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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, card fees and mortgage banking revenue. 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 (gain) on other real estate owned and other 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, leasing and mortgage banking 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. On August 18, 2014, the Company completed the Taylor Capital Group, Inc. ("Taylor Capital") merger. Consideration paid was $639.8 million, including $519.3 million in common stock and $120.5 million in cash. The Company issued 19.6 million shares of common stock as a result of the merger. In addition, each share of Taylor Capital's Perpetual Non-Cumulative Preferred Stock, Series A was converted into one share of the Company's Perpetual Non-Cumulative Preferred Stock, Series A with substantially identical terms. The results of operations acquired from Taylor Capital have been included in the Company's results of operations for the 44 days since the date of acquisition. The Company had net income of $6.9 million for the three months ended September 30, 2014 compared to net income of $24.4 million for the three months ended September 30, 2013. Net income available to common stockholders was $4.9 million for the three months ended September 30, 2014. Fully diluted earnings per common share were $0.08 for the three months ended September 30, 2014 compared to $0.44 per common share for the three months ended September 30, 2013. The Company had net income of $50.0 million for the nine months ended September 30, 2014 compared to net income of $74.6 million for the nine months ended September 30, 2013. Net income available to common stockholders was $48.0 million for the nine months ended September 30, 2014. Fully diluted earnings per common share were $0.82 for the nine months ended September 30, 2014 compared to $1.36 per common share for the nine months ended September 30, 2013. The results of operations for the three and nine months ended September 30, 2014 were also impacted by $27.2 million and $28.3 million in merger related expenses, respectively. See "Non-interest Expenses" section for a detailed schedule of merger related expenses. In addition, our results of operations for the periods were affected by $10.6 million in contingent consideration expense that we recognized in the third quarter of 2014. In December 2012, we acquired Celtic Leasing Corp. ("Celtic"). The purchase consideration paid to Celtic's selling shareholders included the right to receive certain contingent payments based on the realization of residuals owned by Celtic on the transaction closing date. Given Celtic's stronger than expected lease residual performance subsequent to the acquisition, we have increased the fair value of the residual based contingent consideration by $10.6 million. 53 -------------------------------------------------------------------------------- In September 2014, we repositioned our balance sheet and shortened the duration of our investment securities portfolio to pre-merger levels by selling $451.6 million in investment securities and utilizing the proceeds from the sales to reduce short term FHLB advances. A $3.2 million loss was recognized on investment securities in the third quarter of 2014 as a result of this balance sheet repositioning. In September 2014, we also redeemed all of the outstanding 9.75% junior subordinated notes relating to the trust preferred securities of TAYC Capital Trust I. These notes were originally issued by Taylor Capital and were assumed by us in connection with the merger. The TAYC Capital Trust I trust preferred securities, which had an aggregate outstanding liquidation amount of $45.4 million, were automatically redeemed as a result of our redemption of the junior subordinated notes. A $1.9 million gain on the early extinguishment of the trust preferred securities was recorded in other operating income in the third quarter of 2014, which represented the difference between the fair market value of these securities on August 18, 2014 and their aggregate liquidation amount at redemption. 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 September 30, 2014, the aggregate residual value of the equipment leased under our direct finance, leveraged, and operating leases totaled $114.8 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 September 30, 2014, the Company had $1.0 million 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 54 -------------------------------------------------------------------------------- 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 September 30, 2014, the Company had approximately $10 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 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 three reporting units: banking, leasing and mortgage banking. No impairment losses were recognized during the three or nine months ended September 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 September 30, 2014. The carrying amount of goodwill was $698.9 million at September 30, 2014 and $423.4 million at December 31, 2013. The increase of $275.6 million in goodwill was due to the Taylor Capital merger. Valuation of Mortgage Servicing Rights. The Company originates and sells residential mortgage loans in the secondary market and may retain the right to service the loans sold. Servicing involves the collection of payments from individual borrowers and the distribution of those payments to the investors. Upon a sale of mortgage loans for which servicing rights are retained, the retained mortgage servicing rights asset is capitalized at the fair value of future net cash flows expected to be realized for performing servicing activities. Purchased mortgage servicing rights are recorded at the purchase price at the date of purchase and at fair value thereafter. Mortgage servicing rights do not trade in an active market with readily observable prices. The Company determines the fair value of mortgage servicing rights by estimating the fair value of the future cash flows associated with the mortgage loans being serviced. Key economic assumptions used in measuring the fair value of mortgage servicing rights include, but are not limited to, prepayment speeds, discount rates, delinquencies and cost to service. The assumptions used in the valuation model are validated on a periodic basis. The fair value is validated on a quarterly basis with an independent third party. Material discrepancies between the internal valuation and the third party valuation are analyzed and an internal committee determines whether or not an adjustment is required. The Company has elected to account for mortgage servicing rights using the fair value option. Changes in the fair value are recognized in mortgage banking revenue on the Company's Consolidated Statements of Income. 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 anticipated effects on results of operations and financial condition. 55 --------------------------------------------------------------------------------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. Three Months Ended September 30, (dollars in thousands) 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Interest Earning Assets: Loans held for sale $ 313,695 $ 2,826 3.60 % $ 1,972 $ - - % Loans (1) (2) (3) 6,862,043 77,077 4.56 5,194,976 57,325 4.38 Loans exempt from federal income taxes (4) 320,049 3,484 4.26 360,060 4,293 4.67 Taxable investment securities 1,726,352 11,028 2.56 1,292,366 6,330 1.96 Investment securities exempt from federal income taxes (4) 1,087,340 13,908 5.12 946,396 12,577 5.32 Federal funds sold 15,460 14 0.38 6,793 7 0.40 Other interest earning deposits 341,758 211 0.24 316,210 193 0.24 Total interest earning assets 10,666,697 $ 108,548 4.04 8,118,773 $ 80,725 3.94 Non-interest earning assets 1,539,333 1,142,518 Total assets $ 12,206,030 $ 9,261,291 Interest Bearing Liabilities: Deposits: NOW and money market deposit $ 3,518,315 $ 1,469 0.17 % $ 2,695,479 $ 862 0.13 % Savings deposit 906,630 128 0.06 844,647 137 0.06 Time deposits 1,828,752 3,018 0.65 1,572,987 3,434 0.87 Short-term borrowings 570,248 231 0.16 205,946 112 0.22 Long-term borrowings and junior subordinated notes 272,458 2,003 2.88 215,041 1,367 2.49 Total interest bearing liabilities 7,096,403 $ 6,849 0.38 5,534,100 $ 5,912 0.42 Non-interest bearing deposits 3,175,513 2,258,357 Other non-interest bearing liabilities 268,028 171,336 Stockholders' equity 1,666,086 1,297,498 Total liabilities and stockholders' equity $ 12,206,030 $ 9,261,291 Net interest income/interest rate spread (5) $ 101,699 3.66 % $ 74,813 3.52 % Less: taxable equivalent adjustment 6,087 5,905 Net interest income, as reported $ 95,612 $ 68,908 Net interest margin (6) 3.56 % 3.37 % Tax equivalent effect 0.22 % 0.29 % Net interest margin on a fully tax equivalent basis (6) 3.78 % 3.66 % (1) Non-accrual loans are included in average loans. (2) Interest income includes amortization of net deferred loan origination fees and costs. (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 and net interest margin on a fully tax equivalent basis for the three and nine months ended September 30, 2014 were impacted by the Taylor Capital merger. Net interest income on a fully tax equivalent basis increased $26.9 million during the three months ended September 30, 2014 compared to the three months ended September 30, 2013. The net interest margin, expressed on a fully tax equivalent basis, was 3.78% for the third quarter of 2014 and 3.66% for the third quarter of 2013. 56 -------------------------------------------------------------------------------- Nine Months Ended September 30, (dollars in thousands) 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Interest Earning Assets: Loans held for sale $ 105,977 $ 2,826 3.56 % $ 3,259 $ - - % Loans (1) (2) (3) 5,787,427 184,672 4.27 5,289,237 173,217 4.38 Loans exempt from federal income taxes (4) 320,263 10,490 4.37 327,618 11,188 4.50 Taxable investment securities 1,516,281 27,968 2.46 1,383,975 18,749 1.81 Investment securities exempt from federal income taxes (4) 997,128 39,066 5.22 930,653 37,537 5.38 Federal funds sold 8,605 23 0.37 3,249 9 0.37 Other interest bearing deposits 326,226 601 0.25 232,529 420 0.24 Total interest earning assets 9,061,907 $ 265,646 3.92 8,170,520 $ 241,120 3.95 Non-interest earning assets 1,331,812 1,162,210 Total assets $ 10,393,719 $ 9,332,730 Interest Bearing Liabilities: Deposits: NOW and money market deposit $ 3,045,178 $ 3,216 0.14 % $ 2,702,567 $ 2,622 0.13 % Savings deposit 879,336 334 0.05 835,754 409 0.07 Time deposits 1,548,468 8,588 0.74 1,692,760 12,243 0.97 Short-term borrowings 319,697 426 0.18 195,677 395 0.27 Long-term borrowings and junior subordinated notes 243,659 4,725 2.56 226,133 4,324 2.52 Total interest bearing liabilities 6,036,338 $ 17,289 0.38 5,652,891 $ 19,993 0.47 Non-interest bearing deposits 2,677,865 2,194,648 Other non-interest bearing liabilities 227,333 193,203 Stockholders' equity 1,452,183 1,291,988 Total liabilities and stockholders' equity $ 10,393,719 $ 9,332,730 Net interest income/interest rate spread (5) $ 248,357 3.54 % $ 221,127 3.48 % Less: taxable equivalent adjustment 17,345 17,054 Net interest income, as reported $ 231,012 $ 204,073 Net interest margin (6) 3.41 % 3.34 % Tax equivalent effect 0.25 % 0.28 % Net interest margin on a fully tax equivalent basis (6) 3.66 % 3.62 % (1) Non-accrual loans are included in average loans. (2) Interest income includes amortization of net deferred loan origination fees and costs. (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 $27.2 million during the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The net interest margin, expressed on a fully tax equivalent basis, was 3.66% for the nine months ended September 30, 2014 and 3.62% for the nine months ended September 30, 2013. As noted above, on August 18, 2014, we completed the Taylor Capital merger. The acquired assets and assumed liabilities were recorded at fair value as required under the acquisition method of accounting. Fair value adjustments are amortized or accreted into net interest income over the remaining terms of the interest earning assets and interest bearing liabilities. The fair value adjustment on acquired loans had the most significant impact on net interest margin. Net interest income in the third quarter of 2014 included interest income of $6.2 million resulting from the accretion of the purchase accounting discount recorded on the loans acquired in the Taylor Capital merger. Excluding the purchase accounting loan discount accretion on Taylor Capital loans, our net interest margin on a fully tax equivalent basis would have been 3.54% and 3.57% for the three and nine months ended September 30, 2014, respectively, compared to 3.66% and 3.62% for the three and nine months ended September 30, 2013. 57 -------------------------------------------------------------------------------- Non-interest Income Three Months Ended September 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest income (in thousands): Lease financing, net $ 17,719 $ 14,070 $ 3,649 25.9 % Mortgage banking revenue 16,823 177 16,646 NM Commercial deposit and treasury management fees 9,345 6,327 3,018 47.7 Trust and asset management fees 5,712 4,799 913 19.0 Card fees 3,836 2,745 1,091 39.7 Capital markets and international banking fees 1,472 972 500 51.4 Consumer and other deposit service fees 3,362 3,648 (286 ) (7.8 ) Brokerage fees 1,145 1,289 (144 ) (11.2 ) Loan service fees 1,069 1,427 (358 ) (25.1 ) Increase in cash surrender value of life insurance 855 851 4 0.5 Net (loss) gain on investment securities (3,246 ) 1 (3,247 ) NM Net loss on sale of assets (7 ) - (7 ) NM Gain on early extinguishment of debt 1,895 - 1,895 NM Other operating income 1,107 1,401 (294 ) (21.0 ) Total non-interest income $ 61,087 $ 37,707 $ 23,380 62.0 % NM - not meaningful Non-interest income increased by $23.4 million, or 62.0%, for the three months ended September 30, 2014 compared to the three months ended September 30, 2013. • Mortgage banking revenue increased due to the acquisition of Taylor Capital's mortgage operations through the merger. • Leasing revenues increased due to higher fees and promotional revenue from the sale of third-party equipment maintenance contracts. The Company acquired another leasing subsidiary, Cole Taylor Equipment Finance, through the Taylor Capital merger. Cole Taylor Equipment Finance contributed approximately $404 thousand to leasing revenues in the third quarter of 2014 since the date of acquisition. • Commercial deposit and treasury management fees increased due to the increased customer base as a result of the Taylor Capital merger and new customer activity prior to the merger. • Card fees increased due to the full quarter impact of a new payroll prepaid card program that started in the second quarter of 2014. • Trust and asset management fees increased due to the addition of new customers and the impact of higher equity values. • A gain on the early extinguishment of debt and net loss on investment securities were recognized in the third quarter of 2014 as a result of the balance sheet repositioning that occurred in September 2014, as noted earlier. 58 -------------------------------------------------------------------------------- Nine Months Ended September 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest income (in thousands): Lease financing, net $ 45,768 $ 45,435 $ 333 0.7 % Mortgage banking revenue 17,069 1,322 15,747 NM Commercial deposit and treasury management fees 23,595 18,322 5,273 28.8 Trust and asset management fees 16,324 14,167 2,157 15.2 Card fees 9,841 8,175 1,666 20.4 Capital markets and international banking fees 3,810 2,719 1,091 40.1 Consumer and other deposit service fees 9,453 10,487 (1,034 ) (9.9 ) Brokerage fees 3,826 3,680 146 4.0 Loan service fees 2,950 4,349 (1,399 ) (32.2 ) Increase in cash surrender value of life insurance 2,516 2,537 (21 ) (0.8 ) Net (loss) gain on investment securities (3,016 ) 14 (3,030 ) NM Net loss on sale of assets (24 ) - (24 ) NM Gain on early extinguishment of debt 1,895 - 1,895 NM Other operating income 3,620 4,142 (522 ) (12.6 ) Total non-interest income $ 137,627 $ 115,349 $ 22,278 19.3 % NM - not meaningful Non-interest income increased by $22.3 million, or 19.3%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. • Mortgage banking revenue increased due to the acquisition of Taylor Capital's mortgage operations through the merger. • Commercial deposit and treasury management fees increased due to robust new customer activity as well as the increased customer base as a result of the Taylor Capital merger. • Trust and asset management fees increased due to the addition of new customers and the impact of higher equity values. • Card fees increased due to a new payroll prepaid card program as well as higher credit card fees. • Capital markets and international banking services 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 NSF and overdraft charges. • A gain on the early extinguishment of debt and net loss on investment securities were recognized in the third quarter of 2014 as a result of the balance sheet repositioning that occurred in September 2014, as noted earlier. 59 -------------------------------------------------------------------------------- Non-interest Expenses Three Months Ended September 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest expenses (in thousands): Salaries and employee benefits $ 79,492 $ 44,918 $ 34,574 77.0 % Occupancy and equipment expense 11,742 8,797 2,945 33.5 Computer services and telecommunication expense 11,506 4,870 6,636 136.3 Advertising and marketing expense 2,235 1,917 318 16.6 Professional and legal expense 8,864 3,102 5,762 185.8 Other intangibles amortization expense 1,470 1,513 (43 ) (2.8 ) Net loss recognized on other real estate owned 1,769 791 978 123.6 Other real estate expense, net 409 240 169 70.4 Other operating expenses 24,714 10,117 14,597 144.3 Total non-interest expenses $ 142,201 $ 76,265 $ 65,936 86.5 % Non-interest expenses increased by $65.9 million, or 86.5%, for the three months ended September 30, 2014 from the three months ended September 30, 2013. Non-interest expenses include $27.2 million in expenses related to the merger with Taylor Capital. The following table presents the detail of the merger related expenses (dollars in thousands): Three Months Ended September 30, 2014 Merger related expenses: Salaries and employee benefits $ 14,259 Occupancy and equipment expense 428 Computer services and telecommunication expense 5,312 Advertising and marketing expense 262 Professional and legal expense 6,363 Other operating expenses 537 Total merger related expenses $ 27,161 Other explanations for changes are as follows: • Salaries and employee benefits increased due to annual salary increases, long-term incentive expense, taxes and temporary staffing needs and the increased staff from the Taylor Capital merger. • Other operating expense increased primarily as a result of the $10.6 million contingent consideration expense related to our acquisition of Celtic Leasing Corp., an increase in filing and other loan expense as well as higher FDIC assessments due to our larger balance sheet 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 the leasing, treasury management and card areas. The increase was also due to increased telecommunication expense related to transitioning to a new provider. • Occupancy and equipment expense increased due to the additional offices acquired in the Taylor Capital merger. 60 -------------------------------------------------------------------------------- Nine Months Ended September 30, Increase/ Percentage 2014 2013 (Decrease) Change Non-interest expenses (in thousands): Salaries and employee benefits $ 170,491 $ 132,341 $ 38,150 28.8 % Occupancy and equipment expense 30,852 27,609 3,243 11.7 Computer services and telecommunication expense 21,669 13,374 8,295 62.0 Advertising and marketing expense 6,537 6,187 350 5.7 Professional and legal expense 12,210 5,750 6,460 112.3 Other intangibles amortization expense 3,884 4,595 (711 ) (15.5 ) Net loss (gain) recognized on other real estate owned 2,147 (894 ) 3,041 (340.2 ) Other real estate expense, net 1,142 572 570 99.7 Other operating expenses 47,346 28,413 18,933 66.6 Total non-interest expenses $ 296,278 $ 217,947 $ 78,331 35.9 % Non-interest expenses increased by $78.3 million, or 35.9%, for the nine months ended September 30, 2014 from the nine months ended September 30, 2013. Non-interest expenses include $28.3 million in expenses related to the merger with Taylor Capital. The following table presents the detail of the merger related expenses (dollars in thousands): Nine Months Ended September 30, 2014 Merger related expenses: Salaries and employee benefits $ 14,363 Occupancy and equipment expense 442 Computer services and telecommunication expense 5,495 Advertising and marketing expense 460 Professional and legal expense 6,852 Other operating expenses 717 Total merger related expenses $ 28,329 We expect to incur additional merger related expenses in the next few quarters primarily in the area of occupancy and equipment expense. Other explanations for changes are as follows: • Salaries and employee benefits increased due to annual salary increases, long-term incentive expense, health insurance and temporary staffing needs and the increased staff from the Taylor Capital merger. • Other operating expense increased primarily as a result of an increase in filing and other loan expense, higher FDIC assessments due to our larger balance sheet and higher currency delivery expenses related to new treasury management accounts and the $10.6 million contingent consideration expense related to our acquisition of Celtic Leasing Corp. • 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 the leasing, treasury management and card areas. The increase was also due to increased telecommunication expense related to transitioning to a new provider. 61 --------------------------------------------------------------------------------Income Taxes Income tax expense for the nine months ended September 30, 2014 was $20.1 million compared to $29.7 million for the nine months ended September 30, 2013. The decrease was primarily due to a decrease in our pre-tax income during the nine months ended September 30, 2014, partially offset by certain costs incurred in 2014 that were not deductible for tax purposes. These include the contingent consideration expense related to the Celtic acquisition and certain legal and professional fees associated with the Taylor Capital merger. Balance Sheet Total assets increased $4.9 billion, or 50.5%, from $9.6 billion at December 31, 2013 to $14.5 billion at September 30, 2014 primarily due to the assets acquired through the Taylor Capital merger. • Cash and cash equivalents decreased $26.7 million, or 5.6% from $473.5 million at December 31, 2013 to $446.8 million at September 30, 2014 primarily due to the repayment of short term borrowings. • Investment securities increased $486.7 million, or 20.7%, from December 31, 2013 to September 30, 2014 mostly as a result of the investment securities acquired through the Taylor Capital merger partly offset by the $451.6 million sale of certain investment securities as part of the balance sheet repositioning in September 2014. • Gross loans, excluding purchased credit-impaired including covered loans, increased by $3.2 billion to $8.7 billion at September 30, 2014 from December 31, 2013 primarily due to the loans acquired through the Taylor Capital merger. Total liabilities increased by $4.2 billion, or 50.5%, from $8.3 billion at December 31, 2013 to $12.5 billion at September 30, 2014 primarily due to the liabilities assumed through the Taylor Capital merger. • Total deposits increased by $3.9 billion, or 52.3%, to $11.2 billion at September 30, 2014 from December 31, 2013 primarily due to the deposits assumed through the Taylor Capital merger. • Noninterest bearing deposits increased by 67.8% and 60.3% compared to September 30, 2013 and December 31, 2013, respectively, primarily due to the noninterest bearing deposits acquired through Taylor Capital Merger. • Total borrowings increased by $222.5 million, or 31.4%, to $930.1 million at September 30, 2014. The increase in total borrowings was primarily due to the borrowings assumed in the Taylor Capital merger partly offset by the repayment of short term FHLB advance and junior subordinated notes as part of the balance sheet repositioning in September 2014. Total stockholders' equity increased $664.7 million to $2.0 billion at September 30, 2014 compared to December 31, 2013 primarily as a result of the equity issued in the connection with the Taylor Capital merger. 62 --------------------------------------------------------------------------------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): September 30, 2014 December 31, 2013 September 30, 2013 Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value Available for sale U.S. Government sponsored agencies and enterprises $ 64,809 $ 65,829 $ 50,486 $ 52,068 $ 50,678 $ 52,527 States and political subdivisions 391,900 409,033 19,398 19,143 19,461 19,312 Residential mortgage-backed securities 795,554 801,940 696,415 701,233 685,126 691,276 Commercial mortgage-backed securities 204,076 204,162 50,891 52,941 50,944 53,446 Corporate bonds 265,720 267,239 284,083 283,070 265,293 263,021 Equity securities 10,470 10,447 10,649 10,457 10,574 10,541 Total Available for Sale 1,732,529 1,758,650 1,111,922 1,118,912 1,082,076 1,090,123 Held to maturity States and political subdivisions 760,674 788,097 932,955 936,173 941,273 946,309 Residential mortgage-backed securities 244,675 257,420 249,578 262,756 252,271 266,439 Total Held to Maturity 1,005,349 1,045,517 1,182,533 1,198,929 1,193,544 1,212,748 Total $ 2,737,878 $ 2,804,167 $ 2,294,455 $ 2,317,841 $ 2,275,620 $ 2,302,871 During the third quarter of 2014, the Company repositioned its balance sheet subsequent to the Taylor Capital merger and sold certain longer-term and lower-coupon investment securities with an approximate carrying amount of $451.6 million. These investment security sales shortened the overall duration of the investment securities portfolio to pre-merger levels. Also as a part of the balance sheet repositioning, securities of states and political subdivisions with an approximate fair value of $291.2 million were transferred from held to maturity to available for sale during the third quarter of 2014. As a result of the repositioning, we recognized a net loss of $3.2 million. 63 --------------------------------------------------------------------------------Loan Portfolio The following table sets forth the composition of our loan portfolio (excluding loans held for sale) as of the dates indicated (dollars in thousands): September 30, 2014 December 31, 2013 September 30, 2013 % of % of % of Amount Total Amount Total Amount Total Commercial related credits: Commercial loans $ 3,078,590 34 % $ 1,281,377 22 % $ 1,169,009 21 % Commercial loans collateralized by assignment of lease payments 1,631,660 18 1,494,188 26 1,468,814 26 Commercial real estate 2,646,895 30 1,647,700 29 1,638,368 29 Construction real estate 230,999 3 141,253 3 136,146 2 Total commercial related credits 7,588,144 85 4,564,518 80 4,412,337 78 Other loans: Residential real estate 516,873 5 314,440 5 311,256 6 Indirect vehicle 273,038 3 262,632 5 257,740 5 Home equity 262,977 3 268,289 5 274,484 5 Other consumer loans 69,028 1 66,952 1 57,418 1 Total other loans 1,121,916 12 912,313 16 900,898 17 Gross loans excluding purchased credit-impaired and covered loans 8,710,060 97 5,476,831 96 5,313,235 95 Purchased credit-impaired including covered loans (1) 272,957 3 235,720 4 273,497 5 Total loans $ 8,983,017 100 % $ 5,712,551 100 % $ 5,586,732 100 % (1) Covered loans refer to loans we acquired in FDIC-assisted transactions that have been subject to loss-sharing agreements with the FDIC. Gross loans, excluding purchased credit-impaired and covered loans, increased by $3.2 billion to $8.7 billion at September 30, 2014 from December 31, 2013. Gross loans increased by $3.3 billion to $9.0 billion at September 30, 2014 from $5.7 billion at December 31, 2013. This increase was primarily due to the Taylor Capital merger. 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 loans held for sale and purchased credit-impaired loans. 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. 64 --------------------------------------------------------------------------------The following table sets forth the amounts of non-performing loans and non-performing assets at the dates indicated (dollars in thousands): September 30, December 31, September 30, 2014 2013 2013 Non-performing loans: Non-accruing loans $ 97,580 $ 106,115 $ 102,042 Loans 90 days or more past due, still accruing interest 2,681 446 410 Total non-performing loans 100,261 106,561 102,452 Other real estate owned 19,179 23,289 31,356 Repossessed assets 126 840 861 Total non-performing assets $ 119,566 $ 130,690 $ 134,669 Total allowance for loan losses $ 102,810 $ 111,746 $ 118,031 Accruing restructured loans (1) 16,877 29,430 29,911 Total non-performing loans to total loans 1.12 % 1.87 % 1.83 % Total non-performing assets to total assets 0.82 1.36 1.45 Allowance for loan losses to non-performing loans 102.54 104.87 115.21 (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 consist 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. 65 -------------------------------------------------------------------------------- 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 FDIC-assisted transactions totaled $19.5 million and $19.6 million at September 30, 2014 and December 31, 2013, respectively, much of which 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 nine months ended September 30, 2014 and 2013 (in thousands): September 30, 2014 2013 Beginning balance $ 23,289 $ 36,977Transfers in at fair value less estimated costs to sell 872 6,060 Acquired from business combination 5,082 - Capitalized other real estate owned costs - 53 Fair value adjustments (2,509 ) 80 Net gains on sales of other real estate owned 835 977 Cash received upon disposition (8,390 ) (12,791 ) Ending balance $ 19,179 $ 31,356 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, excluding purchased credit-impaired loans, at the dates indicated (in thousands): September 30, December 31, 2014 2013 Commercial loans $ 23,898 $ 43,844 Commercial loans collateralized by assignment of lease payments 2,412 2,459 Commercial real estate 25,380 32,895 Construction real estate - 391 Total $ 51,690 $ 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. 66 -------------------------------------------------------------------------------- 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 $76.6 million as of September 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. 67 -------------------------------------------------------------------------------- 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 $5.8 million as of September 30, 2014 due primarily to an improvement in credit quality on impaired loans and in part to loans charged off. 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 $20.4 million at September 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. 68 --------------------------------------------------------------------------------The following table presents an analysis of the allowance for loan losses for the periods presented (dollars in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Balance at beginning of period $ 103,905 $ 125,497 $ 113,462 $ 128,279 Allowance for unfunded credit commitments acquired through business combination 1,261 - 1,261 - Utilization of allowance for unfunded credit commitments (637 ) - (637 ) - Provision for credit losses 3,109 (3,304 ) 2,309 (2,804 ) Charge-offs: Commercial loans 606 1,686 1,142 3,030 Commercial loans collateralized by assignment of lease payments - - 40 - Commercial real estate 1,027 1,236 9,910 5,131 Construction real estate 5 26 75 855 Residential real estate 740 713 1,438 2,074 Home equity 566 437 2,002 2,547 Indirect vehicles 1,043 572 2,546 1,930 Other consumer loans 497 485 1,582 1,501 Total charge-offs 4,484 5,155 18,735 17,068 Recoveries: Commercial loans 564 579 2,888 1,808 Commercial loans collateralized by assignment of lease payments 425 - 555 1,131 Commercial real estate 2,227 966 3,279 5,353 Construction real estate 25 420 201 827 Residential real estate 4 48 529 461 Home equity 46 228 306 442 Indirect vehicles 402 372 1,283 1,111 Other consumer loans 65 74 211 185 Total recoveries 3,758 2,687 9,252 11,318 Net charge-offs 726 2,468 9,483 5,750 Allowance for credit losses 106,912 119,725 106,912 119,725 Allowance for unfunded credit commitments (4,102 ) (1,694 ) (4,102 ) (1,694 ) Allowance for loan losses $ 102,810 $ 118,031 $ 102,810 $ 118,031 Total loans $ 8,983,017 $ 5,586,732 $ 8,983,017 $ 5,586,732 Ratio of allowance to total loans 1.14 % 2.11 % 1.14 % 2.11 % Ratio of net charge-offs to average loans 0.04 0.18 0.21 0.14 Net charge-offs of $9.5 million were recorded in the nine months ended September 30, 2014 compared to net charge-offs of $5.8 million in the nine months ended September 30, 2013. A provision for credit losses of $2.3 million was recorded for the nine months ended September 30, 2014 compared to a negative provision for credit losses of $2.8 million for the nine months ended September 30, 2013. The provision for credit losses for the nine months ended September 30, 2014 included a negative provision for credit losses of $2.4 million for the legacy MB Financial portfolio and a positive provision of $4.7 million related to the acquired Taylor Capital portfolio for loan renewals subsequent to the acquisition date and the establishment of a corresponding general reserve for Taylor Capital loans in excess of the loan discount. We anticipate recording a provision related to the acquired portfolio in future quarters related to renewing Taylor loans which will largely offset the accretion from non-purchase credit-impaired loans. 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. 69 -------------------------------------------------------------------------------- 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-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. 70 --------------------------------------------------------------------------------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): September 30, December 31, September 30, 2014 2013 2013 Direct finance leases: Minimum lease payments $ 312,507 $ 155,945 $ 140,162 Estimated unguaranteed residual values 62,628 31,272 31,515 Less: unearned income (29,448 ) (14,473 ) (14,607 ) Direct finance leases (1) $ 345,687 $ 172,744 $ 157,070 Leveraged leases: Minimum lease payments $ 13,549 $ 24,320 $ 23,232 Estimated unguaranteed residual values 1,712 2,508 2,573 Less: unearned income (734 ) (1,644 ) (1,644 ) Less: related non-recourse debt (13,064 ) (23,243 ) (22,174 ) Leveraged leases (1) $ 1,463 $ 1,941 $ 1,987 Operating leases: Equipment, at cost $ 231,529 $ 218,473 $ 202,879 Less accumulated depreciation (94,409 ) (87,384 ) (90,388 ) Lease investments, net $ 137,120 $ 131,089 $ 112,491 (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 purchases internally, but has some loans at other banks which totaled $32.8 million at September 30, 2014, $17.5 million at December 31, 2013 and $17.7 million at September 30, 2013. 71 --------------------------------------------------------------------------------At September 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 $ 4,637 $ 28 $ 6,374 $ 11,039 2015 8,694 954 8,259 17,907 2016 7,875 606 10,276 18,757 2017 14,743 105 9,105 23,953 2018 10,053 19 6,663 16,735 Thereafter 16,626 - 9,769 26,395 $ 62,628 $ 1,712 $ 50,446 $ 114,786 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 generally 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 $1 million 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 3,785 leases at September 30, 2014 compared to 3,590 at December 31, 2013. The average residual value per lease schedule was approximately $30 thousand at September 30, 2014 and $21 thousand at December 31, 2013. The average residual value per master lease schedule was approximately $125 thousand at September 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 $281.7 million for the nine months ended September 30, 2014 compared to net cash flows provided by operating activities of $126.3 million for the nine months ended September 30, 2013. The change is primarily due to the increase in sales of loans held for sale as a result of the acquisition of Taylor Capital's mortgage operations through the merger. 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 nine months ended September 30, 2014, the Company had net cash flows provided by investing activities of $705.1 million compared to net cash flows provided by investing activities of $139.0 million for the nine months ended September 30, 2013. The change was primarily due to proceeds from sales of investment securities related to the balance sheet repositioning in September 2014 as well as the decrease in covered loans. Cash flows from financing activities include transactions and events whereby cash is obtained from depositors, creditors or investors. For the nine months ended September 30, 2014, the Company had net cash flows used in financing activities of $1.0 billion compared to net cash flows used in financing activities of $296.2 million for the nine months ended September 30, 2013. The change in cash flows from financing activities was primarily due to the decrease in short-term borrowings as a result of the balance sheet repositioning in September 2014. 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 September 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 September 30, 2014, the Company had $354.2 million outstanding in FHLB advances, and could borrow an additional amount of approximately $798.5 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 72 --------------------------------------------------------------------------------September 30, 2014, the Company had approximately $1.7 billion of unpledged securities, excluding securities available for pledge at the FHLB. 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 September 30, 2014, $15.0 million was outstanding. The holding company had $33.4 million in cash as of September 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 September 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 September 30, 2014, the Company's total risk-based capital ratio was 13.58%, Tier 1 capital to risk-weighted assets ratio was 12.62% and Tier 1 capital to average asset ratio was 12.27%. MB Financial Bank's total risk-based capital ratio was 13.13%, Tier 1 capital to risk-weighted assets ratio was 12.16% and Tier 1 capital to average asset ratio was 11.82%. MB Financial Bank was categorized as "Well-Capitalized" at September 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 recently completed 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 other acquisition transactions we previously completed will not be realized; (3) the credit risks of lending activities, including changes in the level and direction of 73 -------------------------------------------------------------------------------- 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, the Consumer Financial Protection Bureau and other regulatory authorities, 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, net interest margin and the value of our mortgage servicing rights; (7) the possibility that our mortgage banking business may increase volatility in our revenues and earnings and the possibility that the profitability of our mortgage banking business could be significantly reduced if we are unable to originate and sell mortgage loans at profitable margins or if changes in interest rates negatively impact the value of our mortgage servicing rights; (8) the impact of repricing and competitors' pricing initiatives on loan and deposit products; (9) fluctuations in real estate values; (10) the ability to adapt successfully to technological changes to meet customers' needs and developments in the market-place; (11) our ability to realize the residual values of our direct finance, leveraged, and operating leases; (12) our ability to access cost-effective funding; (13) changes in financial markets; (14) changes in economic conditions in general and in the Chicago metropolitan area in particular; (15) the costs, effects and outcomes of litigation; (16) 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; (17) changes in accounting principles, policies or guidelines; (18) our future acquisitions of other depository institutions or lines of business; and (19) 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. |