Liberty Bank Shareholder LetterTuesday, May 3, 2011
Dear Liberty Bank Shareholder:
Much has transpired since our last communication. This writing will bring you up to date on the status and progress of a number of important issues:
- Student Lending Program
- Formal Agreement with the Office of the Comptroller of the Currency (OCC)Strategic Direction
- Utilizing Technology
- Letter of Intent with a Private Investor
- Private Placement
- Change of Annual Meeting Date to October 25, 2011
Your Bank is alive and well at March 31, 2011. Liberty Bank has completed its second consecutive positive earnings quarter and is meeting its 2011 budget. It has been a long time coming but I believe we are back on track to produce the results that will provide the return that you deserve. Economic conditions have improved but continue to represent a challenge. Our optimism is based upon issues specific to Liberty Bank and I will attempt to capture some of them in this writing.
Student Lending Program
To understand Liberty Bank’s recent successes and challenges we must first understand the Bank’s student lending business. This topic was discussed in the 2010 Letter to Shareholders. However I believe it warrants revisiting at this time. I hope to provide the logic for our continuation of wholesale student lending and describe the associated risk that presently exists due to participation in this business as well as the benefits derived from the program’s success.
The Bank has been in the private student lending business since 2005 as an originating lender with commitments for loan sales to third parties in the private wholesale secondary market. The key differentiating factor of Liberty’s program is that the student loans that we originate are to be secured by 100% cash collateral. Unfortunately, during 2008, certain student lending commitments were made without cash collateralization. When the secondary market for these loans collapsed after the first quarter of 2008, our then partners whose responsibility it was to deliver these loans for sale to the secondary market, reneged. However, with all of our current programs being collateralized with cash, that risk is now eliminated.
Since its inception, the program has produced over $20 million in revenue for the Bank. The earnings for the Bank included a 0.25% fee for loans sold into the secondary market and spread income of over 3% while the loans remained on the books of the Bank. The volume of student lending increased dramatically during the period from 2005 through the first quarter of 2008, with over $500 million in private student loans being originated in 2007 alone. This production came to an abrupt stop after the first quarter of 2008, at which time the secondary market for these and many other investments collapsed. At that time the Bank had approximately $38 million in student loans in the pipeline that were prepared to be sold in the secondary market but had not been placed. The result of the collapse of the market was that Liberty Bank was forced to change the status of these loans from “held for sale” status to “held to maturity.” This change required the Bank to establish a reserve to support the performance of the portfolio as well as provide monitoring tools for reporting and ongoing evaluation of a fairly large portfolio for a Bank our size.
The private student loan process is much like a line of credit for students. They enter school for programs that are two to four years in length and sometimes extend those through graduate programs up to as much time as four to six years. At some point they graduate or cease attending school and, after a six month grace period, interest begins to accrue on the loan and they are required to begin their repayment schedule. The Bank’s accounting rules require that, in the event that the loan becomes 120 days delinquent, the entire loan balance is written off as a loss. Because student loans are not dischargeable in bankruptcy and consequently will follow a student throughout life, the loans have a high rate of eventual collection. However, once a loan is written off it cannot be reinstated as an asset of the Bank, regardless of subsequent recoveries. Accordingly, when the collection process produces a recovery, only the payment amount is recovered. Consequently, it could take up to 15 years to recover all the income lost through the write off of a student loan.
This loss experience for Liberty was quite significant with respect to the acquired portfolio loans. Beginning in 2008 and continuing to present, an average of 27% of the acquired portfolio loans that moved into repayment status have subsequently defaulted and were written off. The financial effects of this activity were significant to the Bank and resulted in over $2.5 million in net charge offs for the period of 2008 through 2010. Couple this with the over $1 million in reserves the Bank established when changing the acquired portfolio status to “held to maturity” in 2008 and the result was a $ 3.5 million charge to earnings for that period. One piece of good news is that, once these portfolio loans move into repayment status and the students begin paying, the overall performance of that portion of the portfolio is quite good. Delinquency averages 2.5%, which is well below the national average for student loans, and that rate has been maintained for the period that these loans have been owned by Liberty.
Since that time, Liberty Bank has resumed its role as an originating lender of student loans with commitments for loan sales to third parties in the private wholesale secondary market, with each loan secured by 100% cash collateral. A further cause for optimism is the fact that, beginning in the fourth quarter of 2010, the net consolidated results of our entire student lending program have become positive.
Formal Agreement with the OCC
The negative student lending issues were detrimental to the Bank’s results in many ways. The most troublesome was the erosion of capital due to the write-offs and reserves. Management has previously committed to maintaining the Bank in a well capitalized status since they took over in 2004. In the second quarter of 2010, the Bank underwent its normal examination by the OCC. Entering the examination, the Bank’s risk-based capital ratio exceeded the minimum requirements needed to be considered “well capitalized.” However, as a result of the examination by the OCC, new capital minimums were established. The previous leverage ratio of 5% was increased to 8% while the total risk-based capital ratio of 10% was increased to 12%. Based upon the imposition of these higher capital minimums, although the Bank’s leverage ratio at March 31, 2011 was 8.54% and its risk-based capital ratio was 11.61%, the Bank fell out of “well capitalized” compliance. Partly for this reason, the Bank entered into a Formal Agreement with the OCC in January of 2011. In addition to increasing certain of the Bank’s minimum capital ratios, which must be in compliance by June 30, 2011, the Formal Agreement also calls for other improvements. The Bank is required to add a chief credit officer, diversify its credit pools, revise its incentive compensation program, enhance its internal process of document collection/tracking and make other improvements to its loan and credit processes. We are committed to correct these and any deficiencies that are brought to our attention. At this writing, I believe we have made significant progress in complying with all areas of the Formal Agreement.
Liberty Bank continues to be guided by our strategic plan. First established in 2004, and revisited annually, I think our strategy remains sound. The Bank’s main objective is to be the bank for business in Northeast Ohio by establishing partnerships with the customers we aim to serve. This focus has resulted in over 100 new relationships in the past two years averaging over $1 million each. Our commercial lending team, led by Senior VP Ron Majka, has concentrated on well capitalized, growing businesses that value direct access to our decision makers and the willingness of Liberty to invest in understanding their individual businesses. As we pursue this strategy and realize the positive loan growth and income derived therefrom, it is important to note that the quality of the Bank’s current underwriting process is considered to be sound and that we are constantly exploring ways to improve it.
The concentrated effort for attraction of business lending employs four commercial loan officers in addition to Ron Majka. One of those four, VP Bernie Dietzel, is a longtime commercial real estate lender who specializes in multifamily lending. The remaining commercial lenders, Jim Hojnacki, Paul Ibsen and Jay Valerian, concentrate on C & I relationships. These lenders, who have been together at Liberty for seven years, are further supported by senior management of the Bank. The Bank employs an active investor approach to finding new business in which the Bank’s Board of Directors, staff, shareholders and existing customers all participate in a referral process which seeks to find new, qualified customers.
The credit process has been recently enhanced with the addition of Craig E. Reay, Sr. VP and Chief Credit Officer. Craig has over 25 years experience in the banking industry, the majority of which has been spent in active credit evaluation and monitoring, first as an OCC examiner and later as a leader in credit evaluation for a number of Ohio banks. Most recently he was the Chief Credit Officer of a $3 billion Ohio bank. Craig is assisted in his duties by Don Waytes, the Bank’s senior credit analyst, and Brian O’Keefe. The Bank’s loan approval and monitoring process also involves Vice President of Loan Administration, Adam Cook, and the Bank’s Portfolio Loan Officer, Ryan McKinley. This team represents a considerable investment into credit quality over the past three years. Three years ago the Bank’s credit team was composed of the CEO and one analyst. With further enhancement coming from newly evaluated software and work-flow process, I believe that Bank has a tremendous opportunity for expansion without significant investment in additional personnel.
Mike Allen, Senior VP and Private Banking Team Lead heads up the Private Banking division which includes the Bank’s student lending business and branches. Mike is supported by Maria Alvarez, VP and Private Banking Sales Team Lead. This team is responsible for residential real estate lending including Home Equity Lines of Credit, cash management, and deposit acquisition and retention. Their approach mirrors that of the commercial team, concentrating on referrals from investors, staff and the Board of Directors.
Management believes that the future of the Bank will greatly depend on the ability to provide high quality electronic banking services for cash management. The lead product for this effort is remote deposit, which allows our business customers to make deposits and view their activity by use of scanners and software. This product is a byproduct of the Check 21 law that made it possible to use a formatted electronic duplicate to take the place of an actual check in a banking transaction. At December of 2008 the Bank had no customers with remote relationships. At March 31, 2011, the Bank had thirty-three (33) remote deposit customers. The use of remote deposit along with other high quality cash management tools is a natural support to attract business relationships of well capitalized growing companies.
In pursuit of these high quality services the Bank has entered into an agreement with a nationally recognized provider of financial data services, the Jack Henry Company. This new business partner, whose interests are closely aligned with those of Liberty, gives the Bank the required software to compete with our larger competitors.
Letter of Intent with a Private Investor
Our projections of asset growth indicated a capital shortfall was on the horizon. In 2009, Management began exploring new strategic partnerships that could add capital and strengthen the Bank’s business model going forward. In early 2011, the Bank entered into a Letter of Intent with a private investor (the “Investor”). The terms of the “Letter of Intent” require the Investor to contribute $10 million in capital to the Bank with an option to purchase up to an additional $2 million of stock from existing shareholders. This “Letter of Intent” includes a future option that could result in the Investor owning a controlling interest in the Bank. Pursuant to the “Letter of Intent,” the identity of the Investor is required to remain confidential until such time as regulatory approval for the transaction is received. The Bank and the Investor have executed a mutual agreement to maintain that confidentiality. The Investor began the process of obtaining regulatory approval for this proposed capital investment in the Bank; however, it has been determined that the decision required for regulatory approval will not be obtained in time for the Bank to meet all of its capital commitments to the OCC by June 30, 2011, as required in the Formal Agreement.
According to the Bank’s capital plan, if the capital anticipated from the “Letter of Intent” is not realized by the time required, the Bank has made plans to raise capital through a Private Placement to qualified investors similar to those capital raises in which the Bank was involved in 2004 and 2006. Under the terms of the Private Placement, investors must meet strict net worth and income requirements. Members of the Bank’s Board of Directors have committed $400,000 to the Private Placement offering. As a good faith commitment to the “Letter of Intent,” the Investor has committed to make a substantial investment in the Private Placement at a level that would not require regulatory control approval and under the same terms as all other investors in the Private Placement. When these existing commitments of the Board of Directors and the Investor are taken into capital, the Bank will exceed the OCC capital requirement set forth in the Formal Agreement. It is the intention of the Bank and the Investor, however, to continue to move forward with the negotiation of a Definitive Agreement once the Investor has received the necessary approval of the “Letter of Intent.” I will advise you as to the outcome of the Investor regulatory approval request.
The Bank will host informational sessions that will provide a forum to answer questions of shareholders regarding all aspects of the capital raise and solicit interest in the offering. Please contact Janet Hendlin (phone: 216-359-5504 or email: email@example.com) to indicate your interest in attending any of the informational sessions described above.
Change of Annual Meeting Date
The Bank’s Board of Directors has determined that the annual meeting, which is normally convened in the month of June, will be conducted on October 25, 2011. The additional time is given to allow for the completion of the capital raise as indicated above and to make corresponding Board of Directors changes that might result from the capital raise. Additional time for approval as indicated by the terms of the OCC Formal Agreement is required.
We trust that this correspondence provides you with satisfactory insight as to the condition of your Bank. Please do not hesitate to contact me directly to discuss anything in this letter or any other matter regarding which you may have a question.
LIBERTY BANK, N. A.
William A. Valerian
Chairman and CEO