expense 1,567 1,353 214 15.8 Other intangibles amortization expense 1,174 1,538 (364 ) (23.7 ) Net loss (gain) recognized on other real estate owned 191 (2,015 ) 2,206 (109.5 ) Other real estate expense, net 337 193 144 74.6 Other operating expenses 11,321 9,083 2,238 24.6 Total non-interest expenses $ 78,030 $ 70,253 $ 7,777 11.1 % Non-interest expenses increased by $7.8 million, or 11.1%, for the three months ended June 30, 2014 from the three months ended June 30, 2013. Non-interest expenses include $488 thousand in expenses related to the pending merger with Taylor Capital Group, Inc. ("Taylor Capital"), mainly for advertising and marketing, computer services and telecommunication, and professional and legal services expenses. • Salaries and employee benefits increased due to annual salary increases, long-term incentive expense, taxes and temporary staffing needs. • A net loss was recognized on other real estate owned for the three months ended June 30, 2014 compared to a net gain for the same period in the prior year. • Other operating expense increased primarily as a result of an increase in filing and other loan expense as well as higher FDIC assessments due to our larger balance sheet, an increase in the clawback liability related to our loss share agreements with the FDIC, and higher currency delivery expenses related to new treasury management accounts. • Computer services and telecommunication expenses increased due primarily to an increase in spending on IT security, data warehouse, investments in our key fee initiatives, as well as higher transaction volumes in leasing, treasury management and card areas. The increase was also due to increased telecommunication expense related to the transitioning to a new provider. 56 -------------------------------------------------------------------------------- Six Months Ended June 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest expenses (in thousands): Salaries and employee benefits $ 90,999 $ 87,423 $ 3,576 4.1 % Occupancy and equipment expense 19,110 18,812 298 1.6 Computer services and telecommunication expense 10,163 8,504 1,659 19.5 Advertising and marketing expense 4,302 4,270 32 0.7 Professional and legal expense 3,346 2,648 698 26.4 Other intangibles amortization expense 2,414 3,082 (668 ) (21.7 ) Net loss recognized on other real estate owned 378 (1,685 ) 2,063 (122.4 ) Other real estate expense, net 733 332 401 120.8 Other operating expenses 22,632 18,296 4,336 23.7 Total non-interest expenses $ 154,077 $ 141,682 $ 12,395 8.7 % Non-interest expenses increased by $12.4 million, or 8.7%, for the six months ended June 30, 2014 from the six months ended June 30, 2013. Non-interest expenses include $1.2 million in expenses related to the pending merger with Taylor Capital, mainly for advertising and marketing, computer services and telecommunication, and professional and legal services expenses. • Other operating expenses increased due to a $2.0 million write-off recognized in the first quarter of 2014 of an investment in low-income housing funds that invested in real estate projects. This investment was made in 2006 as a community development initiative. The extended slow real estate recovery in some low income areas of Chicago negatively impacted this investment. • Other operating expenses also increased as a result of an increase in filing and other loan expense as well as higher FDIC assessments due to our larger balance sheet, higher ATM and debit card processing costs and higher currency delivery expenses related to new treasury management accounts. • Salaries and employee benefits increased due to annual salary increases, long-term incentive expense, taxes and temporary staffing needs. • A net loss was recognized on other real estate owned for the six months ended June 30, 2014 compared to a net gain for the same period in the prior year. • Computer services and telecommunication expenses increased due primarily to an increase in spending on IT security, data warehouse, investments in our key fee initiatives, as well as higher transaction volumes in leasing, treasury management and card areas. The increase was also due to increased telecommunication expense related to the transitioning to a new provider. Income Taxes Income tax expense for the six months ended June 30, 2014 was $15.6 million compared to $20.4 million for the six months ended June 30, 2013. The decrease was primarily due to a decrease in our pre-tax income during the six months ended June 30, 2014. Balance Sheet Total assets increased $177.3 million, or 1.8%, from $9.6 billion at December 31, 2013 to $9.8 billion at June 30, 2014. • Cash and cash equivalents increased $287.8 million, or 60.8% from $473.5 million at December 31, 2013 to $761.3 million at June 30, 2014 primarily due to the deposit inflows. • Investment securities increased $94.9 million, or 4.0%, from December 31, 2013 to June 30, 2014 mostly as a result of the partial deployment of the increased deposits. • Gross loans, excluding covered loans, decreased by $55.1 million to $5.4 billion at June 30, 2014 from December 31, 2013. 57 --------------------------------------------------------------------------------Total liabilities increased by $138.6 million, or 1.7%, from $8.3 billion at December 31, 2013 to $8.5 billion at June 30, 2014. • Total deposits increased by $381.8 million, or 5.2%, to $7.8 billion at June 30, 2014 from December 31, 2013 due to the increase in low cost deposits (noninterest bearing deposits, money market and NOW accounts and savings accounts). • Over the past year and quarter, our deposit mix continued to improve as low cost deposits increased by $614.7 million, or 10.6%, compared to June 30, 2013 and by $496.1 million, or 8.4%, compared to December 31, 2013. This improvement was driven by the growth in noninterest bearing deposits which were 34% of total deposits at June 30, 2014. • Noninterest bearing deposits increased by 16.8% and 9.7% compared to June 30, 2013 and December 31, 2013, respectively. • Total borrowings decreased by $254.3 million, or 35.9%, to $453.3 million at June 30, 2014. The decrease in total borrowings was primarily due to the repayment of the $300.0 million FHLB advance entered into the fourth quarter of 2013 to increase our balance sheet liquidity in preparation for an adverse market reaction to the Federal government shutdown and potential breach of the debt ceiling. Total stockholders' equity increased $38.6 million to $1.4 billion at June 30, 2014 compared to December 31, 2013 primarily as a result of our earnings for the six months ended June 30, 2014 partly offset by dividends. Investment Securities The following table sets forth the amortized cost and fair value of our investment securities, by type of security as indicated (in thousands): June 30, 2014 December 31, 2013 June 30, 2013 Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value Available for sale U.S. Government sponsored agencies and enterprises $ 50,096 $ 51,727 $ 50,486 $ 52,068 $ 32,050 $ 33,935 States and political subdivisions 19,228 19,498 19,398 19,143 669,791 684,710 Residential mortgage-backed securities 738,519 747,925 696,415 701,233 639,681 647,858 Commercial mortgage-backed securities 47,977 49,858 50,891 52,941 51,000 53,343 Corporate bonds 271,351 275,529 284,083 283,070 219,362 215,256 Equity securities 10,414 10,421 10,649 10,457 10,560 10,570 Total Available for Sale 1,137,585 1,154,958 1,111,922 1,118,912 1,622,444 1,645,672 Held to maturity States and political subdivisions 993,937 1,030,478 932,955 936,173 282,655 285,904 Residential mortgage-backed securities 247,455 261,767 249,578 262,756 253,779 268,675 Total Held to Maturity 1,241,392 1,292,245 1,182,533 1,198,929 536,434 554,579 Total $ 2,378,977 $ 2,447,203 $ 2,294,455 $ 2,317,841 $ 2,158,878 $ 2,200,251 Securities of states and political subdivisions with a fair value of $656.6 million were transferred from available for sale to held to maturity during the third quarter of 2013, which is the new cost basis. As of the date of the transfer, the resulting unrealized holding gain continues to be reported as a separate component of stockholders' equity as accumulated other comprehensive income, net of tax. This unrealized gain will be amortized over the remaining life of the securities as a yield adjustment. 58 --------------------------------------------------------------------------------Loan Portfolio The following table sets forth the composition of our loan portfolio (dollars in thousands): June 30, 2014 December 31, 2013 June 30, 2013 % of % of % of Amount Total Amount Total Amount Total Commercial related credits: Commercial loans $ 1,272,200 23 % $ 1,281,377 22 % $ 1,198,862 22 % Commercial loans collateralized by assignment of lease payments 1,515,446 27 1,494,188 26 1,422,901 25 Commercial real estate 1,619,322 29 1,647,700 29 1,710,964 30 Construction real estate 116,996 2 141,253 3 121,420 2 Total commercial related credits 4,523,964 81 4,564,518 80 4,454,147 79 Other loans: Residential real estate 309,234 6 314,440 5 305,710 5 Indirect vehicle 272,841 5 262,632 5 242,964 5 Home equity 245,135 4 268,289 5 281,334 5 Other consumer loans 70,584 1 66,952 1 75,476 1 Total other loans 897,794 16 912,313 16 905,484 16 Gross loans excluding covered loans 5,421,758 97 5,476,831 96 5,359,631 95 Covered loans (1) 134,966 3 235,720 4 308,556 5 Total loans (2) $ 5,556,724 100 % $ 5,712,551 100 % $ 5,668,187 100 % (1) Loans that MB Financial Bank will share losses with the FDIC are referred to as "covered loans." (2) Gross loan balances at June 30, 2014, December 31, 2013, and June 30, 2013 are net of unearned income, including net deferred loans fees of $1.0 million, $1.9 million, and $955 thousand, respectively. Gross loans, excluding covered loans, decreased by $55.1 million to $5.4 billion at June 30, 2014 from December 31, 2013. Gross loans decreased by $155.8 million to $5.6 billion at June 30, 2014 from $5.7 billion at December 31, 2013. Asset Quality Non-performing loans include loans accounted for on a non-accrual basis and accruing loans contractually past due 90 days or more as to interest or principal. Management reviews the loan portfolio for problem loans on an ongoing basis. During the ordinary course of business, management becomes aware of borrowers that may not be able to meet the contractual requirements of loan agreements. These loans are placed under close supervision with consideration given to placing the loan on non-accrual status, increasing the allowance for loan losses and (if appropriate) partial or full charge-off. After a loan is placed on non-accrual status, any interest previously accrued but not yet collected is reversed against current income. Generally, if interest payments are received on non-accrual loans, these payments will be applied to principal and not taken into income. Loans will not be placed back on accrual status unless back interest and principal payments are made. Our general policy is to place loans 90 days past due on non-accrual status, as well as those loans that continue to pay, but display a well-defined material weakness. Non-performing loans exclude purchased credit-impaired loans that were acquired as part of the Heritage, InBank, Corus, Benchmark, Broadway, and New Century FDIC-assisted transactions. Fair value of these loans as of acquisition includes estimates of credit losses. See Note 6 of the notes to our consolidated financial statements for further information regarding purchased credit-impaired loans. 59 --------------------------------------------------------------------------------The following table sets forth the amounts of non-performing loans and non-performing assets at the dates indicated (dollars in thousands): June 30, December 31, June 30, 2014 2013 2013 Non-performing loans: Non-accruing loans $ 108,414 $ 106,115 $ 112,926 Loans 90 days or more past due, still accruing interest 2,363 446 2,322 Total non-performing loans 110,777 106,561 115,248 Other real estate owned 20,306 23,289 32,993 Repossessed assets 73 840 749 Total non-performing assets $ 131,156 $ 130,690 $ 148,990 Total allowance for loan losses $ 100,910 $ 111,746 $ 123,685 Accruing restructured loans (1) 26,793 29,430 28,270 Total non-performing loans to total loans 1.99 % 1.87 % 2.03 % Total non-performing assets to total assets 1.34 1.36 1.59 Allowance for loan losses to non-performing loans 91.09 104.87 107.32 (1) Accruing restructured loans consists primarily of residential real estate and home equity loans that have been modified and are performing in accordance with those modified terms. A loan is classified as a troubled debt restructuring when a borrower is experiencing financial difficulties that leads to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses. A loan that is modified at a market rate of interest may no longer be classified as troubled debt restructuring in the calendar year subsequent to the restructuring if it is in compliance with the modified terms. Payment performance prior and subsequent to the restructuring is taken into account in assessing whether it is likely that the borrower can meet the new terms. This may result in the loan being returned to accrual at the time of restructuring. A period of sustained repayment for at least six months generally is required for return to accrual status. Occasionally, the Company will restructure a note into two separate notes (A/B structure), charging off the entire B portion of the note. The A note is structured with appropriate loan-to-value and cash flow coverage ratios that provide for a high likelihood of repayment. The A note is classified as a non-performing note until the borrower has displayed a historical payment performance for a reasonable time prior to and subsequent to the restructuring. A period of sustained repayment for at least six months generally is required to return the note to accrual status provided that management has determined that the performance is reasonably expected to continue. The A note will be classified as a restructured note (either performing or non-performing) through the calendar year of the restructuring that the historical payment performance has been established. Non-performing assets consists of non-performing loans as well as other repossessed assets and other real estate owned. Other real estate owned represents properties acquired through foreclosure or other proceedings and is recorded at fair value less the estimated cost of disposal at the date of acquisition. Other real estate owned is evaluated regularly to ensure that the recorded amount is supported by its current fair value. Valuation allowances to reduce the carrying amount to fair value less estimated costs of disposal are recorded as necessary. Gains and losses and changes in valuations on other real estate owned are included in net gain (loss) recognized on other real estate within non-interest expense. Expenses, net of rental income, from the operations of other real estate owned are reflected as a separate line item on the income statement. Other repossessed assets primarily consist of repossessed vehicles. Losses on repossessed vehicles are charged-off to the allowance when title is taken and the vehicle is valued. Once MB Financial Bank obtains title, repossessed vehicles are not included in loans, but are classified as "other assets" on the consolidated balance sheets. The typical holding period for resale of repossessed automobiles is less than 90 days unless significant repairs to the vehicle are needed which occasionally results in a longer holding period. The typical holding period for motorcycles can be more than 90 days, as the average motorcycle re-sale period is longer than the average automobile re-sale period. The longer average period for motorcycles is a result of cyclical trends in the motorcycle market. 60 -------------------------------------------------------------------------------- Other real estate owned that is related to our FDIC-assisted transactions is excluded from non-performing assets. Other real estate owned related to the Heritage, Benchmark, Broadway, and New Century transactions, which totaled $12.6 million and $19.6 million at June 30, 2014 and December 31, 2013, respectively, is subject to the loss-share agreements with the FDIC. See Note 6 of the notes to our consolidated financial statements for further information. The following table presents a summary of other real estate owned, excluding assets related to FDIC-assisted transactions, for the six months ended June 30, 2014 and 2013 (in thousands): June 30, 2014 2013 Beginning balance $ 23,289 $ 36,977Transfers in at fair value less estimated costs to sell 651 4,214 Capitalized other real estate owned costs - 8 Fair value adjustments (426 ) 821 Net gains on sales of other real estate owned 100 990 Cash received upon disposition (3,308 ) (10,017 ) Ending balance $ 20,306 $ 32,993 Potential Problem Loans We define potential problem loans as performing loans rated substandard and that do not meet the definition of a non-performing loan (See "Asset Quality" section above for non-performing loans). We do not necessarily expect to realize losses on potential problem loans, but we recognize potential problem loans carry a higher probability of default and require additional attention by management. The following table sets forth the aggregate principal amount of potential problem loans at the dates indicated (in thousands): June 30, December 31, 2014 2013 Commercial loans $ 21,083 $ 43,844 Commercial loans collateralized by assignment of lease payments 2,536 2,459 Commercial real estate 39,858 32,895 Construction real estate - 391 Total $ 63,477 $ 79,589 Allowance for Loan Losses Management believes the allowance for loan losses accounting policy is critical to the portrayal and understanding of our financial condition and results of operations. Selection and application of this "critical accounting policy" involves judgments, estimates, and uncertainties that are subject to change. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, materially different financial condition or results of operations is a reasonable possibility. We maintain our allowance for loan losses at a level that management believes is appropriate to absorb probable losses on existing loans based on an evaluation of the collectability of loans, underlying collateral and prior loss experience. Our allowance for loan losses is comprised of three elements: a commercial related general loss reserve; a commercial related specific reserve for impaired loans; and a consumer related reserve for smaller-balance homogenous loans. Each element is discussed below. Commercial Related General Loss Reserve. We maintain a general loan loss reserve for the four categories of commercial-related loans in our portfolio: commercial loans, commercial loans collateralized by the assignment of lease payments (lease loans), commercial real estate loans and construction real estate loans. 61 -------------------------------------------------------------------------------- Under our loan risk rating system, each loan, with the exception of those included in large groups of smaller-balance homogeneous consumer related loans, is risk rated between one and nine by the originating loan officer, Senior Credit Management, Loan Review or any loan committee. Loans rated "one" represent those loans least likely to default and a loan rated "nine" represents a loss. The probability of loans defaulting for each risk rating, sometimes referred to as default factors, are estimated based on the frequency with which loans migrate from one risk rating to another and to default status over time. We use a loan loss reserve model that incorporates the migration of loan risk ratings and historical default data over a multi-year period to develop our estimated default factors (EDFs). The model tracks annual loan rating migrations by loan type and currently uses loan risk rating migrations for 13 years. The migration data is adjusted by using average losses for an economic cycle (approximately 12 years) to develop EDFs by loan type, risk rating and maturity. EDFs are updated annually in December. Estimated loan default factors are multiplied by individual loan balances in each risk-rating category and again multiplied by an historical loss given default estimate for each loan type (which incorporates estimated recoveries) to determine the appropriate allowance by loan type. This approach is applied to the commercial, lease, commercial real estate, and construction real estate components of the portfolio. To account for current economic conditions, the general allowance for loan and lease losses (ALLL) also includes adjustments for macroeconomic factors. Macroeconomic factors adjust the ALLL upward or downward based on the current point in the economic cycle using predictive economic data and are applied to the loan loss model through a separate allowance element for the commercial, commercial real estate, construction real estate and lease loan components. To determine our macroeconomic factors, we use specific economic data that has shown to be a statistically reliable predictor of our credit losses relative to our long term average credit losses. We tested over 20 economic variables (U.S. manufacturing index, unemployment rate, U.S. GDP growth, etc.). We annually review this data to determine that such a relationship continues to exist. We currently use the following macroeconomic indicators in our macroeconomic factor computation: Commercial loans and lease loans: Japanese bilateral dollar exchange, our prior period charge-off rates and the consumer confidence index. Commercial real estate loans and construction loans: Prime rate, our prior period charge-off rates and the annual change in the U.S. commercial real estate index. Using the indicators noted above, a predicted charge-off percentage is calculated. The predicted charge-off percentage is then compared to the cycle average charge-off percentage used in our EDF computation discussed above, and a macroeconomic adjustment factor is calculated. The macroeconomic adjustment factor is applied to each commercial loan type. Each year, we review the predictive nature of the macroeconomic factors by comparing actual charge-offs to the predicted model charge-offs, re-run our regression analysis and re-calibrate the macroeconomic factors as appropriate. The commercial related general loss reserve was $70.9 million as of June 30, 2014 and $78.3 million as of December 31, 2013. The decrease in the general reserve related primarily to an improvement in risk ratings. Reserves on impaired commercial related loans are included in the "Commercial Related Specific Reserves" section below. Commercial Related Specific Reserves. Our allowance for loan losses also includes specific reserves on impaired commercial loans. A loan is considered to be impaired when management believes, after considering collection efforts and other factors, the borrower's financial condition is such that the collection of all contractual principal and interest payments due is doubtful. At each quarter-end, impaired commercial loans are reviewed individually, with adjustments made to the general calculated reserve for each loan as deemed necessary. Specific adjustments are made depending on expected cash flows and/or the value of the collateral securing each loan. Generally, the Company obtains a current external appraisal (within 12 months) on real estate secured impaired loans. Our appraisal policy is designed to comply with the Interagency Appraisal and Evaluation Guidelines, most recently updated in December 2010. As part of our compliance with these guidelines, we maintain an internal Appraisal Review Department that engages and reviews all third party appraisals. In addition, each impaired commercial loan with real estate collateral is reviewed quarterly by our appraisal department to determine that the most recent valuation remains appropriate during subsequent quarters until the next appraisal is received. If considered necessary by our appraisal department, the appraised value may be further discounted by internally applying accepted appraisal methodologies to an older appraisal. Accepted appraisal methodologies include: income capitalization approach adjusting for changes in underlying leases, adjustments related to condominium projects with units sales, adjustments for loan fundings, and "As is" compared to "As Stabilized" valuations. 62 -------------------------------------------------------------------------------- Other valuation techniques are also used to value non-real estate assets. Discounts may be applied in the impairment analysis used for general business assets (GBA). Examples of GBA include accounts receivable, inventory, and any marketable securities pledged. The discount is used to reflect collection risk in the event of default that may not have been included in the valuation of the asset. The total commercial related specific reserves component of the allowance decreased from $12.8 million as of December 31, 2013 to $10.3 million as of June 30, 2014. Consumer Related Reserves. Pools of homogenous loans with similar risk and loss characteristics are also assessed for probable losses. These loan pools include consumer, residential real estate, home equity, credit cards and indirect vehicle loans. Migration probabilities obtained from past due roll rate analyses and historical loss rates are applied to current balances to forecast charge-offs over a one-year time horizon. The reserves for consumer related loans totaled $19.8 million at June 30, 2014 and $20.6 million at December 31, 2013. We consistently apply our methodology for determining the appropriateness of the allowance for loan losses but may adjust our methodologies and assumptions based on historical information related to charge-offs and management's evaluation of the loan portfolio. In this regard, we periodically review the following to validate our allowance for loan losses: historical net charge-offs as they relate to prior periods' allowance for loan loss, comparison of historical loan migration in past years compared to the current year, overall credit trends and ratios and any significant changes in loan concentrations. In reviewing this data, we adjust qualitative factors within our allowance methodology to appropriately reflect any changes warranted by the validation process. Management believes it has established an allowance for probable loan losses as appropriate under GAAP. 63 --------------------------------------------------------------------------------The following table presents an analysis of the allowance for loan losses for the periods presented (dollars in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Balance at beginning of period $ 108,395 $ 124,733 $ 113,462 $ 128,279 Provision for credit losses (1,950 ) 500 (800 ) 500 Charge-offs: Commercial loans 446 433 536 1,344 Commercial loans collateralized by assignment of lease payments 40 - 40 - Commercial real estate 1,727 1,978 8,883 3,895 Construction real estate 14 747 70 829 Residential real estate 433 399 698 1,361 Home equity 817 1,323 1,436 2,110 Indirect vehicles 583 629 1,503 1,358 Other consumer loans 590 451 1,085 1,016 Total charge-offs 4,650 5,960 14,251 11,913 Recoveries: Commercial loans 696 777 2,324 1,229 Commercial loans collateralized by assignment of lease payments 130 987 130 1,131 Commercial real estate 567 3,647 1,052 4,387 Construction real estate 77 131 176 407 Residential real estate 6 199 525 413 Home equity 127 100 260 214 Indirect vehicles 439 324 881 739 Other consumer loans 68 59 146 111 Total recoveries 2,110 6,224 5,494 8,631 Net charge-offs 2,540 (264 ) 8,757 3,282 Allowance for credit losses 103,905 125,497 103,905 125,497 Allowance for unfunded credit commitments (2,995 ) (1,812 ) (2,995 ) (1,812 ) Allowance for loan losses $ 100,910 $ 123,685 $ 100,910 $ 123,685 Total loans $ 5,556,724 $ 5,668,187 $ 5,556,724 $ 5,668,187 Ratio of allowance to total loans 1.82 % 2.18 % 1.82 % 2.18 % Ratio of net charge-offs to average loans 0.18 (0.02 ) 0.32 0.12 Net charge-offs of $8.8 million were recorded in the six months ended June 30, 2014 compared to net charge-offs of $3.3 million in the six months ended June 30, 2013. A negative provision for credit losses of $800 thousand was recorded for the six months ended June 30, 2014 compared to a provision for credit losses of $500 thousand for the six months ended June 30, 2013 as a result of reduced levels of classified and special mention assets. Additions to the allowance for loan losses, which are charged to earnings through the provision for credit losses, are determined based on a variety of factors, including specific reserves, current loan risk ratings, delinquent loans, historical loss experience and economic conditions in our market area. In addition, federal regulatory authorities, as part of the examination process, periodically review our allowance for loan losses. The regulators may require us to record adjustments to the allowance level based upon their assessment of the information available to them at the time of examination. Although management believes the allowance for loan losses is sufficient to cover probable losses inherent in the loan portfolio, there can be no assurance that the allowance will prove sufficient to cover actual loan losses. We utilize an internal asset classification system as a means of reporting problem and potential problem assets. At scheduled meetings of the board of directors of MB Financial Bank, a watch list is presented, showing significant loan relationships listed as "Special Mention," "Substandard," and "Doubtful." An asset is classified Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as Loss are those considered uncollectible and viewed as valueless assets and have been charged- 64 --------------------------------------------------------------------------------off. Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that deserve management's close attention are deemed to be Special Mention. Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the Office of the Comptroller of the Currency, MB Financial Bank's primary regulator, which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing our loan portfolio, will not request us to materially adjust our allowance for loan losses. The Office of the Comptroller of the Currency, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the allowance for loan losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that (1) institutions have effective systems and controls to identify, monitor and address asset quality problems; (2) management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and (3) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. We analyze our process regularly, with modifications made if needed, and report those results four times per year at meetings of our board of directors. However, there can be no assurance that regulators, in reviewing our loan portfolio, will not request us to materially adjust our allowance for loan losses at the time of their examination. Although management believes that appropriate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary. Lease Investments The lease portfolio is comprised of various types of equipment, generally technology related, including computer systems and satellite equipment, material handling and general manufacturing equipment. Lease investments by categories follow (in thousands): June 30, December 31, June 30, 2014 2013 2013 Direct finance leases: Minimum lease payments $ 190,216 $ 155,945 $ 124,549 Estimated unguaranteed residual values 30,309 31,272 31,789 Less: unearned income (15,518 ) (14,473 ) (10,783 ) Direct finance leases (1) $ 205,007 $ 172,744 $ 145,555 Leveraged leases: Minimum lease payments $ 16,620 $ 24,320 $ 27,023 Estimated unguaranteed residual values 1,908 2,508 2,672 Less: unearned income (979 ) (1,644 ) (2,081 ) Less: related non-recourse debt (15,979 ) (23,243 ) (25,627 ) Leveraged leases (1) $ 1,570 $ 1,941 $ 1,987 Operating leases: Equipment, at cost $ 218,688 $ 218,473 $ 205,541 Less accumulated depreciation (91,494 ) (87,384 ) (91,583 ) Lease investments, net $ 127,194 $ 131,089 $ 113,958 (1) Direct finance and leveraged leases are included as commercial loans collateralized by assignment of lease payments for financial statement purposes. Leases that transfer substantially all of the benefits and risk related to the equipment ownership are classified as direct finance leases. If these direct finance leases have non-recourse debt associated with them and meet the additional requirements for a leveraged lease, they are further classified as leverage leases, and the associated debt is netted with the outstanding balance in the consolidated financial statements. Interest income on direct finance and leveraged leases is recognized using methods which approximate a level yield over the term of the lease. Operating leases are investments in equipment leased to other companies, where the residual component makes up more than 10% of the investment. The Company funds most of the lease equipment 65 --------------------------------------------------------------------------------purchases internally, but has some loans at other banks which totaled $27.0 million at June 30, 2014, $17.5 million at December 31, 2013 and $18.0 million at June 30, 2013. At June 30, 2014, the following reflects the residual values for leases by category in the year the initial lease term ends (in thousands): Residual Values Direct End of initial lease term Finance Leveraged Operating December 31, Leases Leases Leases Total 2014 $ 8,384 $ 210 $ 8,633 $ 17,227 2015 7,504 968 8,302 16,774 2016 6,463 607 10,141 17,211 2017 4,335 105 8,501 12,941 2018 1,763 18 6,081 7,862 Thereafter 1,860 - 2,484 4,344 $ 30,309 $ 1,908 $ 44,142 $ 76,359 The lease residual value represents the present value of the estimated fair value of the leased equipment at the termination of the lease. Lease residual values are reviewed quarterly, and any write-downs or charge-offs deemed necessary are recorded in the period in which they become known. To mitigate this risk of loss, we usually limit individual leased equipment residuals to approximately $500 thousand per transaction and seek to diversify both the type of equipment leased and the industries in which the lessees participate. Often times, there are several individual lease schedules under one master lease. There were 3,569 leases at June 30, 2014 compared to 3,590 at December 31, 2013. The average residual value per lease schedule was approximately $21 thousand at June 30, 2014 and December 31, 2013. The average residual value per master lease schedule was approximately $83 thousand at June 30, 2014 and $82 thousand at December 31, 2013, respectively. Liquidity and Sources of Capital Our cash flows are composed of three classifications: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Cash flows from operating activities primarily include net income, adjusted for items in net income that did not impact cash. Net cash flows provided by operating activities were $101.8 million for the six months ended June 30, 2014 compared to net cash flows provided by operating activities of $60.8 million for the six months ended June 30, 2013. The change is primarily due to the decrease in payables partly offset by the decrease in the change in other assets. Cash used in investing activities reflects the impact of loans and investment securities acquired for the Company's interest-earning asset portfolios, as well as cash flows from asset sales and the impact of acquisitions. For the six months ended June 30, 2014, the Company had net cash flows provided by investing activities of $71.7 million compared to net cash flows provided by investing activities of $235.2 million for the six months ended June 30, 2013. The change was primarily due to a decrease in principal payments received on mortgage-backed securities. Cash flows from financing activities include transactions and events whereby cash is obtained from depositors, creditors or investors. For the six months ended June 30, 2014, the Company had net cash flows provided by financing activities of $114.4 million compared to net cash flows used in financing activities of $150.6 million for the six months ended June 30, 2013. The change in cash flows from financing activities was primarily due to the increase in deposits partly offset by the repayment of the $300.0 million FHLB advance. In the event that additional short-term liquidity is needed, we have established relationships with several large and regional banks to provide short-term borrowings in the form of federal funds purchases. While, at June 30, 2014, there were no firm lending commitments in place, management believes that we could borrow approximately $280 million for a short time from these banks on a collective basis. Additionally, we are a member of Federal Home Loan Bank of Chicago (FHLB). As of June 30, 2014, the Company had $4.2 million outstanding in FHLB advances, and could borrow an additional amount of approximately $480.4 million. As a contingency plan for significant funding needs, the Asset/Liability Committee may also consider the sale of investment securities, selling securities under agreement to repurchase, or the temporary curtailment of lending activities. As of June 30, 2014, the Company had approximately $1.4 billion of unpledged securities, excluding securities available for pledge at the FHLB. 66 -------------------------------------------------------------------------------- Our main sources of liquidity at the holding company level are dividends from MB Financial Bank and cash on hand. In addition, the Company has a $35.0 million unsecured line of credit with a correspondent bank. As of June 30, 2014, no amount was outstanding. The holding company had $154.7 million in cash as of June 30, 2014. See Notes 9 and 10 of the Financial Statements presented under Item 1 of this report for details of period end balances and other information for these various funding sources. There were no material changes outside the ordinary course of business in the Company's contractual obligations at June 30, 2014 as compared to December 31, 2013. MB Financial Bank is subject to various regulatory capital requirements which affect its ability to pay dividends to us. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Additionally, our current internal policy effectively limits the amount of dividends our subsidiary bank may pay to us by requiring the bank to maintain total risk-based capital, Tier 1 risk-based capital and Tier 1 leverage capital ratios of 12.00%, 9.00% and 8.00%, respectively. The minimum ratios required for a bank to be considered "well capitalized" for regulatory purposes are 10.00%, 6.00% and 5.00%, respectively. In addition to adhering to our policy, there are regulatory restrictions on the ability of national banks to pay dividends. See "Item 1. Business - Supervision and Regulation" in our Annual Report on Form 10-K for the year ended December 31, 2013. At June 30, 2014, the Company's total risk-based capital ratio was 17.18%, Tier 1 capital to risk-weighted assets ratio was 15.92% and Tier 1 capital to average asset ratio was 11.61%. MB Financial Bank's total risk-based capital ratio was 14.67%, Tier 1 capital to risk-weighted assets ratio was 13.42% and Tier 1 capital to average asset ratio was 9.77%. MB Financial Bank was categorized as "Well-Capitalized" at June 30, 2014 under the regulations of the Office of the Comptroller of the Currency. Non-GAAP Financial Information This report contains certain financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (GAAP). These measures include net interest income on a fully tax equivalent basis and net interest margin on a fully tax equivalent basis. Our management uses these non-GAAP measures, together with the related GAAP measures, in its analysis of our performance and in making business decisions. Management also uses these measures for peer comparisons. The tax equivalent adjustment to net interest income recognizes the income tax savings when comparing taxable and tax-exempt assets and assumes a 35% tax rate. Management believes that it is a standard practice in the banking industry to present net interest income and net interest margin on a fully tax equivalent basis, and accordingly believes that providing these measures may be useful for peer comparison purposes. These disclosures should not be viewed as substitutes for the results determined to be in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. Reconciliations of net interest income on a fully tax equivalent basis to net interest income and net interest margin on a fully tax equivalent basis to net interest margin are contained in the tables under "Net Interest Margin." Forward-Looking Statements When used in this Quarterly Report on Form 10-Q and in other documents filed or furnished with the Securities and Exchange Commission, in press releases or other public shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "believe," "will," "should," "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," "plans," or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date made. These statements may relate to MB Financial, Inc.'s future financial performance, strategic plans or objectives, revenues or earnings projections, or other financial items. By their nature, these statements are subject to numerous uncertainties that could cause actual results to differ materially from those anticipated in the statements. Important factors that could cause actual results to differ materially from the results anticipated or projected include, but are not limited to, the following: (1) expected revenues, cost savings, synergies and other benefits from the pending MB Financial-Taylor Capital merger and our other merger and acquisition activities might not be realized within the anticipated time frames or at all, and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, might be greater than expected; (2) the possibility that the expected benefits of the FDIC-assisted and other transactions we previously completed will not be realized; (3) the credit risks of lending activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan losses, which could necessitate additional provisions for loan losses, resulting both from loans we originate and loans we acquire from other financial institutions; (4) results of examinations by the Office of Comptroller of Currency, the Federal Reserve Board and other regulatory authorities, 67 -------------------------------------------------------------------------------- including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for loan losses or write-down assets; (5) competitive pressures among depository institutions; (6) interest rate movements and their impact on customer behavior and net interest margin; (7) the impact of repricing and competitors' pricing initiatives on loan and deposit products; (8) fluctuations in real estate values; (9) the ability to adapt successfully to technological changes to meet customers' needs and developments in the market-place; (10) our ability to realize the residual values of our direct finance, leveraged, and operating leases; (11) our ability to access cost-effective funding; (12) changes in financial markets; (13) changes in economic conditions in general and in the Chicago metropolitan area in particular; (14) the costs, effects and outcomes of litigation, including, without limitation, litigation relating to the pending MB Financial-Taylor Capital merger; (15) new legislation or regulatory changes, including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act") and regulations adopted thereunder, changes in capital requirements pursuant to the Dodd-Frank Act and the implementation of the Basel III capital standards, other governmental initiatives affecting the financial services industry and changes in federal and/or state tax laws or interpretations thereof by taxing authorities; (16) changes in accounting principles, policies or guidelines; (17) our future acquisitions of other depository institutions or lines of business; and (18) future goodwill impairment due to changes in our business, changes in market conditions, or other factors. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date on which the forward-looking statement is made. |