MutualFirst Financial, Inc.

(Exact Name of Registrant as Specified in its Charter)

Maryland		35-2085640
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
110 E. Charles Street, Muncie, Indiana		47305-2419
(Address of principal executive offices)		(Zip Code)

Large accelerated filer   ¨	Accelerated filer   ¨	Non-accelerated filer   ¨	Smaller reporting company   x
		(Do not check if smaller     reporting company)

Item 1.   Business

 

General

 

MutualFirst Financial, Inc., a Maryland corporation (“ MutualFirst ” or the “Company”), is the holding company of its wholly-owned subsidiary MutualBank, a federal savings bank (“MutualBank” or the “Bank”).   MutualFirst Financial was formed in September 1999 to become the holding company of MutualBank in connection with MutualBank’s conversion from the mutual to stock form of organization on December 29, 1999.  The words “we,” “our” and “us” in this Form 10-K refer to MutualFirst and MutualBank on a consolidated basis, unless indicated otherwise herein.

 

At December 31, 2009, we had total assets of $1.4 billion, deposits of $1.0 billion and stockholders’ equity of $129.7 million.  Our executive offices are located at 110 E. Charles Street, Muncie, Indiana 47305-2400, and our common stock is traded on the Nasdaq Global Market under the symbol “MFSF.”

 

Substantially all of MutualFirst ’s business is conducted through MutualBank, which is a federal savings bank subject to extensive regulation by the Office of Thrift Supervision (“OTS”). MutualBank’s deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation (“FDIC”). MutualBank has 33 retail financial centers, spanning nine Indiana counties and is the 10 th largest depository institution headquartered in Indiana. MutualBank also has trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan.

 

Our principal business consists of attracting retail deposits from the general public, including some brokered deposits, and investing those funds primarily in loans secured by first mortgages on owner-occupied, one- to four-family residences, a variety of consumer loans, loans secured by commercial and multi-family real estate and commercial business loans.  Funds not invested in loans generally are invested in investment securities, including mortgage-backed and mortgage-related securities.  MutualWealth is the wealth management division of the bank providing a variety of fee-based financial services, including trust, investment, insurance, broker advisory, retirement plan and private banking services, in the Bank’s market area.  As of December 31, 2009, MutualWealth managed assets of $313.3 million.

 

Our profitability depends primarily on net interest income, which is the difference between interest and dividend income on interest-earning assets, and interest expense on interest-bearing liabilities.  Interest-earning assets include principally loans, investment securities, including mortgage-backed and related securities and interest-earning deposits in other institutions.  Net interest income is dependent upon the level of interest rates and the extent to which such rates are changing.  Our profitability is also dependent on the level of noninterest income, provision for loan losses, noninterest expense and income taxes.  Our operations and profitability are subject to changes in interest rates, applicable statutes and regulations, and general economic conditions, as well as other factors beyond our control.  The Company continues to reduce the impact of interest rate changes on its net interest income by shortening the term of its interest-earning assets to better match the terms of our interest-bearing liabilities and by selling long-term fixed rate loans.  See “Quantitavie and Qualitative Disclosures About Market Risk – Asset and Liability Management and Market Risk” in Item A.

 

During 2008 and 2009, market and economic trends in our industry and in Indiana have declined resulting in increased delinquencies and foreclosures.  A number of federal legislative and regulatory initiatives have been enacted to address these conditions.  See “Asset Quality” and “How We Are Regulated” in Item 1, “Risk Factors” in Item 1A and the “Management’s Discussion and Analysis” in Item 7.

 

On July 18, 2008, the Company acquired MFB Corp and its banking subsidiary, MFB Financial, in a merger transaction involving the issuance of 2.9 million shares of common stock and payment of $11.5 million in cash to former stockholders of MFB Corp.  The Company obtained $167.9 million in residential mortgage loans, $48.5 million in consumer loans, $91.6 million in commercial real estate loans and $75.5 million in commercial business loans and assumed $331.1 million in deposits and $96.4 million in borrowings in the acquisition of MFB Corp.

 

1

---

 

On December 23, 2008, as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program, the Company entered into a Letter Agreement and Securities Purchase Agreement (collectively, the “Purchase Agreement”) with the United States Department of the Treasury (“Treasury”), pursuant to which the Company (i) sold 32,382 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) for a purchase price of $32,382,000 in cash and (ii) issued a warrant (the “Warrant”) to purchase 625,135 shares of the Company’s common stock, par value $0.01 per share (the “Common Stock”), for a per share price of $7.77 per share.  The Series A Preferred Stock is entitled to cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter.  The Series A Preferred Stock may be redeemed by the Company at any time, subject to consultation by the Treasury with the Office of Thrift Supervision (“OTS”).  The Warrant has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $7.77 per share of the Common Stock.  If the Series A Preferred Stock is redeemed, the Warrant will be liquidated at the current market price.  Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant that it holds.

 

Pursuant to the terms of the Purchase Agreement, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its Junior Stock (as defined below) and Parity Stock (as defined below) will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share ($0.16) declared on the Common Stock prior to December 23, 2008.  The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted.  These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the Series A Preferred Stock, (b) the date on which the Series A Preferred Stock has been redeemed in whole; and (c) the date Treasury has transferred all of the Series A Preferred Stock to third parties.  In addition, the ability of the Company to declare or pay dividends or distributions on, or repurchase, redeem or otherwise acquire for consideration, shares of its Junior Stock and Parity Stock will be subject to restrictions in the event that the Company fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on its Series A Preferred Stock. “Junior Stock” means the Common Stock and any other class or series of stock of the Company the terms of which expressly provide that it ranks junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company. “Parity Stock” means any class or series of stock of the Company the terms of which do not expressly provide that such class or series will rank senior or junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company (in each case without regard to whether dividends accrue cumulatively or non-cumulatively).

 

The Company placed $29.1 million of its TARP proceeds in the Bank and retained the remaining $3.2 million as working capital.  The Bank initially placed approximately $20.0 million of the proceeds in highly rated securities.  Of the $20.0 million, approximately $14.8 million was placed in mortgage securities, $3.2 million in municipal securities and $2.0 million in corporate bonds.  These securities provide liquidity as needed to meet current and future loan demand.  The remaining funds held at the Bank were placed in working capital, which was used to fund loans and meet the cash needs of MutualBank.  During 2009, the TARP proceeds have provided the Bank with a continued ability to lend to businesses and individuals along with the ability to purchase agency mortgage backed securities.

 

Forward-Looking Statements

 

This Form 10-K contains various forward-looking statements that are based on assumptions and describe our future plans and strategies and our expectations.  These forward-looking statements are generally identified by words such as “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar words.  Our ability to predict results or the actual effect of future plans or strategies is uncertain.  Factors which could cause actual results to differ materially from those estimated include, but are not limited to, changes in interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of our loan and investment portfolios, demand for our loan products, deposit flows, our operating expenses, competition, demand for financial services in our market areas and accounting principles and guidelines.  These risks and uncertainties should be considered in evaluating forward-looking statements, and you should not rely too much on these statements.  We do not undertake, and specifically disclaim, any obligation to publicly revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

2

---

 

Market Area

 

We are a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve. We are headquartered in Muncie, Indiana and we offer our financial services through 33 full service retail financial center offices in Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties. MutualBank also has trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. We also originate mortgage loans in the counties contiguous to these counties, and we have historically originated indirect consumer loans throughout Indiana. See “Lending Activities — Consumer and Other Lending.”

 

Lending Activities

 

General.   Our loans carry either a fixed- or an adjustable-rate of interest.  At December 31, 2009 our net loan portfolio totaled $1.1 billion, which constituted 75.7% of our total assets.

 

Loans up to $600,000 may be approved by certain individual loan officers.  Loans in excess of $600,000, but not in excess of $1.2 million, may be approved by the signature of an Executive Loan Committee member and one other loan officer to the total of their combined individual lending authority.  Loans not to exceed $3.0 million, to a borrower whose aggregate debt is not greater than $5.0 million, may be approved by a majority vote of the Executive Loan Committee.  All loans in excess of $3.0 million and loans of any amount to a borrower whose aggregate debt will exceed $5.0 million must be approved by the Board of Directors.  The aggregate limit may be increased or decreased by a specific guidance by the Board for a specific borrower.

 

At December 31, 2009, the maximum amount that we could lend to any one borrower and the borrower’s related entities was approximately $20.1 million.  As of December 31, 2009, our largest lending relationship to a single borrower or group of related borrowers consisted of fourteen loans totaling a commitment of $8.2 million, with $6.2 million outstanding at year-end. All of the loans in this relationship are secured by real estate and  guaranteed by the principal.  Each of these loans to this group of borrowers was current and performing in accordance with its terms at December 31, 2009.

 

3

---

 

The following table presents information concerning the composition of our loan portfolio in dollar amounts and in percentages as of the dates indicated.

 

		December 31,
		2009								2008								2007								2006								2005
		Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent
		(Dollars in thousands)
Real Estate Loans:
One- to four-family		$	471,015	(1)			43.69	%		$	521,364	(2)			46.11	%		$	431,018	(3)			53.02	%		$	433,123	(4)			53.01	%		$	451,914	(5)			54.00	%
Multi-family			2,621				0.24				2,698				0.24				3,929				0.48				5,073				0.62				5,505				0.66
Commercial			257,368				23.88				250,693				22.17				82,116				10.10				73,912				9.05				77,270				9.23
Construction and development			9,817				0.91				12,232				1.08				13,560				1.67				14,451				1.77				22,938				2.74
Total real estate loans			740,821				68.72				786,987				69.60				530,623				65.28				526,559				64.45				557,627				66.63
Other Loans:
Consumer Loans:
Automobile			18,848				1.75				22,715				2.01				22,917				2.82				31,336				3.84				39,802				4.76
Home equity			64,930				6.02				66,460				5.88				27,232				3.35				30,051				3.68				31,962				3.82
Home improvement			42,116				3.91				45,339				4.01				45,156				5.55				38,546				4.72				31,933				3.82
Manufactured housing			689				0.06				727				0.06				992				0.12				1,422				0.17				2,106				0.25
R.V.			81,663				7.58				79,884				7.07				77,805				9.57				71,321				8.73				64,222				7.67
Boat			45,581				4.23				46,928				4.15				47,816				5.88				46,311				5.67				40,631				4.85
Other			5,961				0.55				6,339				0.56				3,593				0.44				3,986				.48				4,305				.51
Total consumer loans			259,788				24.10				268,392				23.74				225,511				27.74				222,973				27.29				214,961				25.68
Commercial business loans			77,384				7.18				75,290				6.66				56,764				6.98				67,476				8.26				64,353				7.69
Total other loans			337,172				31.28				343,682				30.40				282,275				34.72				290,449				35.55				279,314				33.37
Total loans receivable, gross			1,077,993	(1)			100.00	%			1,130,669	(2)			100.00	%			812,898	(3)			100.00	%			817,008	(4)			100.00	%			836,941	(5)			100.00	%
Less:
Undisbursed portion of loans			2,546								4,372								3,984								5,520								7,724
Deferred loan fees and costs			(3,182)								(3,484	)							(3,519	)							(3,623	)							(3,453	)
Allowance for losses			16,414								15,107								8,352								8,156								8,100
Total loans receivable, net		$	1,062,215							$	1,114,674							$	804,081							$	806,955							$	824,570

---

(1)	Includes loans held for sale of $2.5 million.

(2)	Includes loans held for sale of $1.5 million.

(3)	Includes loans held for sale of $1.6 million.

(4)	Includes loans held for sale of $1.3 million.

(5)	Includes loans held for sale of $2.0 million.

 

 

4

---

 

The following table shows the composition of our loan portfolio by fixed- and adjustable-rate at the dates indicated.

		December 31,
		2009								2008								2007								2006								2005
		Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent
		(Dollars in thousands)
Fixed-Rate Loans:
Real estate:
One- to four-family		$	248,485	(1)			23.05	%		$	261,969	(2)			23.17	%		$	254,235	(3)			31.28	%		$	271,405	(4)			33.22	%		$	305,911	(5)			36.55	%
Multi-family			2,339				0.22				2,401				0.21				3,610				0.44				4,488				0.55				4,587				0.55
Commercial			129,297				12.00				115,922				10.25				17,281				2.13				9,408				1.15				9,375				1.12
Construction and development			8,559				0.79				9,724				0.86				10,197				1.25				8,310				1.02				12,690				1.52
Total real estate loans			388,680				36.06				390,016				34.49				285,323				35.10				293,611				35.94				332,563				39.74
Consumer			215,434				19.98				229,326				20.28				198,068				24.37				192,715				23.59				182,784				21.84
Commercial business			40,025				3.71				37,865				3.35				19,842				2.44				27,093				3.32				20,000				2.39
Total fixed-rate loans			644,139				59.75				657,207				58.12				503,233				61.91				513,419				62.85				535,347				63.97
Adjustable-Rate Loans:
Real estate:
One- to four-family			222,530				20.64				259,395				22.94				176,783				21.75				161,718				19.79				146,003				17.44
Multi-family			282				0.03				297				0.03				319				0.04				585				.07				918				0.11
Commercial			128,071				11.88				134,771				11.92				64,835				7.98				64,504				7.90				67,895				8.11
Construction and development			1,258				0.12				2,508				0.22				3,363				0.41				6,141				.75				10,248				1.22
Total real estate loans			352,141				32.67				396,971				35.11				245,300				30.18				232,948				28.51				225,064				26.88
Consumer			44,354				4.11				39,066				3.46				27,443				3.38				30,258				3.70				32,177				3.85
Commercial business			37,359				3.47				37,425				3.31				36,922				4.53				40,383				4.94				44,353				5.30
Total adjustable-rate loans			433,854				40.25				473,462				41.88				309,665				38.09				303,589				37.15				301,594				36.03
Total loans			1,077,993	(1)			100.00	%			1,130,669	(2)			100.00	%			812,898	(3)			100.00	%			817,008	(4)			100.00	%			836,941	(5)			100.00	%
Less:
Undisbursed portion of loans			2,546								4,372								3,984								5,520								7,724
Deferred loan fees and costs			(3,182	)							(3,484	)							(3,519	)							(3,623	)							(3,453	)
Allowance for loan losses			16,414								15,107								8,352								8,156								8,100
Total loans receivable, net		$	1,062,215							$	1,114,674							$	804,081							$	806,955							$	824,570

---

(1)	Includes loans held for sale of $2.5 million.

(2)	Includes loans held for sale of $1.5 million.

(3)	Includes loans held for sale of $1.6 million.

(4)	Includes loans held for sale of $1.3 million.

(5)	Includes loans held for sale of $2.0 million.

 

5

---

 

The following schedule illustrates the contractual maturity of our loan portfolio at December 31, 2009.  Mortgages that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due.  The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.

 

		Real Estate
		One- to Four-Family (1)								Multi-family and Commercial								Construction and Development (2)								Consumer								Commercial Business								Total
		Amount				Weighted   Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate				Amount				Weighted Average Rate
		(Dollars in thousands)
Due During Years Ending December 31,
2010 (3)		$	648				6.56	%		$	65,297				5.07	%		$	286				6.63	%		$	10,506				6.73	%		$	30,135				4.14	%		$	106,872				4.98	%
2011			717				5.72				17,165				6.10				214				7.63				10,464				7.23				9,332				5.18				37,892				6.19
2012			1,221				6.01				19,548				6.03				166				8.91				13,261				7.37				13,587				5.67				47,783				6.31
2013 and 2014			8,054				5.70				76,629				5.95				431				7.51				30,121				6.79				15,444				6.21				130,679				6.16
2015 to 2016			9,846				5.98				7,648				7.23				19				9.81				17,886				7.37				4,172				6.11				39,571				6.87
2017 to 2031			150,172				5.39				68,794				6.40				1,699				4.81				177,009				6.85				4,714				6.03				402,388				6.21
2032 and following			297,836				5.55				4,908				5.85				7,002				5.13				541				5.97				—				0.00				310,287				5.55
Total		$	468,494				5.51	%		$	259,989				5.90	%		$	9,817				5.35	%		$	259,788				6.91	%		$	77,384				5.17	%		$	1,075,472				5.92	%

---

(1)   Does not include mortgage loans held for sale.

(2)   Once the construction phase has been completed, these loans will automatically convert to permanent financing.

(3)   Includes demand loans, loans having no stated maturity and overdraft loans.

 

6

---

 

The total amount of loans due after December 31, 2010 that have predetermined interest rates is $599.5 million, and the total amount of loans due after such date which have floating or adjustable interest rates is $369.1 million.

 

One- to Four-Family Residential Real Estate Lending.   We focus our real estate lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences in our market areas.  At December 31, 2009, one- to four-family residential mortgage loans totaled $471.0 million, or 43.7% of our gross loan portfolio.

 

We generally underwrite and document our one- to four-family loans based on the loan applicant’s employment and credit history and the appraised value of the subject property consistent with secondary market standards or other prudent underwriting guidelines.  Generally, we lend up to 95% of the lesser of the appraised value or purchase price for one- to four-family residential loans.  For loans with a loan-to-value ratio in excess of 80%, we generally require private mortgage insurance in order to reduce our exposure to below 80%.  Properties securing our one- to four-family loans are appraised by independent state licensed fee appraisers approved by the Bank’s Board of Directors.  We require borrowers to obtain title insurance in the amount of their mortgage.  Hazard insurance and flood insurance, if necessary, are required in an amount of the lesser of the value of the property improvements or our mortgage amount.

 

We originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates.  Our pricing strategy for mortgage loans includes setting interest rates that are competitive with the secondary market and other local financial institutions and are consistent with our internal needs.  Adjustable-rate mortgage or ARM loans are offered with a one-year, three-year, five-year, seven-year or ten-year term to the initial repricing date.  After the initial period, the interest rate for each ARM loan adjusts annually for the remainder of the term of the loan.  We use the weekly average of the one-year Treasury Bill Constant Maturity Index to reprice our ARM loans.  During fiscal 2009, we originated $31.5 million of one- to four-family ARM loans and $218.5 million of one- to four-family fixed-rate mortgage loans.  By way of comparison, during fiscal 2008, we originated $33.1 million of one- to four-family ARM loans and $78.0 million of one- to four-family fixed-rate mortgage loans.

 

Fixed-rate loans secured by one- to four-family residences have contractual maturities of up to 30 years and are generally fully amortizing, with payments due monthly.  These loans normally remain outstanding, however, for a substantially shorter period of time because of refinancing and other prepayments.  A significant change in interest rates could alter considerably the average life of a residential loan in our portfolio.  Our one- to four-family loans are generally not assumable, do not contain prepayment penalties and do not permit negative amortization of principal.  Most are written using underwriting guidelines which make them saleable in the secondary market.  Our real estate loans generally contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the security property.

 

Our one- to four-family residential ARM loans are fully amortizing loans with contractual maturities of up to 30 years, with payments due monthly. Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment on the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds.

 

In order to remain competitive in our market areas, we sometimes originate ARM loans at initial rates below the fully indexed rate.  ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower’s payment rises, increasing the potential for default.  Our payment history for ARM loans has not been substantially different from fixed rate loans.  See “Asset Quality — Non-performing Assets” and “— Classified Assets.”  At December 31, 2009, our one- to four-family ARM loan portfolio totaled $222.5 million, or 20.6% of our gross loan portfolio.  At that date, the fixed-rate one- to four-family mortgage loan portfolio totaled $248.5 million, or 23.1% of our gross loan portfolio.

 

Multi-family and Commercial Real Estate Lending .  We offer a variety of multi-family and commercial real estate loans for acquisition, renovation or construction.  These loans are secured by the real estate and improvements financed.  The collateral securing these loans ranges from industrial and commercial buildings to churches, office buildings and multi-family housing complexes.  At December 31, 2009, multi-family and commercial real estate loans totaled $260.0 million, or 24.1% of our gross loan portfolio.

 

7

---

 

Our loans secured by multi-family and commercial real estate are originated with either a fixed or adjustable interest rate.  The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower.  Loan-to-value ratios on our multi-family and commercial real estate loans typically do not exceed 80% of the current appraised value of the property securing the loan.  These loans typically require monthly payments, may not be fully amortizing and generally have maximum maturities of 25 years.  Developmental loans are secured by real estate and repaid by the sale of lots.

 

Loans secured by multi-family and commercial real estate are underwritten based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt. We may require personal guarantees of the borrowers in addition to the real estate as collateral for such loans. We also generally require an assignment of rents or leases in order to be assured that the cash flow from the real estate can be used to repay the debt. Appraisals on properties securing multi-family and commercial real estate loans are performed by independent state licensed fee appraisers approved by MutualBank’s Board of Directors. See “Loan Originations, Purchases, Sales and Repayments.”

 

We generally do not maintain a tax or insurance escrow account for loans secured by multi-family and commercial real estate.  In order to monitor the adequacy of cash flows on income-producing properties, the borrower is required to provide periodic financial information.

 

Loans secured by multi-family and commercial real estate are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans.  Multi-family and commercial real estate loans typically involve large balances to single borrowers or groups of related borrowers.  Because payments on loans secured by multi-family and commercial real estate are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy.  If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired.  See “Asset Quality — Non-performing Assets.”

 

Construction and Development Lending . We originate construction loans primarily secured by existing residential building lots. We make construction loans to builders and to individuals for the construction of their residences. Substantially all of these loans are secured by properties located within our market area. At December 31, 2009, we had $9.8 million in construction and development loans outstanding, representing 0.9% of our gross loan portfolio.

 

Construction and development loans are obtained through continued business with builders who have previously borrowed from us, from walk-in customers and through referrals from realtors and architects.  The application process includes submission of complete plans, specifications and costs of the project to be constructed.  This information and an independent appraisal is used to determine the value of the subject property.  Loans are based on the lesser of the current appraised value and/or the cost of construction, including the land and the building.  We generally conduct regular inspections of the construction project being financed.  Residential construction loans are done with one closing for both the construction period and the long term financing.

 

Construction loans for one- to four-family homes are generally granted with a construction period of up to nine months.  During the construction phase, the borrower generally pays interest only on a monthly basis.  Loan-to-value ratios on our construction and development loans typically do not exceed 90% of the appraised value of the project on an as completed basis.  Single family construction loans with loan-to-value ratios over 80% usually require private mortgage insurance.

 

Because of the uncertainties inherent in estimating construction and development costs and the market for the project upon completion, it is difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of ultimate success of the project.  These loans also involve many of the same risks discussed above regarding multi-family and commercial real estate loans and tend to be more sensitive to general economic conditions than many other types of loans.  In addition, payment of interest from loan proceeds can make it difficult to monitor the progress of a project.

 

8

---

 

Consumer and Other Lending .  Consumer loans generally have shorter terms to maturity, which reduces our exposure to changes in interest rates, and carry higher rates of interest than one- to four-family residential mortgage loans.  In addition, management believes that offering consumer loan products helps to expand and create stronger ties to our customer base by increasing the number of customer relationships and providing cross-marketing opportunities.  At December 31, 2009, our consumer loan portfolio totaled $259.8 million, or 24.1% of our gross loan portfolio. We offer a variety of secured consumer loans, including home equity and lines of credit, home improvement, auto, boat and recreational vehicle loans, and loans secured by savings deposits.  We also offer a limited amount of credit card and unsecured loans.  We originate our consumer loans both in our market area and throughout Indiana with some customers residing in contiguous states through our indirect lending program.

 

At December 31, 2009, our home equity loans, including lines of credit and home improvement loans, totaled $107.0 million, or 9.9% of our gross loan portfolio.   These loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 100% of the value of the property securing the loan.  The term to maturity on our home equity and home improvement loans may be up to 15 years.  Most home equity lines of credit have a maximum term to maturity of 20 years and require a minimum monthly payment based on the outstanding loan balance per month, which amount may be reborrowed at any time.  A limited number of home equity lines of credit are approved with monthly payments of accrued interest only.  Other consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower.

 

We directly and indirectly originate auto, boat and recreational vehicle loans.  We generally buy indirect auto loans on a rate basis, paying the dealer a cash payment for loans with an interest rate in excess of the rate we require.  This premium is amortized over the remaining life of the loan.  As specified in written agreements with these dealers, prepayments or delinquencies are charged to future amounts owed to that dealer, with no dealer reserve or other guarantee of payment if the dealer stops doing business with us.

 

We employ the Fair Isaac’s credit scoring models for all consumer loan applications.  These models evaluate credit and application attributes.  We originate consumer loans through bank financial centers and indirect channels.  These loans are underwritten traditionally, with a review of the borrower’s employment and credit history and an assessment of the borrower’s ability to repay the loan.

 

At December 31, 2009, auto loans totaled $18.8 million, or 1.8% of our gross loan portfolio.  Auto loans may be written for up to six years and usually have a fixed rate of interest.  Loan-to-value ratios are up to 100% of the MSRP or 120% of invoice for new autos and 110% of value on used cars, based on valuation from official used car guides.

 

Loans for boats and recreational vehicles totaled $127.2 million at December 31, 2009, or 11.8% of our gross loan portfolio.  At December 31, 2009, we decided to suspend originations of boat and recreational vehicle loans from indirect sources.

 

Consumer loans may entail greater risk than one- to four-family residential mortgage loans, especially consumer loans secured by rapidly depreciable assets, such as automobiles, boats and recreational vehicles.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance.  As a result, consumer loan collections are dependent on the borrower’s continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

 

Commercial Business Lending .  At December 31, 2009, commercial business loans totaled $77.4 million, or 7.2% of our gross loan portfolio. Most of our commercial business loans have been extended to finance businesses in our market area.  Credit accommodations extended include lines of credit for working capital needs, term loans to purchase capital goods and real estate, development lending to foster residential, business and community growth and agricultural lending for inventory and equipment financing.

 

9

---

 

The terms of loans extended on the security of machinery and equipment are based on the projected useful life of the machinery and equipment, generally not to exceed seven years.  Lines of credit generally are available to borrowers for up to 13 months, and may be renewed by us after an annual review of current financial information.

 

We issue a few financial-based standby letters of credit which are offered at competitive rates and terms and are generally on a secured basis.  We continue to expand our volume of commercial business loans.

 

Our commercial business lending policy includes credit file documentation and analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral as well as an evaluation of other conditions affecting the borrower.  Analysis of the borrower’s past, present and future cash flows also is an important aspect of our credit analysis.  We may obtain personal guarantees on our commercial business loans.  Nonetheless, these loans are believed to carry higher credit risk than traditional single family loans.

 

Unlike residential mortgage loans, commercial business loans are typically made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business.  As a result, the availability of funds for the repayment of commercial business loans may substantially depend on the success of the business itself (which, in turn, often depends in part upon general economic conditions).  Our commercial business loans are usually secured by business assets.  However, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

 

Loan Originations, Purchases, Sales and Repayments

 

We originate loans through referrals from real estate brokers and builders, our marketing efforts, and our existing and walk-in customers. Historically, we have originated many of our consumer loans through relationships with dealerships. While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans depends upon customer demand for loans in our market areas. Demand is affected by local competition and the interest rate environment. During the last several years, due to low market rates of interest, our dollar volume of fixed-rate, one- to four-family loans has exceeded the dollar volume of the same type of adjustable-rate loans. As part of our interest rate risk management efforts, we have from time to time sold our fixed rate, one- to four-family residential loans. We have also purchased adjustable rate one- to four-family residential and commercial real estate loans.

 

In periods of economic uncertainty, the ability of financial institutions, including us, to originate or purchase large dollar volumes of loans may be substantially reduced or restricted, with a resultant decrease in interest income.

 

The following table shows our loan origination, purchase, sale and repayment activities for the years indicated.

 

10

---

 

		Year Ended December 31,
		2009				2008				2007
		(Dollars in thousands)
Originations by type:
Adjustable rate:
Real estate - one- to four-family		$	31,542			$	33,083			$	28,275
- multi-family			56				1,323				—
- commercial			7,713				7,132				11,557
- construction or development			1,138				5,617				4,894
Non-real estate - consumer			317				43				56
- commercial business			1,322				2,061				2,026
Total adjustable-rate			42,088				49,259				46,808
Fixed rate:
Real estate - one- to four-family			218,546				78,040				58,338
- multi-family			1,444				2,052				—
- commercial			16,536				12,737				2,171
- construction or development			7,382				9,171				11,687
Non-real estate - consumer			39,745				42,465				44,423
- commercial business			9,447				5,409				3,153
Total fixed-rate			293,100				149,874				119,772
Total loans originated			335,188				199,133				166,580
Purchases: (1)
Real estate - one- to four-family			—				213,441				16,058
- commercial			—				93,479				—
- construction or development			—				1,770				—
Non-real estate - consumer			—				9,677				—
- commercial business			—				75,496				—
Total loans purchased			—				393,863	(2)			16,058
Sales and Repayments:
Sales:
Real estate - one- to four-family			160,019				92,914				24,113
Total loans sold			160,019				92,914				24,113
Principal repayments			231,254				179,187				162,159
Total reductions			391,273				272,101				186,272
Increase (decrease) in other items, net			2,409				(3,124	)			(476	)
Net increase (decreases)		$	(53,676)			$	317,771			$	(4,110	)

 

---

(1)	Does not include market value adjustment for loans related to acquisitions of branches from other financial institutions.

(2)	Includes $385.3 million of loans acquired as part of the Company’s acquisition of MFB.

Asset Quality

 

When a borrower fails to make a payment on a mortgage loan on or before the default date, a late charge and delinquency notice is mailed. All delinquent accounts are reviewed by a collector, who attempts to cure the delinquency by contacting the borrower once the loan is 30 days past due. If the loan becomes 30 days delinquent, the collector will generally contact the borrower by phone or send a letter to the borrower in order to identify the reason for the delinquency. Once the loan becomes 60 days delinquent, the borrower is asked to pay the delinquent amount in full, or establish an acceptable repayment plan to bring the loan current. Prior to foreclosure a drive-by inspection is made to determine the condition of the property. If the account becomes 120 days delinquent, and an acceptable repayment plan has not been agreed upon, a collection officer will generally refer the account to legal counsel, with instructions to prepare a notice of intent to foreclose. The notice of intent to foreclose allows the borrower up to 30 days to bring the account current. During this 30 day period, the collector may accept a repayment plan from the borrower which would bring the account current prior to foreclosure. The Bank has suspended foreclosure activities when directed by government sponsored entities or the Bank’s regulator.

 

11

---

 

For consumer loans, a similar process is followed, with the initial written contact being made once the loan is 20 days past due.

 

Commercial loan relationships exceeding $250,000 are reviewed on a regular basis by the commercial credit department.  Larger relationships are monitored through a system of internal and external loan review.  All relationships that are deemed to warrant special attention are monitored at least quarterly.  Individual commercial officers maintain communication with borrowers and recommend action plans to a Loan Quality Review committee which meets monthly to discuss credits graded Special Mention or worse.  The Asset Classification committee meets quarterly and establishes specific reserves for losses on relationships that are deemed to be under-collateralized and at risk of continued non-payment.  Collection and loss mitigation efforts are a cooperative effort between the Commercial Loan Department and the Risk Management Division.

 

Delinquent Loans.   The following table sets forth, as of December 31, 2009, our loans delinquent for 60 to 89 days by type, number, amount and percentage of type.

 

		Loans Delinquent For:
		60-89 Days
		Number				Amount				Percent of Loan Category
		(Dollars in thousands)
Real Estate:
One- to four-family			58			$	4,411				0.94	%
Multi-family			—				—				—
Commercial			6				667				0.26
Construction and development			3				729				7.43
Consumer			116				1,992				0.77
Commercial business			2				111				0.14
Total			185			$	7,910				0.74	%

As of December 31, 2008, our total loans delinquent for 60 to 89 days was $9.1 million or .81% of total loans.

Non-performing Assets.   The table below sets forth the amounts and categories of non-performing assets in our loan portfolio at the dates indicated.  Generally, loans are placed on non-accrual status when the loan becomes more than 90 days delinquent or when collection of interest becomes doubtful.  Foreclosed assets owned include assets acquired in settlement of loans.

 

12

---

 

		December 31,
		2009				2008			2007				2006			2005
		(Dollars in thousands)
Non-accruing loans:
One- to four-family		$	14,617			$	7,917		$	2,997			$	2,762		$	2,967
Multi-family			—				—			—				—			—
Commercial real estate			8,986				7,723			2,656				356			569
Construction and development			—				—			—				—			—
Consumer			3,610				1,851			1,294				983			628
Commercial business			1,873				2,507			2,002				1,468			1,257
Total			29,086				19,998			8,949				5,569			5,421
Accruing loans delinquent 90 days or more:
One- to four-family			1,861				1,284			—				—			67
Multi-family			—				—			—				—			—
Commercial real estate			—				189			1,421				—			1,858
Construction and development			—				—			—				—			—
Consumer			73				—			—				—			35
Commercial business			—				—			—				—			—
Total			1,934				1,473			1,421				—			1,960
Total nonperforming loans			31,020				21,471			10,370				5,569			7,381
Restructured loans			1,563				293			107				111			116
Foreclosed assets:
One- to four-family			3,483				1,786			927				947			912
Multi-family			—				—			—				—			—
Commercial real estate			1,941				1,193			437				326			595
Construction and development			—				—			—				—			—
Consumer			1,927				1,861			1,137				1,322			978
Commercial business			—				—			—				—			—
Total			7,351				4,840			2,501				2,595			2,485
Non-performing investments			100				—			—				—			—
Total non-performing assets		$	40,034			$	26,604		$	12,978			$	8,275		$	9,982
Total as a percentage of total assets			2.86	%			1.92	%		1.35	%			0.86	%		1.03	%

The majority of the increase in 2009 in non-performing assets is a result of consumer real estate and other consumer loans increasing in delinquency.  Commercial loan delinquency has remained mainly flat between December 31, 2008 and December 31, 2009.

For the year ended December 31, 2009, gross interest income that would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to $1.8 million.  The amount included in interest income on these loans for the year ended December 31, 2009, was $827,000.

 

At December 31, 2009, foreclosed commercial real estate consisted of seven commercial buildings, one in Delaware County, three in Grant County, one in Elkhart County, one in St. Joseph County and one in Florida, all of which are currently being offered for sale.  In addition, forty-one residential properties with a book value of $3.5 million remain as foreclosed assets at December 31, 2009. These properties are being offered for sale.  Non-accruing one- to four-family loans increased to $14.6 million at December 31, 2009.  Non-accruing commercial real estate loans increased from $7.7 million at December 31, 2008, to $9.0 million at December 31, 2009.   At the same time, non-accrual commercial business loans decreased from $2.5 million to $1.9 million. The increases in non-performing assets are primarily a result of the current economic slowdown.  Management continues to monitor these loans aggressively and it is management’s opinion that the non-accruing loans are sufficiently reserved as of December 31, 2009.

 

13

---

 

Other Loans of Concern.   In addition to the non-performing assets set forth in the table above, as of December 31, 2009, there was an aggregate of $28.8 million in loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the abilities of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories.  Due to current economic conditions, we have seen an increase in the amount of these loans during 2009.  These loans have been considered in management’s determination of the adequacy of our allowance for loan losses.  Management reviews each of these relationships at least quarterly to determine if further downgrades and specific loan reserves are prudent.

 

Included in the $28.8 million above are 20 commercial business loans totaling $6.9 million, 35 commercial real estate loans totaling $15.7 million and 48 residential mortgage loans totaling $4.5 million. Loans of $2.1 million had specific loan loss reserves established and the majority of these loans were current as of December 31, 2009.

 

Classified Assets.   Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered by the OTS to be of lesser quality, as “substandard,” “doubtful” or “loss.”  An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected.  Assets classified as “doubtful” have all of 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 of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.

 

When an insured institution classifies problem assets as either substandard or doubtful, it may establish general allowances for loan losses in an amount deemed prudent by management and approved by the board of directors.  General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets.  When an insured institution classifies problem assets as “loss,” it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge off such amount.  An institution’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the OTS and the FDIC, which may order the establishment of additional general or specific loss allowances.

 

In connection with the filing of the Bank’s periodic reports with the OTS and in accordance with our classification of assets policy, we regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations.  On the basis of management’s review, at December 31, 2009, we had classified $68.1 million of the Bank’s assets as substandard, $2.2 million as doubtful and $2.8 million as loss. Loans classified as loss are fully reserved but not charged off, because there are certain indications that collection is still possible.  The total amount classified represented 56.32% of our stockholders’ equity and 5.22% of our assets at December 31, 2009, compared to 26.20% and 2.46%, respectively, at December 31, 2008.

 

Provision for Loan Losses .  We recorded a provision for loan losses during the year ended December 31, 2009 of $6.5 million, compared to $7.0 million for the year ended December 31, 2008 and $2.2 million for the year ended December 31, 2007.  The provision for loan losses is charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed below under “— Allowance for Loan Losses.”

 

Allowance for Loan Losses .  We maintain an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated losses inherent in the loan portfolio.  Our methodology for assessing the appropriateness of the allowance consists of several key elements, including the general allowance and specific allowances for identified problem loans and portfolio segments.  In addition, the allowance incorporates the results of measuring impaired loans as provided in FASB ASC 310, Receivables .  These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans.

 

14

---

 

The general allowance is calculated by applying loss factors to outstanding loans based on the internal risk evaluation of such loans or pools of loans. Changes in risk evaluations of both performing and nonperforming loans affect the amount of the general allowance. Loss factors are based on our historical loss experience as well as on significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date.

 

The appropriateness of the allowance is reviewed by management based upon its evaluation of then-existing economic and business conditions affecting our key lending areas and other conditions, such as credit quality trends (including trends in non-performing loans expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments and recent loss experience in particular segments of the portfolio that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectibility of the loan.  Senior management reviews these conditions quarterly in discussions with our senior credit officers.  To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment.  Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the loss related to this condition is reflected in the general allowance for loan losses.  The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.

 

The allowance for loan losses is based on estimates of losses inherent in the loan portfolio.  Actual losses can vary significantly from the estimated amounts.  Our methodology as described permits adjustments to any loss factor used in the computation of the general allowance in the event that, in management’s judgment, significant factors which affect the collectibility of the portfolio as of the evaluation date are not reflected in the loss factors.  By assessing the probable incurred losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon any more recent information that has become available.  Due to the loss of numerous manufacturing jobs in the communities we serve during recent years, including 2009, and the increase in higher risk loans, like consumer and commercial loans, as a percentage of total loans, management has concluded that our allowance for loan losses should be greater than historical loss experience and specifically identified losses would otherwise indicate.

 

At December 31, 2009, our allowance for loan losses was $16.4 million, or 1.53% of the total loan portfolio, and approximately 50.4% of total non-performing loans.  Assessing the adequacy of the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, that are susceptible to significant change.  In the opinion of management, the allowance, when taken as a whole, is adequate to absorb reasonable estimated loan losses inherent in our loan portfolio.

 

15

---

 

The following table sets forth an analysis of our allowance for loan losses.

 

		Year Ended December 31,
		2009				2008				2007				2006				2005
		(Dollars in thousands)
Balance at beginning of period		$	15,107			$	8,352			$	8,156			$	8,100			$	6,867
Charge-offs:
One- to four-family			1,728				480				645				526				303
Multi-family			—				—				—				—				—
Commercial real estate			1,291				1,548				44				102				6
Construction and development			—				—				—				—				—
Consumer			3,154				2,174				1,731				1,288				1,276
Commercial business			83				230				303				387				954
			6,256				4,432				2,723				2,303				2,539
Recoveries:
One- to four-family			110				42				121				81				22
Multi-family			—				—				—				—				—
Commercial real estate			184				558				—				—				120
Construction and development			—				—				—				—				—
Consumer			767				556				357				199				194
Commercial business			2				57				201				11				15
			1,063				1,213				679				291				351
Net charge-offs			5,193				3,219				2,044				2,012				2,188
Amount acquired in acquisitions			—				2,954				—				—				1,646
Provisions charged to operations			6,500				7,020				2,240				2,068				1,775
Balance at end of period		$	16,414			$	15,107			$	8,352			$	8,156			$	8,100
Ratio of net charge-offs during the period to average loans outstanding during the period			0.47	%			0.34	%			0.25	%			0.24	%			0.29	%
Allowance as a percentage of non- performing loans			50.38	%			69.41	%			79.72	%			143.59	%			109.74	%
Allowance as a percentage of total loans (end of period)			1.53	%			1.34	%			1.03	%			1.00	%			0.98	%

 

 

16

---

 

The distribution of our allowance for loan losses at the dates indicated is summarized as follows:

 

		December 31,
		2009												2008												2007												2006												2005
		Amount of Loan Loss Allowance				Loan Amounts by Category				Percent of Loans in Each Category to Total Loans				Amount of Loan Loss Allowance				Loan Amounts by Category				Percent of Loans in Each Category to Total Loans				Amount of Loan Loss Allowance				Loan Amounts by Category				Percent of Loans in Each Category to Total Loans				Amount of Loan Loss Allowance				Loan Amounts by Category				Percent of Loans in Each Category to Total Loans				Amount of Loan Loss Allowance				Loan Amounts by Category				Percent of Loans in Each Category to Total Loans
		(Dollars in thousands)
One- to four-family		$	2,359			$	471,015	(1)			43.69	%		$	1,997				521,364	(2)			46.11	%		$	1,200				431,018	(3)			53.02	%		$	1,219			$	433,123	(4)			53.01	%		$	1,267				451,914	(5)			54.00	%
Multi-family			17				2,621				0.24				73				2,698				.24				20				3,929				0.48				61				5,073				0.62				68				5,505				.66
Commercial real estate			7,555				257,368				23.88				6,869				250,693				22.17				2,158				82,116				10.10				2,000				73,912				9.05				2,039				77,270				9.23
Construction or development			10				9,817				0.91				12				12,232				1.08				14				13,560				1.67				72				14,451				1.77				115				22,938				2.74
Consumer			4,052				259,788				24.10				3,990				268,392				23.74				3,885				225,511				27.74				3,801				222,973				27.29				3,605				214,961				25.68
Commercial business			2,421				77,384				7.18				2,166				75,290				6.66				1,075				56,764				6.99				1,003				67,476				8.26				1,006				64,353				7.69
Unallocated			—				—								—				—				—				—				—				—				—				—				—				—				—				—
Total		$	16,414			$	1,077,993				100.00	%		$	15,107			$	1,130,669				100.00	%		$	8,352			$	812,898				100.00	%		$	8,156			$	817,008				100.00	%		$	8,100			$	836,941				100.00	%

 

---

(1)	Includes loans held for sale of $2.5 million.

(2)	Includes loans held for sale of $1.5 million.

(3)	Includes loans held for sale of $1.6 million.

(4)	Includes loans held for sale of $1.3 million.

(5)	Includes loans held for sale of $2.0 million.

 

17

---

 

Investment Activities

 

MutualBank may invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, including callable agency securities, certain certificates of deposit of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements and federal funds.  Subject to various restrictions, it also may invest in investment grade commercial paper and corporate debt securities and mutual funds the assets of which conform to the investments that a federally chartered savings institution is otherwise authorized to make directly.  See “How We Are Regulated – MutualBank” for a discussion of additional restrictions on our investment activities.

 

The Chief Financial Officer has the basic responsibility for the management of our investment portfolio, subject to the direction and guidance of the Asset and Liability Management Committee.  The Chief Financial Officer considers various factors when making decisions, including the marketability, maturity and tax consequences of the proposed investment.  The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.

 

The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk.  See “Quantitative and Qualitative Disclosures About Market Risk” in Item 7A of this Form 10-K.

 

Our investment securities currently consist of U.S. Agency securities, mortgage-backed securities, collateralized mortgage obligations, municipal securities, marketable equity securities (which consist of shares in mutual funds that invest in government obligations, corporate obligations, mortgage-backed securities and asset-backed securities) and corporate obligations.  See Note 5 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.  Our mortgage-backed securities portfolio currently consists of securities issued under government-sponsored agency programs.

 

While mortgage-backed securities carry a reduced credit risk as compared to whole loans, these securities remain subject to the risk that a fluctuating interest rate environment, along with other factors like the geographic distribution of the underlying mortgage loans, may alter the prepayment rate of the mortgage loans and affect both the prepayment speed and value of the securities.

 

In the past, we also have maintained a trading portfolio of U.S. Government securities.  We are permitted by the board of directors to have a portfolio of up to $5.0 million and to trade up to $2.0 million in these securities at any one time.  At December 31, 2009, however, we did not have a trading portfolio. See Note 5 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

 

In 2007, MutualBank transferred the management of a portion of its securities portfolio to its wholly owned subsidiary, Mutual Federal Investment Company.  Mutual Federal Investment Company, a Nevada corporation, holds, services, manages and invests that portion of the Bank’s investment portfolio as may be transferred from time to time by the Bank to Mutual Federal Investment Company.  Mutual Federal Investment Company’s investment policy, for the most part, mirrors that of the Bank.  At December 31, 2009, MutualBank had $139.1 million in consolidated investment securities.  The portfolio is comprised of $130.9 million in investments available for sale and $8.1 in investments held to maturity.  Mutual Federal Investment Company managed $118.4 million of the total available for sale portfolio.

 

MutualBank evaluates all securities for other-than-temporary impairment (“OTTI”) on a quarterly basis.  During the year ending December 31, 2009, the Bank determined that several securities met the definition of OTTI.  The first security was a Lehman’s corporate bond that was written down $200,000.  Four securities were pooled trust preferred securities that had a total write-down of $1.8 million.  Seven securities were private label mortgage backed securities that were written down $548,000.  Impairment on these securities was determined after analyzing the underlying collateral and determining the amount of additional losses needed in the individual pools to create a shortfall in interest or principal payments.  All trust preferred securities were priced using a discounted cash flow analysis as of December 31, 2009.

 

18

---

 

P ooled Trust Preferred Securities.   Mutual First Financial has a current par balance in pooled trust preferred securities of $7.2 million, which was originally $10.3 million prior to other than temporary impairment write-downs in 2008 and 2009.  These securities have been written down through other comprehensive income to a book balance of $2.4 million.  The following table provides additional information related to the Bank’s investment in trust preferred securities as of December 31, 2009 :

 

					Original				Book				Fair				Unrealized				Realized Losses							Lowest
Deal		Class			Par				Value				Value				Loss				2009				2008			Rating
		(Dollars in thousands)
Alesco Preferred Funding IX		A2A			$	1,000			$	893			$	431			$	(462	)		$	-			$	-		BB
Alesco Preferred Funding XVII		C1				1,000				100				2				(98	)			(900	)			-		Ca
Preferred Term Securities XIII		B1				1,000				823				298				(525	)			(177	)			-		Ca
Preferred Term Securities XVIII		C				1,000				965				252				(713	)			-				-		Ca
Preferred Term Securities XXVII		C1				1,000				1,004				189				(815	)			-				-		Ca
U.S. Capital Funding I		B1				3,000				2,891				995				(1,896	)			(109	)			-		CC
U.S. Capital Funding III		B1				1,000				500				268				(232	)			-				(500	)	Caa1
U.S. Capital Funding V		B1				1,300				45				1				(44	)			(605	)			(650	)	CC
Total					$	10,300			$	7,221			$	2,436			$	(4,785	)		$	(1,791	)		$	(1,150	)

 

The OTTI taken on trust preferred securities in 2009 was the result of significant deterioration in the performance of the underlying collateral.  The deterioration was the result of increased defaults and deferrals of dividend payments in the current year, creating credit impairment along with weakening financial performance of performing collateral, increasing the risk of future deferrals of dividends and defaults.

The Bank’s trust preferred securities valuation was prepared by an independent third party.  Their approach to determining fair value involved several steps including:

·

Detailed credit and structural evaluation of each piece of collateral in the trust preferred securities;

·

Collateral performance projections for each piece of collateral in the trust preferred security;

·

Terms of the trust preferred structure, as laid out in the indenture; and

·

Discounted cash flow modeling.

 

MutualFirst Financial uses market-based yield indicators as a baseline for determining appropriate discount rates, and then adjusts the resulting discount rates on the basis of its credit and structural analysis of specific trust preferred securities.  The primary focus is on the returns a fixed income investor would require in order to allocate capital on a risk adjusted basis.  There is currently no active market for pooled trust preferred securities; however, the Company looks principally to market yields for stand-alone trust preferred securities issued by banks, thrifts and insurance companies for which there is an active and liquid market.  The next step is to make a series of adjustments to reflect the differences that exist between these products (both credit and structural) and, most importantly, to reflect idiosyncratic credit performance differences (both actual and projected) between these products and the underlying collateral in the specific trust preferred security.  Importantly, as part of the analysis described above, MutualFirst considers the fact that structured instruments frequently exhibit leverage not present in stand-alone instruments, and make adjustments as necessary to reflect this additional risk.

 

19

---

 

The default and recovery probabilities for each piece of collateral were formed based on the evaluation of the collateral credit and a review of historical industry default data and current/near-term operating conditions.  For collateral that has already defaulted, the Company assumed no recovery.  For collateral that was in deferral, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions, and 15% of par for insurance companies.  Although the Company conservatively assumed that the majority of the deferring collateral continues to defer and eventually defaults, we also recognize there is a possibility that some deferring collateral may become current at some point in the future.

Private Label Mortgage Backed Securities.   In 2008, the Company redeemed two mutual funds and received cash and underlying securities in the mutual fund as payment.  These held to maturity securities had a par value of $10.1 million and a book value of $7.6 million.  The securities received were agency and private label mortgage backed securities.  The agency MBS have a par value of $2.9 million and a book value of $2.7 million.  The private labeled MBS have a par value of $7.2 million and a book value of $4.9 million.  In 2009, the private label MBS had other than temporary impairment of $548,000.  An independent analysis was performed on several MBS that met certain criteria to determine if OTTI was present.  The average book value of the private label securities is $51,000.    All of these securities are monitored on a quarterly basis by management.

Other information about the private label mortgage backed securities received in the redemption in-kind transaction include:

·

The securities have vintage years between 1993 and 2007, with the majority being between 2002 and 2007.

·

The securities include sub-prime, Alt-A, and home equity loans.

·

Investment grade securities total $1.6 million in book value and $3.3 million in book value are below investment grade.

 

Investment in Limited Partnerships.   MutualBank has investments in eight separate Indiana limited partnerships that were organized to construct, own and operate two multi-unit apartment complexes in the Indianapolis area, one in Findley, Ohio, two in Goshen, Indiana, one in Elkhart, Indiana, and two in Niles, Michigan (the Pedcor Projects).  The general partner in each of these Pedcor Projects is Pedcor Investments.  All of the Pedcor Projects are operated as multi-family, low and moderate-income housing projects, and have been performing as planned for several years.  At the inception of the Findley, Ohio Pedcor Project in February 1998, we invested $2.1 million and committed to invest an additional $1.9 million.  As of December 31, 2009, $226,000 of this commitment remained payable over the next year.

 

A low and moderate-income housing project qualifies for certain federal income tax credits if (1) it is a residential rental property, (2) the units are used on a non-transient basis, and (3) at least 20% of the units in the project are occupied by tenants whose incomes are 50% or less of the area median gross income, adjusted for family size, or alternatively, at least 40% of the units in the project are occupied by tenants whose incomes are 60% or less of the area median gross income. Qualified low-income housing projects generally must comply with these and other rules for 15 years, beginning with the first year the project qualified for the tax credit, or some or all of the tax credit together with interest may be recaptured. The tax credit is subject to the limitation for use as a general business credit, but no basis reduction is required for any portion of the tax credit claimed. As of December 31, 2009, at least 83% of the units in the Pedcor Projects were occupied, and all of the tenants met the income test required for the tax credits.

 

We received tax credits totaling $874,000 for the year ended December 31, 2009, $1.2 million for the year ended December 31, 2008 and $811,000 for the year ended December 31, 2007 from the Pedcor Projects.   The Pedcor Projects have incurred operating losses in the early years of their operations primarily due to accelerated depreciation of assets.  We have accounted for our investment in the Pedcor Projects on the equity method.  Accordingly, we have recorded our share of these losses as reductions to MutualBank’s investment in the Pedcor Projects.

 

20

---

 

The following summarizes MutualBank’s equity in the Pedcor Projects’ losses and tax credits recognized in our consolidated financial statements.

 

		For the Year Ended December 31,
		2009				2008				2007
		(Dollars in thousands)
Investments in Pedcor low income housing projects		$	4,161			$	4,561			$	3,246
Equity in income (losses), net of income tax effect		$	71			$	(104	)		$	(66	)
Tax credit			874				1,214				811
Increase in after-tax income from Pedcor Investments		$	945			$	1,110			$	745

See Note 10 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for additional information regarding our limited partnership investments.

 

The following table sets forth the composition of our investment and mortgage-related securities portfolio and other investments at the dates indicated.  As of December 31, 2009, our investment securities portfolio did not contain securities of any issuer with an aggregate book value in excess of 10% of our equity capital, excluding those issued by the United States Government or its agencies.

 

		December 31,
		2009								2008								2007
		Amortized Cost				Fair Value				Amortized Cost				Fair Value				Amortized Cost				Fair Value
		(Dollars in thousands)
Investment securities available-for-sale:
Mutual funds		$	1,685			$	1,643			$	1,635			$	1,497			$	16,382			$	15,914
Government sponsored entities			158				157				570				572				608				605
Mortgage-backed securities			29,175				29,890				14,771				15,163				2,310				2,352
Collateralized mortgage obligations			85,726				87,029				43,821				43,639				8,327				8,322
Corporate obligations			7,321				2,539				18,797				15,527				16,655				16,399
Municipal obligations			9,313				9,656				857				857				—				—
Total investment securities held for sale			133,378				130,914				80,451				77,255				44,282				43,592
Investment securities held to maturity:
Mortgage-backed securities			4,619				3,275				5,498				4,983				—				—
Collateralized mortgage obligations			3,028				2,554				4,178				3,545				—				—
Government sponsored entities			500				504				—				—				—				—
Total investment securities held to maturity			8,147				6,333				9,676				8,528				—				—
Investment in limited partnerships			4,161				N/A				4,561				N/A				3,246				N/A
Investment in insurance company			—				N/A				590				N/A				590				N/A
Federal Home Loan Bank stock			18,632				N/A				18,632				N/A				10,037				N/A
Total investments		$	164,318			$	137,247			$	113,910			$	85,783			$	58,155			$	43,592

 

 

21

---

 

The following table indicates, as of December 31, 2009, the composition and maturities of our investment securities, excluding Federal Home Loan Bank stock.

 

		Due in
		Less Than 1 Year				1 to 5 Years			5 to 10 Years					Over 10 Years				Total Investment Securities
		Amortized Cost				Amortized Cost			Amortized Cost					Amortized Cost				Amortized Cost				Fair Value
		(Dollars in thousands)
Available-for-sale:
Corporate obligations		$	100			$	—			$	—			$	7,221			$	7,321			$	2,539
Government sponsored entities			87				10				2,626				6,748				9,471				9,813
Mutual funds			1,685				—				—				—				1,685				1,643
Mortgage-backed securities:
Freddie Mac			—				52				753				47,327				48,132				49,418
Fannie Mae			—				806				36				20,382				21,224				22,097
Ginnie Mae			—				—				—				33,867				33,867				33,939
Other			193				—				7,177				4,308				11,678				11,465
		$	2,065			$	868			$	10,592			$	119,853			$	133,378			$	130,914
Weighted average yield			4.00	%			4.97	%			5.52	%			4.35	%			4.44	%
Held-to-maturity:
Government sponsored entities		$	—			$	500			$	—			$	—			$	500			$	504
Mortgage-backed securities:
Freddie Mac			—				—				—				802				802				762
Fannie Mae			—				—				—				2,067				2,067				2,205
Other			—				—				—				4,778				4,778				2,862
		$	—			$	500			$	—			$	7,647			$	8,147			$	6,333
Weighted average yield							2.00	%							3.46	%			3.46	%

Sources of Funds

 

General.   Our sources of funds are deposits, borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and funds provided from operations.

 

Deposits .   We offer deposit accounts to consumers and businesses having a wide range of interest rates and terms.  Our deposits consist of savings deposit accounts, NOW and demand accounts and certificates of deposit.  We solicit deposits in our market areas.  We primarily rely on competitive pricing policies, marketing and customer service to attract and retain these deposits.  Occasionally we will accept brokered deposits from a broker without paying a fee to that broker.  At December 31, 2009, our brokered deposits totaled $6.9 million, or .7% of total deposits, with an average interest rate of 1.87% and a 1.5 year weighted average maturity.

 

The flow of deposits is influenced significantly by general economic conditions, changes in money market and prevailing interest rates, and competition.  The variety of our deposit accounts has allowed us to be competitive in obtaining funds and to respond to changes in consumer demand.  We have become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious.  We try to manage the pricing of our deposits in keeping with our asset/liability management, liquidity and profitability objectives, subject to competitive factors.  Based on our experience, we believe that our deposits are relatively stable sources of funds.  Our ability to attract and maintain these deposits, however, and the rates paid on them, has been and will continue to be affected significantly by market conditions.

 

The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts, primarily checking, NOW and Super NOW checking accounts.  At December 31, 2009, we were in compliance with these reserve requirements.

 

22

---

 

The following table sets forth the dollar amount of savings deposits in the various types of deposit programs we offered at the dates indicated.

 

		December 31,
		2009								2008								2007
		Amount				Percent of Total				Amount				Percent of Total				Amount				Percent of Total
		(Dollars in thousands)
Transactions and Savings Deposits:
Noninterest bearing accounts		$	98,025				9.38	%		$	93,393				9.70	%		$	47,172				7.08	%
Passbook accounts			84,553				8.09				79,111				8.22				50,388				7.56
Interest-bearing NOW and demand accounts			154,431				14.77				156,787				16.29				117,863				17.69
Money market accounts			60,479				5.79				47,584				4.94				22,664				3.40
Total non-certificates			397,488				38.03				376,875				39.16				238,087				35.73
Certificates:
0.00 -1.99%			188,995				18.08				55,064				5.72				8,627				1.29
2.00 -3.99%			355,758				34.04				359,899				37.39				47,500				7.13
4.00 -5.99%			102,894				9.84				170,611				17.73				372,145				55.84
6.00 -7.99%			61				.01				65				0.01				48				0.01
8.00 -9.99%			—				—				—				—				—				—
10.00% and over			—				—				—				—				—				—
Total certificates			647,708				61.97				585,639				60.84				428,320				64.27
Total deposits		$	1,045,196				100.00	%		$	962,514	(1)			100.00	%		$	666,407				100.00	%

 

---

(1)	Includes $332.1 million due to MFB acquisition

The following table shows rate and maturity information for our certificates of deposit as of December 31, 2009.

 

			1.00- 1.99%				2.00- 3.99%				4.00- 5.99%				6.00- 7.99%			Total			Percent of Total
		(Dollars in thousands)
Certificate accounts maturing in quarter ending:
March 31, 2010		$	67,890			$	53,162			$	12,163			$	—			$	133,215		20.57	%
June 30, 2010			38,224				53,025				9,948				—				101,197		15.61	%
September 30, 2010			42,161				43,011				5,019				—				90,191		13.92	%
December 31, 2010			20,743				36,417				1,944				—				59,104		9.13	%
March 31, 2011			7,362				15,741				1,305				—				24,408		3.77	%
June 30, 2011			1,453				34,402				2,151				—				38,006		5.87	%
September 30, 2011			8,149				18,104				2,863				—				29,116		4.50	%
December 31, 2011			1,000				22,118				5,746				61				28,925		4.47	%
March 31, 2012			—				13,296				8,929				—				22,225		3.43	%
June 30, 2012			384				6,101				9,178				—				15,663		2.42	%
September 30, 2012			671				1,259				5,463				—				7,393		1.14	%
December 31, 2012			958				802				2,563				—				4,323		0.67	%
Thereafter			—				58,320				35,622				—				93,942		14.50	%
Total		$	188,995			$	355,758			$	102,894			$	61			$	647,708		100.00	%
Percent of total			29.18	%			54.92	%			15.89	%			.01	%			100.00	%

 

23

---

 

The following table indicates, as of December 31, 2009, the amount of our certificates of deposit and other deposits by time remaining until maturity.

 

		Maturity
		3 Months or Less				Over 3 to 6 Months				Over 6 to 12 Months				Over 12 months				Total
		(Dollars in thousands)
Certificates of deposit less than $100,000		$	92,626			$	71,066			$	100,063			$	171,496			$	435,251
Certificates of deposit of $100,000 or more			39,720				29,413				48,127				92,005				209,265
Public funds (1)			869				718				1,105				500				3,192
Total certificates of deposit		$	133,215			$	101,197			$	149,295			$	264,001			$	647,708

 

---

(1)	Deposits from governmental and other public entities.

Borrowings .   Although deposits are our primary source of funds, we utilize borrowings when they are a less costly source of funds and can be invested at a positive interest rate spread, when we desire additional capacity to fund loan demand or when they meet our asset/liability management goals.  Our borrowings historically have consisted of advances from the Federal Home Loan Bank of Indianapolis.  See Note 14 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

 

We may obtain advances from the Federal Home Loan Bank of Indianapolis upon the security of certain of our mortgage loans and mortgage-backed securities.  These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities and call features.  At December 31, 2009, we had $198.0 million in Federal Home Loan Bank advances outstanding.  Based on current collateral levels we could borrow an additional $82.4 million from the Federal Home Loan Bank at prevailing interest rates.  We believe that we will continue to have sufficient funds, through deposits and borrowings, to meet our current commitments.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity” contained in Item 7 of this Form 10-K.

 

In order to have access to Federal Home Loan Bank advances, we are required to own stock in the Federal Home Loan Bank of Indianapolis.  At December 31, 2009, we had $18,632,000 in that stock.  We continue to monitor the activities of the Federal Home Loan Bank of Indianapolis and believe they have the ability to meet our borrowing needs during this difficult economic environment.

 

We also have a term note with a balance of $10.0 million from First Tennessee Bank, N.A. as of December 31, 2009. See Note 15 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K.

 

We also are authorized to borrow from the Federal Reserve Bank of Chicago’s “discount window” after we have exhausted other reasonable alternative sources of funds, including Federal Home Loan Bank borrowings.  We have never borrowed from our Federal Reserve Bank.

 

The Company acquired $5.0 million of issuer trust preferred securities as part of the acquisition of MFB.  The net balance of the note as of December 31, 2009 was $3.9 million due to the purchase accounting adjustment from the acquisition.  The securities mature 30 years from the date of issuance, July 29, 2005.  The securities bear a fixed rate of interest of 6.22% for the first five years, resetting quarterly thereafter at the prevailing three-month LIBOR rate plus 170 basis points.  In December 2009, the Company entered into a cash flow hedge with FTN Financial to fix the floating portion of the issued trust preferred security at 5.15% for the next five years starting on September 15, 2010.  The Company may redeem the trust preferred securities, in whole or in part, without penalty, on or after September 15, 2010, or earlier upon the occurrence of certain events with the payment of a premium upon redemption.  These securities mature on September 15, 2035.

 

24

---

 

The following table sets forth, for the years indicated, the maximum month-end balance and average balance of Federal Home Loan Bank advances and other borrowings.

 

		Year Ended December 31,
		2009				2008				2007
		(Dollars in thousands)
Maximum Balance:
Federal Home Loan Bank advances		$	250,566			$	300,147			$	191,675
Notes payable			231				1,123				1,427
Other borrowings			15,359				15,967				4,311
Average Balance:
Federal Home Loan Bank advances		$	221,896			$	224,822			$	157,309
Notes payable			228				718				1,160
Other borrowings			15,076				7,967				155

The following table sets forth certain information as to our borrowings at the dates indicated.

 

		December 31,
		2009				2008				2007
		(Dollars in thousands)
Federal Home Loan Bank advances		$	197,960			$	263,113			$	191,675
Notes payable			226				647				1,055
Other borrowings			13,888				15,345				3,908
Total borrowings		$	212,074			$	279,105			$	196,638
Weighted average interest rate of FHLB advances			4.00	%			4.27	%			4.88	%
Weighted average interest rate of notes payable (1)			—				—				—
Weighted average interest rate of other borrowings (2)			5.99	%			5.28	%			6.48

 

---

(1)	Our notes payable are capitalized loans with no current interest expense as of December 31, 2009.

(2)	Our other borrowings are a term loan and subordinate debt as of December 31, 2009.

Subsidiary and Other Activities

 

As a federal savings bank, MutualBank is permitted by OTS regulations to invest up to 2% of its assets, or $28.0 million at December 31, 2009, in the stock of, or unsecured loans to, service corporation subsidiaries.  MutualBank may invest an additional 1% of its assets in service corporations where such additional funds are used for inner-city or community development purposes.  Service corporations may engage in activities not permitted for MutualBank and are not required to be controlled by MutualBank.  MutualBank also is authorized to invest an unlimited amount in operating subsidiaries that only may engage in activities authorized for MutualBank and must be controlled by MutualBank.

 

The Bank's insurance agency subsidiary, Mishawaka Financial Services, Inc., is engaged in the sale, as agent, of life insurance and credit-life and health insurance to the Bank's customers and the general public.

 

25

---

 

At December 31, 2009, MutualBank had one active subsidiary, Mutual Federal Investment Company, which is an operating subsidiary.  Mutual Federal Investment Company is a Nevada corporation that holds and manages a portion of MutualBank’s investment portfolio.  As of December 31, 2009, the market value of securities managed was $118.4 million.  Mutual Federal Investment Company has one active subsidiary, Mutual Federal REIT, Inc.  Mutual Federal REIT, Inc. is a Maryland corporation holding approximately $91.7 million in one-to four-family mortgage loans.

 

Competition

 

We face strong competition in originating real estate and other loans and in attracting deposits.  Competition in originating real estate loans comes primarily from other savings institutions, commercial banks, credit unions and mortgage bankers.  Other savings institutions, commercial banks, credit unions and finance companies provide vigorous competition in consumer lending.

 

We attract our deposits through our branch office system.  Competition for deposits comes principally from other savings institutions, commercial banks and credit unions located in the same community, as well as mutual funds and other alternative investments.  We compete for deposits by offering superior service and a variety of account types at competitive rates.

 

Employees

 

At December 31, 2009, we had a total of 369 full-time and 67 part-time employees. Our employees are not represented by any collective bargaining group.  Management considers its employee relations to be good.

 

How We Are Regulated

 

Set forth below is a brief description of certain laws and regulations that apply to us. This description, as well as other descriptions of laws and regulations contained in this Form 10-K, is not complete and is qualified in its entirety by reference to the applicable laws and regulations.

 

Legislation is introduced from time to time in the United States Congress that may affect our operations.  In addition, the regulations by which we are governed may be amended from time to time.  Any such legislation or regulatory changes could adversely affect us.  We cannot assure you as to whether or in what form any such changes will occur.

 

Congress is currently considering significant regulatory reform legislation initially proposed by the Obama administration.  This legislation, if enacted, would have a significant impact on the regulation and operations of financial institutions and their holding companies.  It currently provides for the elimination of the OTS, our primary regulator, and would require the Company to become a bank holding company and be subject to regulatory capital requirements for the first time.  This elimination of OTS may require MutualBank to convert to a national bank or state bank charter.  The legislation also provides for the creation of a new consumer financial protection agency that would issue and enforce consumer protection initiatives governing financial products and services.  The details and impact of this regulatory reform proposal cannot be determined until the proposal is enacted into law.

 

MutualFirst .   MutualFirst is a unitary savings and loan holding company subject to regulatory oversight by the OTS. MutualFirst is required to register and file reports with the OTS and is subject to regulation and examination by the OTS.  In addition, the OTS has enforcement authority over us and our non-savings institution subsidiaries.

 

MutualFirst generally is not subject to activity restrictions.  If MutualFirst acquired control of another savings institution as a separate subsidiary, it would become a multiple savings and loan holding company, and its activities and any of its subsidiaries (other than MutualBank or any other savings institution) would generally become subject to additional restrictions.

 

If MutualBank fails the qualified thrift lender test described below, MutualFirst must obtain the approval of the OTS prior to continuing, directly or through other subsidiaries, any business activity other than those approved for multiple thrift holding companies or their subsidiaries.  In addition, within one year of such failure MutualFirst must register as, and will become subject to, the restrictions applicable to bank holding companies.  The activities authorized for a bank holding company are more limited than the activities authorized for a unitary or multiple thrift holding company.

 

26

---

 

MutualBank .  MutualBank, as a federally chartered savings institution, is subject to federal regulation, periodic examination and oversight by the OTS extending to all aspects of MutualBank’s operations. MutualBank also is subject to regulation and examination by the FDIC, which insures the deposits of MutualBank to the maximum extent permitted by law.  This regulation and supervision primarily is intended for the protection of depositors and not for the purpose of protecting stockholders.

 

The investment and lending authority of federal savings institutions are prescribed by federal laws and regulations, and federal savings institutions are prohibited from engaging in any activities not permitted by such laws and regulations.  In addition, all savings institutions, including MutualBank, are required to maintain qualified thrift lender status to avoid certain restrictions on their operations.  This status is maintained by meeting the OTS qualified thrift lender test, which requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis.  As an alternative, the savings institution may maintain 60% of its assets in the assets specified in Section 7701(a)(19) of the Internal Revenue Code.  Under either test, such assets primarily consist of residential housing related loans and investments.  At December 31, 2009, MutualBank met the test and has met the test since its effectiveness.  If MutualBank loses qualified thrift lender status, it becomes subject to national bank investment and activity limits.

 

The OTS regularly examines MutualBank and prepares reports for the consideration of MutualBank’s board of directors on any deficiencies that it may find in MutualBank’s operations.  When these examinations are conducted, the examiners may require MutualBank to provide for higher general or specific loan loss reserves.  MutualBank’s relationship with its depositors and borrowers also is regulated to a great extent by both Federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of MutualBank’s mortgage requirements.  The OTS also has extensive enforcement authority over all savings institutions and their holding companies, including MutualBank and MutualFirst.

 

MutualBank’s general permissible lending limit for loans extended to one-borrower (including a group of certain related borrowers) is equal to the greater of $500,000 or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus).  At December 31, 2009, MutualBank’s lending limit under this restriction was $20.1 million.  MutualBank has no loans in excess of the lending limit.

 

The OTS, as well as the other federal banking agencies, has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits.  Any institution which fails to comply with these standards must submit a compliance plan.

 

FDIC Regulation and Insurance of Accounts.   The Bank’s deposits are insured up to the applicable limits by the FDIC, and such insurance is backed by the full faith and credit of the United States Government.  As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions.  Our deposit insurance premiums for the year ended December 31, 2009 were $2.3 million.  Those premiums have increased in recent years due to strains on the FDIC deposit insurance fund due to the cost of large bank failures and the increase in the number of troubled banks.

 

The Bank is a member of the deposit insurance fund administered by the FDIC.  Deposits are insured up to the applicable limits by the FDIC.  Through December 31, 2013, the basic deposit insurance is $250,000, instead of the $100,000 limit that had been in effect prior to October 2008.  The FDIC also provides unlimited deposit insurance coverage for noninterest-bearing transaction accounts (typically business checking accounts), NOW accounts bearing interest at 0.5% or less, and certain funds swept into noninterest-bearing savings accounts at institutions that opt into this enhanced deposit insurance coverage.  MutualBank opted into this program, which is set to expire on June 30, 2010.  The Bank pays a fee of 10 basis points (annualized) on the balance of each covered account in excess of $250,000 during the period through June 30, 2010.  During 2009, we paid total fees of $14,000 for participating in this program.

 

27

---

 

The FDIC assesses deposit insurance premiums quarterly on each FDIC-insured institution based on annualized rates for one of four risk categories applied to its deposits subject to certain adjustments. Each institution is assigned to one of four risk categories based on its capital, supervisory ratings and other factors. Well capitalized institutions that are financially sound with only a few minor weaknesses are assigned to Risk Category I. Risk Categories II, III and IV present progressively greater risks to the deposit insurance fund. Under the FDIC’s risk-based assessment rules, effective April 1, 2009, the initial base assessment rates prior to adjustments range from 12 to 16 basis points for Risk Category I, and are 22 basis points for Risk Category II, 32 basis points for Risk Category III, and 45 basis points for Risk Category IV. Initial base assessment rates are subject to adjustments based on an institution’s unsecured debt, secured liabilities and brokered deposits, such that the total base assessment rates after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43 basis points for Risk Category II, 27 to 58 basis points for Risk Category III, and 40 to 77.5 basis points for Risk Category IV. Rates increase uniformly by 3 basis points effective January 1, 2011.

 

In addition to the regular quarterly assessments, due to losses and projected losses attributed to failed institutions, the FDIC imposed a special assessment of 5 basis points on the amount of each depository institution’s assets reduced by the amount of its Tier 1 capital (not to exceed 10 basis points of its assessment base for regular quarterly premiums) as of June 30, 2009, which was collected on September 30, 2009.

 

As a result of a decline in the reserve ratio (the ratio of the net worth of the deposit insurance fund to estimated insured deposits) and concerns about expected failure costs and available liquid assets in the deposit insurance fund, the FDIC required each insured institution to prepay on December 30, 2009, the estimated amount of its quarterly assessments for the fourth quarter of 2009 and all quarters through the end of 2012 (in addition to the regular quarterly assessment for the third quarter which was due on December 30, 2009). The prepaid amount is recorded as an asset with a zero risk weight and the institution will continue to record quarterly expenses for deposit insurance. For purposes of calculating the prepaid amount, assessments are measured at the institution’s assessment rate as of September 30, 2009, with a uniform increase of 3 basis points effective January 1, 2011, and are based on the institution’s assessment base for the third quarter of 2009, with growth assumed quarterly at an annual rate of 5%. If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments in cash, or receive a rebate of prepaid amounts not exhausted after collection of assessments due on January 13, 2013, as applicable. Collection of the prepayment does not preclude the FDIC from changing assessment rates or revising the risk-based assessment system in the future. The rule includes a process for exemption from the prepayment for institutions whose safety and soundness would be affected adversely.

 

The FDIC estimates that the reserve ratio will reach the designated reserve ratio of 1.15% by 2017 as required by statute.

 

The FDIC also may prohibit any FDIC-insured institution from engaging in any activity that it determines by regulation or order to pose a serious risk to the deposit insurance fund. The FDIC also has the authority to initiate enforcement actions against the Bank and may terminate our deposit insurance if it determines that we have engaged in unsafe or unsound practices or are in an unsafe or unsound condition.

 

Regulatory Capital Requirements. MutualBank is required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a leverage ratio or core capital requirement and a risk-based capital requirement applicable to such savings institutions. The OTS also may impose capital requirements in excess of these standards on individual institutions on a case-by-case basis.

 

The capital standards generally require core capital equal to at least 4.0% of adjusted total assets. Core capital consists of tangible capital plus certain intangible assets, including a limited amount of purchased credit card relationships. At December 31, 2009, MutualBank had core capital equal to $130.3 million, or 9.4% of adjusted total assets, which is $74.8 million above the minimum requirement of 4% in effect on that date.

 

28

---

 

The OTS also requires savings institutions to have total capital of at least 8.0% of risk-weighted assets.  Total capital consists of core capital, as defined above, and supplementary capital.  Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets.  The OTS is also authorized to require a savings institution to maintain an additional amount of total capital to account for concentration of credit risk and the risk of non-traditional activities.  In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset.  As of December 31, 2009, MutualBank had total risk-based capital of $133.9 million and risk-weighted assets of $1.0 billion; or total capital of 12.8% of risk-weighted assets.  This amount was $50.3 million above the 8% requirement in effect on that date.

 

The OTS and the FDIC are authorized and, under certain circumstances, required to take actions against savings institutions that fail to meet their capital requirements.  The OTS is generally required to restrict the activities of an “undercapitalized institution,” which is an institution with less than either a 4% core capital ratio, a 4% Tier 1 risked-based capital ratio or an 8.0% risk-based capital ratio.  Any such institution must submit a capital restoration plan and, until such plan is approved by the OTS, may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions.

 

Any savings institution that fails to comply with its capital plan or has Tier 1 risk-based or core capital ratio of less than 3.0% or a risk-based capital ratio of less than 6.0% and is considered “significantly undercapitalized” must be made subject to one or more additional specified actions and operating restrictions which may cover all aspects of its operations and may include a forced merger or acquisition of the institution.  An institution that becomes “critically undercapitalized” because it has a tangible capital ratio of 2.0% or less is subject to further restrictions on its activities in addition to those applicable to significantly undercapitalized institutions.  In addition, the OTS must appoint a receiver, or conservator with the concurrence of the FDIC, for a savings institution, with certain limited exceptions, within 90 days after it becomes critically undercapitalized.  Any undercapitalized institution is also subject to the general enforcement authority of the OTS and the FDIC, including the appointment of a conservator or a receiver.

 

The OTS is also generally authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

The imposition by the OTS or the FDIC of any of these measures on MutualBank may have a substantial adverse effect on our operations and profitability.

 

Limitations on Dividends and Other Capital Distributions .  OTS regulations impose various restrictions on distributions of capital, which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account.

 

Generally, for savings institutions such as MutualBank, it is required that before and after the proposed distribution the institution remain well-capitalized.  Savings institutions may make capital distributions during any calendar year equal to the greater of 100% of net income for the year-to-date plus retained net income for the two preceding years.  However, an institution deemed to be in need of more than normal supervision by the OTS may have its dividend authority restricted by the OTS.  MutualBank may pay dividends in accordance with this general authority.

 

Savings institutions proposing to make any capital distribution need not submit written notice to the OTS prior to such distribution unless they are a subsidiary of a holding company or would not remain well-capitalized following the distribution.  Savings institutions that do not, or would not meet their current minimum capital requirements following a proposed capital distribution or propose to exceed these net income limitations must obtain OTS approval prior to making such distribution.  The OTS may object to the distribution during that 30-day period based on safety and soundness concerns.  See “– Regulatory Capital Requirements.”

 

Our ability to pay dividends on or to repurchase our common stock is subject to limits due to our participation in the TARP Capital Purchase Program.  See “General” and Item 1A.

 

29

---

 

Federal Taxation

 

General. We are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to us. MutualBank’s federal income tax returns have been closed without audit by the IRS through its year ended December 31, 2005. MutualFirst and MutualBank will file a consolidated federal income tax return for fiscal year 2009.

 

Taxable Distributions and Recapture. Prior to 1998, bad debt reserves created prior to the year ended December 31, 1997 were subject to recapture into taxable income if MutualBank failed to meet certain thrift asset and definitional tests. Federal legislation eliminated these thrift recapture rules. However, under current law, pre-1988 reserves remain subject to recapture should MutualBank make certain non-dividend distributions or cease to maintain a thrift/bank charter.

 

Minimum Tax. The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, called alternative minimum taxable income. The alternative minimum tax is payable to the extent such alternative minimum taxable income is in excess of an exemption amount. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. MutualBank is subject to the alternative minimum tax, and has $173,000 available as credits for carryover.

 

Corporate Dividends-Received Deduction. MutualFirst may eliminate from its income dividends received from MutualBank as a wholly owned subsidiary of MutualFirst if it elects to file a consolidated return with MutualBank. The corporate dividends-received deduction is 100% or 80%, in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend. Corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.

 

State Taxation

 

MutualBank is subject to Indiana’s financial institutions tax, which is imposed at a flat rate of 8.5% on “adjusted gross income” apportioned to Indiana. “Adjusted gross income,” for purposes of the financial institutions tax, begins with taxable income as defined by Section 63 of the Internal Revenue Code and incorporates federal tax law to the extent that it affects the computation of taxable income. Federal taxable income is then adjusted by several Indiana modifications including only considering members of the combined group which have Indiana nexus.

 

Other applicable state taxes include generally applicable sales and use taxes plus real and personal property taxes.

 

Internet Website

 

We maintain a website with the address of www.bankwithmutual.com. The information contained on our website is not included as a part of, or incorporated by reference into, this Annual Report on Form 10-K. This Annual Report on Form 10-K and our other reports, proxy statements and other information, including earnings press releases, filed with the SEC are available on that website through a link to the SEC’s website at “Resource Center – Investor Relations - SEC Filings.” For more information regarding access to these filings on our website, please contact our Corporate Secretary, MutualFirst Financial, Inc., 110 E. Charles Street, Muncie, Indiana, 47305-2419; telephone number (765) 747-2800.

 

30

---

 

Item1A.              Risk Factors

 

The following are certain risk factors that could impact our business, financial results and results of operations. Investing in our common stock involves risks, including those described below. These risk factors should be considered by prospective and current investors in our common stock when evaluating the disclosures in this Annual Report on Form 10-K (particularly the forward-looking statements). These risk factors could cause actual results and conditions to differ materially from those projected in forward-looking statements. If any of the events in the following risks actually occur, or if additional risks and uncertainties not presently known to us or that we believe are immaterial do materialize, then our business, financial condition or results of operations could be materially adversely impacted. In addition, the trading price of our common stock could decline due to any of the events described in these risks.

 

Our financial condition and results of operations are dependent on the economy, particularly in the Bank’s market area. The current economic recession in the market area we serve may continue to impact our earnings adversely and could increase the credit risk of our loan portfolio.

 

Our primary market area is concentrated in north central and eastern Indiana. Adverse economic conditions in that market area can reduce our rate of growth, affect our customers’ ability to repay loans and adversely impact our financial condition and earnings. General economic conditions, including inflation, unemployment and money supply fluctuations, also may affect our profitability adversely. Our market area is undergoing a recession, which has resulted in higher levels of loan delinquencies, problem assets and foreclosures, decreased demand for our products and services and a decline in the value of our loan collateral. If this recession continues or becomes more severe, this negative impact on our business, financial condition and earnings may increase.

 

A continuation of recent turmoil in the financial markets could have an adverse effect on our financial position or results of operations.

 

Beginning in 2008, United States and global financial markets have experienced severe disruption and volatility, and general economic conditions have declined significantly. Adverse developments in credit quality, asset values and revenue opportunities throughout the financial services industry, as well as general uncertainty regarding the economic, industry and regulatory environment, have had a marked negative impact on the industry. Dramatic declines in the U.S. housing market over the past two years, with falling home prices, increasing foreclosures and increasing unemployment, have negatively affected the credit performance of mortgage loans and resulted in significant write-downs of asset values by many financial institutions. The United States and the governments of other countries have taken steps to try to stabilize the financial system, including investing in financial institutions, and have also been working to design and implement programs to improve general economic conditions. Notwithstanding the actions of the United States and other governments, these efforts may not succeed in restoring industry, economic or market conditions and may result in adverse unintended consequences. Factors that could continue to pressure financial services companies, including the Company, are numerous and include (i) worsening credit quality, leading among other things to increases in loan losses and reserves, (ii) continued or worsening disruption and volatility in financial markets, leading among other things to continuing reductions in asset values, (iii) capital and liquidity concerns regarding financial institutions generally, (iv) limitations resulting from or imposed in connection with governmental actions intended to stabilize or provide additional regulation of the financial system, or (v) recessionary conditions that are deeper or last longer than currently anticipated.

 

Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.

 

Lending money is a substantial part of our business. Every loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:

 

·

cash flow of the borrower and/or the project being financed;

 

·

in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral;

 

·

the credit history of a particular borrower;

 

·

changes in economic and industry conditions; and

 

31

---

 

·

the duration of the loan.

 

We maintain an allowance for loan losses which we believe is appropriate to provide for potential losses in our loan portfolio. The amount of this allowance is determined by our management through a periodic review and consideration of several factors, including, but not limited to:

 

·

an ongoing review of the quality, size and diversity of the loan portfolio;

 

·

evaluation of non-performing loans;

 

·

historical default and loss experience;

 

·

historical recovery experience;

 

·

existing economic conditions;

 

·

risk characteristics of the various classifications of loans; and

 

·

the amount and quality of collateral, including guarantees, securing the loans.

 

If our loan losses exceed our allowance for probable loan losses, our business, financial condition and profitability may suffer.

 

The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.  In determining the amount of the allowance for loan losses, we review our loans and the loss and delinquency experience, and evaluate economic conditions and make significant estimates of current credit risks and future trends, all of which may undergo material changes.  If our estimates are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for additions to our allowance through an increase in the provision for loan losses.  Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses.  Our allowance for loan losses was 1.5% of gross loans held for investment and 50.4% of nonperforming loans at December 31, 2009.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than that of management.  If charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses.  Any increases in the provision for loan losses will result in a decrease in net income and may have a material adverse effect on our financial condition, results of operations and our capital.

 

Our provision for loan losses has increased substantially and additional increases in the provision and loan charge-offs may be required, adversely impacting operations.

 

For the year ended December 31, 2009, we recorded a provision for loan losses of $6.5 million compared to $7.0 million for the 2008 fiscal year.  We also recorded net loan charge-offs of $5.2 million in 2009, compared to $3.2 million in 2008.  During 2008 and 2009, we have experienced increasing loan delinquencies and credit losses.  As a result, nonperforming loans increased from $21.8 million at the end of 2008 to $32.6 million at the end of 2009.  If the declining trends in the housing, real estate and local business markets continue, we expect increased levels of delinquencies and credit losses to continue, which adversely impacts our financial condition and results of operations.

 

32

---

 

If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation reserves, our earnings could be reduced.

 

We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed and the property taken in as real estate owned (“REO”), and at certain other times during the assets holding period. Our net book value (“NBV”) in the loan at the time of foreclosure and thereafter is compared to the updated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset’s NBV over its fair value. If our valuation process is incorrect, the fair value of our investments in real estate may not be sufficient to recover our NBV in such assets, resulting in the need for additional charge-offs. Additional material charge-offs to our investments in real estate could have a material adverse effect on our financial condition and results of operations. Our bank regulator periodically reviews our REO and may require us to recognize further charge-offs. Any increase in our charge-offs, as required by such regulator, may have a material adverse effect on our financial condition and results of operations.

 

Other-than-temporary impairment charges in our investment securities portfolio could result in losses and adversely affect our continuing operations.

 

During the year ended December 31, 2009, we recognized a $5.3 million non-cash other than temporary impairment (“OTTI”) charge on available-for-sale and held-to-maturity securities we hold for investment. At December 31, 2009, the fair value of these securities were $2.8 million. Management concluded that the decline of the estimated fair value below the cost of the security was other than temporary and recorded a credit loss of $2.6 million through non-interest income. We determined the remaining decline in value was not related to specific credit deterioration. We do not intend to sell these securities and it is not more than likely than not we will be required to sell the securities before anticipated recovery of the remaining amortized cost basis. We closely monitor our investment securities for changes in credit risk. The valuation of our investment securities also is influenced by external market and other factors, including implementation of Securities and Exchange Commission and Financial Accounting Standards Board guidance on fair value accounting. Our valuation of our securities will be influenced by the default rates of specific financial institutions whose securities provide the underlying collateral for these securities. The current market environment significantly limits our ability to mitigate our exposure to valuation changes in these securities by selling them. Accordingly, if market conditions deteriorate further and we determine our holdings of these or other investment securities are OTTI, our future earnings, shareholders’ equity, regulatory capital and continuing operations could be materially adversely affected.

 

Our business may be adversely affected by credit risk associated with residential property.

 

At December 31, 2009, $578.1 million, or 53.6% of our total loan portfolio, was secured by one-to four-family mortgage loans and home equity loans (including home equity lines of credit). This type of lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. The decline in residential real estate values as a result of the downturn in the Indiana housing markets has reduced the value of the real estate collateral securing these types of loans and increased the risk that we would incur losses if borrowers default on their loans. Continued declines in both the volume of real estate sales and the sales prices coupled with the current recession and the associated increases in unemployment may result in higher than expected loan delinquencies or problem assets, a decline in demand for our products and services, or lack of growth or a decrease in deposits. These potential negative events may cause us to incur losses, adversely affect our capital and liquidity and damage our financial condition and business operations.

 

Our loan portfolio possesses increased risk due to our substantial number of multi-family, commercial real estate, consumer and commercial business loans.

 

Approximately 46.4% of our loan portfolio as of December 31, 2009, consisted of multi-family, commercial real estate, construction, consumer (non-mortgage) and commercial business loans. Multi-family, commercial and construction real estate loans accounted for approximately 25.0% of our total loan portfolio as of December 31, 2009. Our commercial business and consumer (non-mortgage) loans accounted, respectively, for approximately 7.2% and 14.2% of our total loan portfolio as of December 31, 2009. Generally, we consider these types of loans to involve a higher degree of risk compared to first mortgage loans on one- to four-family, owner-occupied residential properties. For further information concerning the risks associated with multi-family, commercial real estate, consumer loans and commercial business loans, see “Lending Activities” and “Asset Quality” in Item 1.

 

33

---

 

Rising interest rates may hurt our profits.

 

To be profitable, we have to earn more money in interest we receive on loans and investments that we make than we pay to our depositors and lenders in interest. If interest rates rise, our net interest income and the value of our assets could be reduced if interest paid on interest-bearing liabilities, such as deposits and borrowings, increases more quickly than interest received on interest-earning assets, such as loans, other mortgage-related investments and investment securities. This is most likely to occur if short-term interest rates increase at a faster rate than long-term interest rates, which would cause income to go down. In addition, rising interest rates may hurt our income, because they may reduce the demand for loans and the value of our securities. In a rapidly changing interest rate environment, we may not be able to manage our interest rate risk effectively, which would adversely impact our financial condition and results of operations. For a further discussion of how changes in interest rates could impact us, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and “Asset and Liability Management and Market Risk” in Item 7A.

 

We face risks related to covenants in our loan sales to investors and secondary mortgage market conditions.

 

Our agreements with investors to sell our loans generally contain covenants that require us to repurchase loans under certain circumstances, including some delinquencies, or to return premiums paid by those investors if the loans are paid off early. If we are required to repurchase sold loans under these covenants, they may be deemed troubled loans, with the potential for charge-offs and/or loss provision changes, which could impact our earnings and asset quality ratios adversely. The Bank was not required to repurchase any loans from our investors during 2009.

 

Our ability to sell loans on the secondary mortgage market is impacted by interest rate changes and investor demand or expected return. If this market becomes less liquid, we may not be able to rely as much on loan sales to reduce our interest rate and credit risk.

 

Declining economic conditions may adversely impact the fees generated by our asset management and trust business.

 

To the extent our asset management and trust clients and their assets become adversely impacted by weak economic and stock market conditions, they may choose to withdraw the assets managed by us and the value of their assets may decline. Our asset management revenues are based on the value of the assets we manage. If our clients withdraw assets or the value of their assets decline, our revenues from these activities may be adversely affected.

 

We face significant operational risks.

 

We operate in many different financial service businesses and rely on the ability of our employees and systems to process a significant number of transactions. Operational risk is the risk of loss from operations, including fraud by employees or outside persons, employees’ execution of incorrect or unauthorized transactions, data processing and technology errors or hacking and breaches of internal control systems.

 

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities or on terms that are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.

 

34

---

 

We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.

 

We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. In addition, we may elect to raise additional capital to repay our TARP funds, support our business or to finance acquisitions, if any, or we may otherwise elect or be required to raise additional capital. In that regard, a number of financial institutions have recently raised considerable amounts of capital in response to a deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors. Should we be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock. The issuance of additional shares of common stock or convertible securities to new stockholders would be dilutive to our current stockholders.

 

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.

 

There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.

 

We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.

 

Anti-takeover provisions could negatively impact our shareholders.

 

Provisions in our charter and bylaws, the corporate law of the State of Maryland and federal regulations could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our stockholders, or otherwise adversely affect the market price of any class of our equity securities, including our common stock. These provisions include: a prohibition on voting shares of common stock beneficially owned in excess of 10% of total shares outstanding, supermajority voting requirements for certain business combinations with any person who beneficially owns more than 10% of our outstanding common stock; the election of directors to staggered terms of three years; advance notice requirements for nominations for election to our Board of Directors and for proposing matters that stockholders may act on at stockholder meetings, a requirement that only directors may fill a vacancy in our Board of Directors, supermajority voting requirements to remove any of our directors and the other provisions of our charter. Our charter also authorizes our Board of Directors to issue preferred stock , and preferred stock could be issued as a defensive measure in response to a takeover proposal. In addition, pursuant to OTS regulations, as a general matter, no person or company, acting individually or in concert with others, may acquire more than 10% of our common stock without prior approval from the OTS.

 

These provisions may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price or adversely affect the market price of, and the voting and other rights of the holders of, our common stock. These provisions could also discourage proxy contests and make it more difficult for holders of our common stock to elect directors other than the candidates nominated by our Board of Directors.

 

35

---

 

The voting limitation provision in our charter could limit your voting rights as a holder of our common stock.

 

Our charter provides that any person or group who acquires beneficial ownership of our common stock in excess of 10% of the outstanding shares may not vote the excess shares. Accordingly, if you acquire beneficial ownership of more than 10% of the outstanding shares of our common stock, your voting rights with respect to the common stock will not be commensurate with your economic interest in our company.

 

Our core deposit premium could be deemed partially or fully impaired, which could reduce our earnings and the values of that intangible asset.

 

At December 31, 2009, we had a core deposit premium of $5.9 million due mainly to the MFB acquisition. Under GAAP, we are required to periodically assess the value of this intangible asset based on a number of factors to determine if there is partial or full impairment. The factors taken into consideration include the market price of our stock, the net present value of our assets and liabilities and valuation information for similar financial institutions. This evaluation involves a substantial amount of judgment. If actual conditions underlying the factors differ from our assessment, the core deposit intangible could be subjected to faster amortization or partial or complete impairment, which would reduce the value of this asset and reduce our earnings, perhaps materially.

 

We currently hold a significant amount of bank-owned life insurance.

 

At December 31, 2009, we held $93.5 million of bank-owned life insurance or BOLI on key employees and executives, with a cash surrender value of $44.2 million. The policies are maintained to fund amounts owed under executive supplemental retirement plans. The eventual repayment of the cash surrender value is subject to the ability of the various insurance companies to pay death benefits or to return the cash surrender value to us if needed for liquidity purposes. We continually monitor the financial strength of the various companies with whom we carry these policies. However, any one of these companies could experience a decline in financial strength, which could impair its ability to pay benefits or return our cash surrender value. If we need to liquidate these policies for liquidity purposes, we would be subject to taxation on the increase in cash surrender value and penalties for early termination, both of which would adversely impact earnings.

 

We may not be able to realize our deferred tax asset fully.

 

At December 31, 2009, we had a $19.5 million deferred income tax benefit based on differences between the financial statement amounts and tax bases of assets and liabilities and reflecting mainly an allowance for loan loss timing difference and business tax and AMT carryover. The value of our deferred income tax benefit is reviewed regularly under various forecasts and assumptions, including anticipated levels of taxable net income, to determine the likelihood of realizing the benefit. If actual results or subsequent forecasts differ from our current judgments, so that this benefit will not be fully realized, we would have to write down this asset, which would negatively impact results of operation and reduce our asset size.

 

If our investment in the Federal Home Loan Bank of Indianapolis becomes impaired, our earnings and stockholders’ equity could decrease.

 

At December 31, 2009, we owned $18.6 million in Federal Home Loan Bank of Indianapolis stock. We are required to own this stock to be a member of and to obtain advances from our Federal Home Loan Bank. This stock is not marketable and can only be redeemed by our Federal Home Loan Bank, which currently is not redeeming any excess member stock. Our Federal Home Loan Bank’s financial condition is linked, in part, to the eleven other members of the Federal Home Loan Bank System and to accounting rules and asset quality risks that could materially lower their capital, which would cause our Federal Home Loan Bank stock to be deemed impaired, resulting in a decrease in our earnings and assets.

 

36

---

 

We operate in a highly regulated environment and our operations and income may be affected adversely by changes in laws and regulations governing our operations, including regulatory reform initiatives of the Obama administration that are pending in Congress.

 

We are subject to extensive regulation, supervision and examination by the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. These regulators govern the activities in which we may engage, primarily for the protection of depositors and the deposit insurance fund. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose restrictions on a bank’s operations, reclassify assets, determine the adequacy of a bank’s allowance for loan losses and determine the level of deposit insurance premiums assessed. Any change in such regulation and oversight, whether in the form of regulatory policy, new regulations or legislation or additional deposit insurance premiums could have a material impact on our operations. Because our business is highly regulated, the laws and applicable regulations are subject to frequent change. Any new laws, rules and regulations could make compliance more difficult or expensive or otherwise adversely affect our business, financial condition or prospects. For example, initiatives to limit our fees on overdraft protection programs or our creditor rights could impact our fee income or ability to resolve problem assets. Pending regulatory reform legislation proposed by the Obama administration and under consideration by Congress, if enacted, could change our primary regulator, create a new consumer finance protection agency, change the Company into a bank holding company with new capital requirements and require MutualBank to convert to a different charter. These changes could possibly adversely impact our operations and net income.

 

Our earnings are adversely impacted by increases in deposit insurance premiums and special FDIC assessments.

 

Beginning in late 2008, the economic environment caused higher levels of bank failures, which dramatically increased FDIC resolution costs and led to a significant reduction in the deposit insurance fund. As a result, the FDIC has significantly increased the initial base assessment rates paid by financial institutions for deposit insurance. The base assessment rate was increased by seven basis points (seven cents for every $100 of deposits) for the first quarter of 2009. Effective April 1, 2009, initial base assessment rates were changed to range from 12 basis points to 45 basis points across all risk categories with possible adjustments to these rates based on certain debt-related components. These increases in the base assessment rate have increased our deposit insurance costs and negatively impacted our earnings. In addition, in May 2009, the FDIC imposed a special assessment on all insured institutions due to recent bank and savings association failures. The emergency assessment amounts to five basis points on each institution’s assets minus Tier 1 capital as of June 30, 2009, subject to 10 basis points times the institution’s assessment base. Our FDIC deposit insurance expense for fiscal 2009 was $2.3 million, including the special assessment of $630,000 recorded in June 2009 and paid on September 30, 2009.

 

Additionally, in November 2009, the FDIC adopted a rule that requires each financial institution to prepay its estimated quarterly risk-based assessment for the fourth quarter of 2009 and for all of 2010, 2011 and 2012, which will be amortized over these periods and adjusted for changes in premium levels or our financial condition. As a result, this prepayment will not immediately impact our earnings.

 

Strong competition within our market area may limit our growth and profitability.

 

Competition in the banking and financial services industry is intense. In our market area, we compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors have substantially greater name recognition, resources and lending limits than we do and may offer certain services or prices for services that we do not or cannot provide. Our profitability depends upon our continued ability to successfully compete in our market.

 

37

---

 

The securities purchase agreement between us and Treasury limits our ability to pay dividends on and repurchase our common stock.

 

The securities purchase agreement between us and Treasury provides that prior to the earlier of (i) December 23, 2011 and (ii) the date on which all of the shares of the Series A Preferred Stock have been redeemed by us or transferred by Treasury to third parties, we may not, without the consent of Treasury, (a) increase the cash dividend on our common stock or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock (other than the Series A Preferred Stock) or any trust preferred securities then outstanding. In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the Series A Preferred Stock. These restrictions, together with the potentially dilutive impact of the warrant described in the next risk factor, could have a negative effect on the value of our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, as and if declared by our Board of Directors. Although we have historically paid cash dividends on our common stock, we are not required to do so and our Board of Directors could reduce or eliminate our common stock dividend in the future.

 

The Series A Preferred Stock impacts net income available to our common shareholders and earnings per common share, and the warrant we issued to Treasury may be dilutive to holders of our common stock.

 

The dividends declared on the Series A Preferred Stock will reduce the net income available to common shareholders and our earnings per common share. The Series A Preferred Stock will also receive preferential treatment in the event of liquidation, dissolution or winding up of MutualFirst Financial. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant we issued to Treasury in conjunction with the sale to Treasury of the Series A Preferred Stock is exercised. The shares of common stock underlying the warrant represent approximately 8.2% of the shares of our common stock outstanding (including the shares issuable upon exercise of the warrant). Although Treasury has agreed not to vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction.

 

If we are unable to redeem our Series A Preferred Stock before December 2013, the cost of this capital to us will increase substantially.

 

If we are unable to redeem the Series A Preferred Stock before December 2013, the cost of the TARP capital will increase substantially from 5.0% per annum (approximately $1.6 million annually) to 9.0% per annum (approximately $2.9 million annually). Depending on our financial condition at the time, this increase in the annual dividend rate on the Series A Preferred Stock could have a material negative effect on our liquidity.

 

We rely on dividends from MutualBank for substantially all of the Company’s revenue.

 

MutualFirst ’s primary source of revenue is dividends from the Bank. The OTS regulates and must approve the amount of Bank dividends to the Company. If the Bank is unable to pay dividends, MutualFirst may not be able to service its debt, pay its other obligations or pay dividends on the Company’s common stock which could have a material adverse impact on our financial condition or the value of your investment in our common stock.

 

Our common stock trading volume may not provide adequate liquidity for investors.

 

Our common stock is listed on the Nasdaq Global Market. However, the average daily trading volume in our common stock is less than that of many larger financial services companies. A public trading market having the desired depth, liquidity and orderliness depends on the presence of a sufficient number of willing buyers and sellers for our common stock at any given time. This presence is impacted by general economic and market conditions and investors’ views of our Company. Because our trading volume is limited, any significant sales of our shares could cause a decline in the price of our common stock.

 

Our directors and executive officers have the ability to influence stockholder actions in a manner that may be adverse to the personal investment objectives of our stockholders.

 

As of December 31, 2009, our directors and executive officers as a group beneficially owned 1,291,870 shares, or 18.5%, of our common stock (including options for 417,390 shares). In addition, our employee stock ownership plan and charitable foundation controlled, respectively, 7.2% and 3.2% of our common stock on that date. In addition, as of December 31, 2009, 314,702 shares were reserved under various stock benefit plans for future awards for our directors, officers and employees. Due to this significant collective ownership of or control over our common stock, our directors and executive officers may be able to influence the outcome of director elections or block significant transactions, such as a merger or acquisition, or any other matter that might otherwise be favored by other shareholders.

 

38

---

 

Item 1B.

Unresolved Staff Comments

 

None

 

Item 2.               Properties

 

At December 31, 2009 we had 33 full service offices. We own the office building in which our home office and executive offices are located. At December 31, 2009 we owned all but two of our other branch offices. The net book value of our investment in premises, equipment and leaseholds, excluding computer equipment, was approximately $32.4 million at December 31, 2009. We believe that our current facilities are adequate to meet our present and immediately foreseeable needs.

 

We utilize a third party service provider to maintain our database of depositor and borrower customer information. At December 31, 2009 the net book value of the data processing and computer equipment utilized by us was $2.1 million .

 

Item 3.               Legal Proceedings

 

From time to time, we are involved as plaintiff or defendant in various legal actions arising in the normal course of business.  We do not anticipate incurring any material liability as a result of such litigation.

 

Item 4.               (Reserved)

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

The common stock of MutualFirst Financial, Inc. is traded under the symbol “MFSF” on the Nasdaq Global Market. The table below shows the high and low closing prices for our common stock for the periods indicated. This information was provided by the Nasdaq. At December 31, 2009, there were 6,984,754 shares of common stock outstanding and at that date we also had 32,382 shares of preferred stock outstanding and approximately 1,400 shareholders of record.

 

		Stock Price							Dividends per Share
2009 Quarters:		High				Low
First Quarter (ended 03/31/09)		$	7.40			$	3.51		$	0.12
Second Quarter (ended 06/30/09)		$	10.00			$	5.05		$	0.12
Third Quarter (ended 09/30/09)		$	8.50			$	6.60		$	0.12
Fourth Quarter (ended 12/31/09)		$	7.83			$	5.57		$	0.06

		Stock Price							Dividends per Share
2008 Quarters:		High				Low
First Quarter (ended 03/31/08)		$	13.98			$	12.80		$	0.16
Second Quarter (ended 06/30/08)		$	13.66			$	9.81		$	0.16
Third Quarter (ended 09/30/08)		$	11.00			$	9.34		$	0.16
Fourth Quarter (ended 12/31/08)		$	10.50			$	6.20		$	0.16

 

39

---

 

Our cash dividend payout policy is continually reviewed by management and the Board of Directors. The Company intends to continue its policy of paying quarterly dividends; however, future dividend payments will depend upon a number of factors, including capital requirements, regulatory limitations, the Company’s financial condition, results of operations and the Bank’s ability to pay dividends to the Company. The Company relies significantly upon such dividends originating from the Bank to accumulate earnings for payment of cash dividends to shareholders. Our TARP agreement limits our ability to pay dividends to common stockholders if dividends on the TARP preferred shares are not paid in full to date.

 

Information regarding our equity compensation plans is included in Item 11 of this Form 10-K.

 

On August 13, 2008, the Company’s Board of Directors authorized management to repurchase an additional 5% of the Company’s outstanding stock, or approximately 350,000 shares. Our ability to repurchase shares is limited under the securities purchase agreement with Treasury. See Item 1A.

 

40

---

 

Item 6.

Selected Financial Data

 

SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA

 

The following information is only a summary and you should read it in conjunction with our consolidated financial statements and accompanying notes contained in Item 8 of this Form 10-K.

 

		At or For the Year Ended December 31,
		2009				2008				2007				2006				2005
		(In thousands)
Selected Financial Condition Data
Total assets		$	1,399,034			$	1,388,827			$	962,517			$	960,842			$	971,829
Cash and cash equivalents			46,341				39,703				23,648				24,915				22,365
Loans, net			1,059,694				1,113,132				802,436				805,625				822,547
Investment securities:
Available-for-sale, at fair value			130,914				77,255				43,592				41,070				39,788
Held to maturity			8,147				9,676				—				—				—
Total deposits			1,045,196				962,514				666,407				703,359				684,554
Total borrowings			212,074				279,104				196,638				158,852				187,791
Total stockholders’ equity			129,727				130,515				87,014				87,264				88,794
Selected Operations Data
Total interest income		$	71,852			$	65,179			$	56,374			$	56,119			$	48,478
Total interest expense			30,624				31,639				32,227				29,890				21,170
Net interest income			41,228				33,540				24,147				26,229				27,308
Provision for loan losses			6,500				7,020				2,240				2,068				1,775
Net interest income after provision for loan losses			34,728				26,520				21,907				24,161				25,533
Service fee income			7,458				6,257				4,831				4,370				4,026
Gain (loss) on sale of loans and investment securities			3,132				(927	)			391				(669	)			228
Other-than-temporary impairment, securities			(2,555)				(1,350	)			—				—				—
Other non-interest income (loss)			5,118				2,542				2,549				2,941				2,478
Total non-interest income			13,153				6,522				7,771				6,642				6,732
Salaries and employee benefits			23,047				19,118				14,759				14,617				13,792
Other expenses			21,460				44,508				10,397				10,402				9,620
Total non-interest expense			44,507				63,626				25,156				25,019				23,412
Income (loss) before taxes			3,374				(30,584	)			4,522				5,784				8,853
Income tax expense (benefit)			211				(8,485	)			296				1,028				2,401
Net income (loss)			3,163				(22,099	)			4,226				4,756				6,452
Preferred stock dividends and amortization			1,803				31				—				—				—
Net income (loss) available to common shareholders		$	1,360			$	(22,130	)		$	4,226			$	4,756			$	6,452

 

 

41

---

 

		At or For the Year Ended December 31,
		2009				2008				2007				2006				2005
Selected Financial Ratios and Other Financial Data:
Performance Ratios:
Return on average assets (ratio of  net income to average total assets)			0.23	%			(1.91	)%			0.44	%			0.49	%			0.73	%
Return on average tangible equity  (ratio of net income to average tangible equity)			1.49				(28.04	)			5.86				6.43				7.79
Interest rate spread information:
Average during the period			2.98				3.01				2.50				2.70				3.13
Net interest margin (1)			3.22				3.22				2.79				2.96				3.37
Ratio of operating expense to average total assets			3.17				5.49				2.64				2.57				2.89
Ratio of average interest-earning assets to average interest-bearing liabilities			110.67				107.14				107.92				107.65				109.30
Efficiency ratio (2)			81.84				158.81				78.81				76.11				68.78
Asset Quality Ratios: (3)
Non-performing assets to total assets			2.86				1.92				1.35				0.86				1.03
Non-performing loans to total loans			3.03				1.93				1.29				0.70				0.90
Allowance for loan losses to non-performing loans			50.38				69.41				79.72				143.59				108.04
Allowance for loan losses to loans receivable, net			1.53				1.34				1.03				1.00				0.98
Capital Ratios:
Equity to total assets (3)			9.27				9.40				9.04				9.08				9.14
Average equity to average assets			9.29				8.89				9.16				9.08				9.90
Share and Per Share Data:
Average common shares outstanding:
Basic			6,840,659				5,249,135				4,103,940				4,196,059				4,328,965
Diluted			6,840,748				5,249,135				4,151,173				4,274,039				4,439,686
Per share:
Basic earnings		$	0.20			$	(4.22	)		$	1.03			$	1.13			$	1.49
Diluted earnings		$	0.20			$	(4.22	)		$	1.02			$	1.11			$	1.45
Dividends		$	0.42			$	0.64			$	0.60			$	0.58			$	0.49
Dividend payout ratio (4)			210.00	%			(15.20	)%			58.25	%			52.25	%			36.55	%
Other Data:
Number of full-service offices			33				33				21				21				20

 

---

(1)	Net interest income divided by average interest earning assets.

(2)	Total non-interest expense divided by net interest income plus total non-interest income.

(3)	At the end of the period.

(4)	Dividends per share divided by diluted earnings per share.

 

 

42

---

 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

Introduction

 

MutualFirst is a savings and loan holding company and MutualBank is its wholly-owned subsidiary. MutualBank has been in business since 1889 and currently conducts its business from 33 full service financial centers located in Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties, Indiana, with its main office located in Muncie. MutualBank also has trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. MutualBank’s principal business consists of attracting deposits from the general public and originating fixed and variable rate loans secured primarily by first mortgage liens on residential and commercial real estate, consumer goods, and business assets. MutualBank’s deposit accounts are insured by the Federal Deposit Insurance Corporation up to applicable limits. We also originate mortgage loans in counties contiguous to these counties, and we originate indirect consumer loans throughout Indiana. We provide investment money management and trust services for our customers.

 

In July 2008, the Company acquired MFB Corp. and merged MFB’s subsidiary bank, MFB Financial into MutualBank. MutualFirst issued an aggregate of 2.9 million shares of its common stock and paid approximately $11.5 million in cash to MFB stockholders in the transaction. MutualFirst also assumed 114,500 MFB stock options, which have converted into approximately 296,555 MutualFirst stock options with a weighted average exercise price of $9.90 per share. As a result of the transaction, MutualBank now has 33 retail financial centers, spanning nine Indiana counties and is the 10 th largest depository institution headquartered in Indiana.

 

In December 2008, as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program, the Company entered into a Letter Agreement and Securities Purchase Agreement (collectively, the “Purchase Agreement”) with the United States Department of the Treasury (“Treasury”), pursuant to which the Company (i) sold 32,382 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) for a purchase price of $32,382,000 in cash and (ii) issued a warrant (the “Warrant”) to purchase 625,135 shares of the Company’s common stock, par value $0.01 per share (the “Common Stock”), for a per share price of $7.77 per share. The Series A Preferred Stock is entitled to cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series A Preferred Stock may be redeemed by the Company at any time, subject to consultation by the Treasury with the Office of Thrift Supervision (“OTS”). The Warrant has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $7.77 per share of the Common Stock. If the Series A Preferred Stock is redeemed, the Warrant will be liquidated at the current market price. Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant that it holds.

 

Pursuant to the terms of the Purchase Agreement, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its Junior Stock (as defined below) and Parity Stock (as defined below) will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share ($0.16) declared on the Common Stock prior to December 23, 2008. The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted. These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the Series A Preferred Stock, (b) the date on which the Series A Preferred Stock has been redeemed in whole; and (c) the date Treasury has transferred all of the Series A Preferred Stock to third parties. In addition, the ability of the Company to declare or pay dividends or distributions on, or repurchase, redeem or otherwise acquire for consideration, shares of its Junior Stock and Parity Stock will be subject to restrictions in the event that the Company fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on its Series A Preferred Stock. “Junior Stock” means the Common Stock and any other class or series of stock of the Company the terms of which expressly provide that it ranks junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company. “Parity Stock” means any class or series of stock of the Company the terms of which do not expressly provide that such class or series will rank senior or junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company (in each case without regard to whether dividends accrue cumulatively or non-cumulatively).

 

The Company placed $29.1 million of TARP proceeds into its wholly-owned subsidiary MutualBank, while maintaining $3.2 million with the Company. MutualBank placed approximately $20.0 million of the proceeds in highly rated securities. Approximately $14.8 million was placed in mortgage securities, $3.2 million in municipal securities and $2.0 million in corporate bonds. These securities provide liquidity as needed to meet current and future loan demand. The remaining funds held at MutualBank were placed in working capital, which was used to fund loans and meet the cash needs of MutualBank.

 

43

---