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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
ANNUAL REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2010
 
Commission file number 1-13805
Harris Preferred Capital Corporation
(Exact name of registrant as specified in its charter)
 
     
Maryland
(State or other jurisdiction
of incorporation or organization)
  # 36-4183096
(I.R.S. Employer
Identification No.)
     
111 West Monroe Street, Chicago, Illinois
(Address of principal executive offices)
  60603
(Zip Code)
 
Registrant’s telephone number, including area code:
(312) 461-2121
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
73/8% Noncumulative Exchangeable
Preferred Stock, Series A, par value
$1.00 per share
  New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
The number of shares of Common Stock, $1.00 par value, outstanding on March 31, 2011 was 1,180. No common equity is held by nonaffiliates.
 


 

 
Harris Preferred Capital Corporation
 
TABLE OF CONTENTS
 
                 
Part I
  Item 1.     Business     2  
  Item 1A.     Risk Factors     7  
  Item 1B.     Unresolved Staff Comments     13  
  Item 2.     Properties     13  
  Item 3.     Legal Proceedings     13  
  Item 4.     Reserved     14  
 
Part II
  Item 5.     Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     14  
  Item 6.     Selected Financial Data     15  
  Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations     16  
  Item 7A.     Quantitative and Qualitative Disclosures About Market Risk     19  
  Item 8.     Financial Statements and Supplementary Data     20  
  Item 9.     Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     20  
  Item 9A.     Controls and Procedures     20  
  Item 9B.     Other Information     21  
 
Part III
  Item 10.     Directors, Executive Officers and Corporate Governance     21  
  Item 11.     Executive Compensation     24  
  Item 12.     Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     24  
  Item 13.     Certain Relationships and Related Transactions, and Director Independence     24  
  Item 14.     Principal Accounting Fees and Services     25  
 
Part IV
  Item 15     Exhibits, Financial Statement Schedules.     25  
        (a) Exhibits        
        24 Power of Attorney        
        31.1 Certification of Pamela C. Piarowski pursuant to Rule 13a-14(a)        
        31.2 Certification of Paul R. Skubic pursuant to Rule 13a-14(a)        
        32.1 Certification pursuant to 18 U.S.C. Section 1350.        
        (b) Reports on Form 8-K        
        None        
Signatures     28  


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PART I
 
Forward-Looking Information
 
This Annual Report on Form 10-K (“Report”) of Harris Preferred Capital Corporation (the “Company”) includes certain forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including (without limitation) statements with respect to the Company’s expectations, intentions, beliefs or strategies regarding the future. Forward-looking statements include the Company’s statements regarding tax treatment as a real estate investment trust, liquidity, provision for loan losses, capital resources and investment activities. In addition, in those and other portions of this document, the words “anticipate,” “believe,” “estimate,” “expect,” “intend” and other similar expressions, as they relate to the Company or the Company’s management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. It is important to note that the Company’s actual results could differ materially from those described herein as anticipated, believed, estimated or expected. Among the factors that could cause the results to differ materially are the risks discussed in “Risk Factors” below (Item 1A of this Report). The Company assumes no obligation to update any such forward-looking statements.
 
ITEM 1.   BUSINESS
 
General
 
Harris Preferred Capital Corporation is a Maryland corporation incorporated on September 24, 1997 pursuant to the Maryland General Corporation Law. The Company’s principal business objective is to acquire, hold, finance and manage qualifying real estate investment trust (“REIT”) assets (the “Mortgage Assets”), consisting of mortgage-backed securities, notes issued by Harris N.A. (the “Bank”) secured by Securing Mortgage Loans (defined below) and other obligations secured by real property, as well as certain other qualifying REIT assets. The Company’s assets are held in a Maryland real estate investment trust subsidiary, Harris Preferred Capital Trust. The Company has elected to be treated as a REIT under the Internal Revenue Code of 1986 (the “Code”), and will generally not be subject to federal income tax if it distributes 90% of its adjusted REIT ordinary taxable income and meets all of the qualifications necessary to be a REIT. All of the shares of the Company’s common stock, par value $1.00 per share (the “Common Stock”), are owned by Harris Capital Holdings, Inc. (“HCH”), a wholly owned subsidiary of the Bank. The Company was formed by the Bank to provide investors with the opportunity to invest in residential mortgages and other real estate assets and to provide the Bank with a cost-effective means of raising capital for federal regulatory purposes. Beginning January 1, 2009, Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single person. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the Common Stock are held by HCH, a wholly owned subsidiary of the Bank, (2) the Common Stock represent more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. The 2010 Illinois statutory tax rate was 7.3% and the 2011 tax rate will be 9.5%. Management believes that the state tax expense to be incurred by the Company in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the Preferred Shares (as defined below). This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of our Common Stock.
 
On February 11, 1998, the Company, through a public offering (the “Offering”), issued 10,000,000 shares of its 73/8% Noncumulative Exchangeable Preferred Stock, Series A (the “Preferred Shares”), $1.00 par value. The Offering raised $250 million less $7.9 million of underwriting fees. The Preferred Shares are traded on the New York Stock Exchange under the symbol “HBC Pr A”. Holders of Preferred Shares are entitled to receive, if declared by the Company’s Board of Directors, noncumulative dividends at a rate of 73/8% per annum of the $25 per share liquidation preference (an amount equivalent to $1.8438 per share per annum). Dividends on the Preferred Shares, if authorized and declared, are payable quarterly in arrears on March 30, June 30, September 30 and December 30 of each year, provided that, if any interest payment date on the Preferred Shares (“Interest Payment Date”) would otherwise fall on a day that is not a Business Day the Interest Payment Date will be on the following Business Day.


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The Preferred Shares may be redeemed for cash at the option of the Company, in whole or in part, at any time and from time to time, at the liquidation preference thereof, plus the quarterly accrued and unpaid dividends, if any, thereon. The Company may not redeem the Preferred Shares without prior approval from the Office of the Comptroller of the Currency (the “OCC”) or the appropriate successor or other federal regulatory agency.
 
Each Preferred Share will be automatically exchanged (the “Automatic Exchange”) for one newly issued preferred share of the Bank (“Bank Preferred Share”) in the event (i) the Bank becomes less than “adequately capitalized” under regulations established pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, as amended, (ii) the Bank is placed into conservatorship or receivership, (iii) the OCC directs such exchange in writing because, in its sole discretion and even if the Bank is not less than “adequately capitalized,” the OCC anticipates that the Bank may become less than adequately capitalized in the near term, or (iv) the OCC in its sole discretion directs in writing an exchange in the event that the Bank has a Tier 1 risk-based capital ratio of less than 5% (each an “Exchange Event”). As a result of an Exchange Event, the Bank Preferred Shares would constitute a new series of preferred shares of the Bank, would have the same dividend rights, liquidation preference, redemption options and other attributes as the Preferred Shares, except that the Bank Preferred Shares would not be listed on the New York Stock Exchange and would rank pari passu in terms of cash dividend payments and liquidation preference with any outstanding shares of preferred stock of the Bank.
 
Concurrent with the issuance of the Preferred Shares, the Bank contributed additional capital of $241 million, net of acquisition costs, to the Company. The Company and the Bank undertook the Offering for two principal reasons: (i) the qualification of the Preferred Shares as Tier 1 capital of the Bank for U.S. banking regulatory purposes under relevant regulatory capital guidelines, as a result of the treatment of the Preferred Shares as a minority interest in a consolidated subsidiary of the Bank, and (ii) lack of federal income tax on the Company’s earnings used to pay the dividends on the Preferred Shares, as a result of the Company’s qualification as a REIT. On December 30, 1998, the Bank contributed the Common Stock of the Company to HCH, a newly-formed and wholly-owned subsidiary of the Bank. The Bank is an indirect wholly-owned U.S. subsidiary of Bank of Montreal (“BMO”). The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any Preferred Shares are outstanding.
 
The Company used the Offering proceeds and the additional capital contributed by the Bank to purchase $356 million of notes (the “Notes”) from the Bank and $135 million of mortgage-backed securities at their estimated fair value. The Notes are obligations issued by the Bank that are recourse only to the underlying mortgage loans (the “Securing Mortgage Loans”) and were acquired pursuant to the terms of a loan agreement with the Bank. The principal amount of the Notes equals approximately 80% of the principal amounts of the Securing Mortgage Loans.
 
On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company entered into a contribution agreement with HCH pursuant to which the Company agreed to issue and sell 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash. HCH acquired the shares on March 5, 2009 and continues to own 100% of the shares of the Common Stock. The Company utilized proceeds from the Common Stock issuance to acquire assets in a manner consistent with Company investment guidelines.
 
Business
 
The Company was formed for the purpose of raising capital for the Bank. One of the Company’s principal business objectives is to acquire, hold, finance and manage Mortgage Assets. These Mortgage Assets generate interest income for distribution to stockholders. A portion of the Mortgage Assets of the Company consists of Notes issued by the Bank that are recourse only to Securing Mortgage Loans that are secured by real property. The Notes mature on October 1, 2027 and pay interest at 6.4% per annum. Payments of interest are made to the Company from payments made on the Securing Mortgage Loans. Pursuant to an agreement between the Company and the Bank, the Company, through the Bank as agent, receives all scheduled payments made on the Securing Mortgage Loans, retains a portion of any such payments equal to the amount due on the Notes and remits the balance, if any, to the Bank. The Company also retains approximately 80% of any prepayments of principal in respect of the Securing Mortgage Loans and applies such amounts as a prepayment on the Notes. The Company has a security interest in the


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real property securing the Securing Mortgage Loans and will be entitled to enforce payment on the loans in its own name if a mortgagor should default. In the event of such default, the Company would have the same rights as the original mortgagee to foreclose the mortgaged property and satisfy the obligations of the Bank out of the proceeds.
 
The Company may from time to time acquire fixed-rate or variable-rate mortgage-backed securities representing interests in pools of mortgage loans. The Bank may have originated a portion of any such mortgage-backed securities by exchanging pools of mortgage loans for the mortgage-backed securities. The mortgage loans underlying the mortgage-backed securities will be secured by single-family residential properties located throughout the United States. The Company intends to acquire only investment grade mortgage-backed securities issued by agencies of the federal government or government sponsored agencies, such as the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“Fannie Mae”) and the Government National Mortgage Association (“GNMA”). The Company does not intend to acquire any interest-only, principal-only or similar speculative mortgage-backed securities. All mortgage back securities at December 31, 2010 and 2009 were all government secured securities.
 
The Bank may from time to time acquire or originate both conforming and nonconforming residential mortgage loans. Conventional conforming residential mortgage loans comply with the requirements for inclusion in a loan guarantee program sponsored by either FHLMC or Fannie Mae. Nonconforming residential mortgage loans are residential mortgage loans that do not qualify in one or more respects for purchase by Fannie Mae or FHLMC under their standard programs. The nonconforming residential mortgage loans that the Company purchases will be nonconforming because they have original principal balances which exceed the limits for FHLMC or Fannie Mae under their standard programs. The Company believes that all residential mortgage loans will meet the requirements for sale to national private mortgage conduit programs or other investors in the secondary mortgage market. As of December 31, 2010 and 2009 and for each of the years then ended, the Company did not directly hold any residential mortgage loans.
 
The Company may from time to time acquire commercial mortgage loans secured by industrial and warehouse properties, recreational facilities, office buildings, retail space and shopping malls, hotels and motels, hospitals, nursing homes or senior living centers. The Company’s current policy is not to acquire any interest in a commercial mortgage loan if commercial mortgage loans would constitute more than 5% of the Company’s Mortgage Assets at the time of its acquisition. Unlike residential mortgage loans, commercial mortgage loans generally lack standardized terms. Commercial real estate properties themselves tend to be unique and are more difficult to value than residential real estate properties. Commercial mortgage loans may also not be fully amortizing, meaning that they may have a significant principal balance or “balloon” payment due on maturity. Moreover, commercial properties, particularly industrial and warehouse properties, are generally subject to relatively greater environmental risks than non-commercial properties, generally giving rise to increased costs of compliance with environmental laws and regulations. There is no requirement regarding the percentage of any commercial real estate property that must be leased at the time the Bank acquires a commercial mortgage loan secured by such commercial real estate property, and there is no requirement that commercial mortgage loans have third party guarantees. The credit quality of a commercial mortgage loan may depend on, among other factors, the existence and structure of underlying leases, the physical condition of the property (including whether any maintenance has been deferred), the creditworthiness of tenants, the historical and anticipated level of vacancies and rents on the property and on other comparable properties located in the same region, potential or existing environmental risks, the availability of credit to refinance the commercial mortgage loan at or prior to maturity and the local and regional economic climate in general. Foreclosures of defaulted commercial mortgage loans are generally subject to a number of complicated factors, including environmental considerations, which are generally not present in foreclosures of residential mortgage loans. As of December 31, 2010 and 2009 and for each of the years then ended, the Company did not hold any commercial mortgage loans.
 
The Company may invest in assets eligible to be held by REITs other than those described above. In addition to commercial mortgage loans and mortgage loans secured by multi-family properties, such assets could include cash, cash equivalents and securities, including shares or interests in other REITs and partnership interests. At December 31, 2010, the Company held $24 million of short-term money market assets and $40 million of U.S. Treasury securities. At December 31, 2009, the Company held $22 million of short-term money market assets and $40 million of U.S. Treasury Securities.


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The Company intends to continue to acquire Mortgage Assets from the Bank and/or affiliates of the Bank on terms that are comparable to those that could be obtained by the Company if such Mortgage Assets were purchased from unrelated third parties. The Company may also from time to time acquire Mortgage Assets from unrelated third parties.
 
The Company intends to maintain a substantial portion of its portfolio in Bank-secured obligations and mortgage-backed securities. The Company may, however, invest in other assets eligible to be held by a REIT. The Company’s current policy and the Servicing Agreement (defined below) prohibit the acquisition of any Mortgage Asset constituting an interest in a mortgage loan (other than an interest resulting from the acquisition of mortgage-backed securities), which mortgage loan (i) is delinquent (more than 30 days past due) in the payment of principal or interest at the time of proposed acquisition; (ii) is or was at any time during the preceding 12 months (a) on nonaccrual status or (b) renegotiated due to financial deterioration of the borrower; or (iii) has been, more than once during the preceding 12 months, more than 30 days past due in payment of principal or interest. Loans that are on “nonaccrual status” are generally loans that are past due 90 days or more in principal or interest. The Company maintains a policy of disposing of any mortgage loan which (i) falls into nonaccrual status, (ii) has to be renegotiated due to the financial deterioration of the borrower, or (iii) is more than 30 days past due in the payment of principal or interest more than once in any 12 month period. The Company may choose, at any time subsequent to its acquisition of any Mortgage Assets, to require the Bank (as part of the Servicing Agreement) to dispose of the mortgage loans for any of these reasons or for any other reason.
 
The Bank services the Securing Mortgage Loans and the other mortgage loans purchased by the Company on behalf of, and as agent for, the Company and is entitled to receive fees in connection with the servicing thereof pursuant to a servicing agreement (the “Servicing Agreement”). The Bank receives a fee equal to 0.25% per annum on the principal balances of the loans serviced. Payment of such fees is subordinate to payments of dividends on the Preferred Shares. The Servicing Agreement requires the Bank to service the loans in a manner generally consistent with accepted secondary market practices, with any servicing guidelines promulgated by the Company and, in the case of residential mortgage loans, with Fannie Mae and FHLMC guidelines and procedures. The Servicing Agreement requires the Bank to service the loans solely with a view toward the interest of the Company and without regard to the interest of the Bank or any of its affiliates. The Bank will collect and remit principal and interest payments, administer mortgage escrow accounts, submit and pursue insurance claims and initiate and supervise foreclosure proceedings on the loans it services. The Bank may, with the approval of a majority of the Company’s Board of Directors, as well as a majority of the Company’s Independent Directors (as defined in Item 13 (c) below), subcontract all or a portion of its obligations under the Servicing Agreement to unrelated third parties. The Bank will not, in connection with the subcontracting of any of its obligations under the Servicing Agreement, be discharged or relieved in any respect from its obligations under the Servicing Agreement. The Company may terminate the Servicing Agreement upon the occurrence of such events as they relate to the Bank’s proper and timely performance of its duties and obligations under the Servicing Agreement. As long as any Preferred Shares remain outstanding, the Company may not terminate, or elect to renew, the Servicing Agreement without the approval of a majority of the Company’s Independent Directors (as defined in Item 13 (c) below).
 
The Bank administers the day-to-day operations of the Company, pursuant to an advisory agreement (the “Advisory Agreement”). The Bank is responsible for (i) monitoring the credit quality of Mortgage Assets held by the Company, (ii) advising the Company with respect to the reinvestment of income from and payments on, and with respect to the acquisition, management, financing and disposition of the Mortgage Assets held by the Company, and (iii) monitoring the Company’s compliance with the requirements necessary to qualify as a REIT, and other financial and tax-related matters. The Bank may from time to time subcontract all or a portion of its obligations under the Advisory Agreement to one or more of its affiliates. The Bank may, with the approval of a majority of the Company’s Board of Directors, as well as a majority of the Company’s Independent Directors, subcontract all or a portion of its obligations under the Advisory Agreement to unrelated third parties. The Bank will not, in connection with the subcontracting of any of its obligations under the Advisory Agreement, be discharged or relieved in any respect from its obligations under the Advisory Agreement. The Advisory Agreement is renewed annually. The Company may terminate the Advisory Agreement at any time upon 60 days’ prior written notice. As long as any Preferred Shares remain outstanding, any decision by the Company either to renew the Advisory Agreement or to


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terminate the Advisory Agreement must be approved by a majority of the Board of Directors, as well as by a majority of the Company’s Independent Directors (as defined in Item 13 (c) below).
 
The Advisory Agreements in effect in 2010 and 2009 entitled the Bank to receive advisory fees of $167 thousand and $196 thousand, respectively. It is expected that 2011 advisory fees will be approximately $170 thousand.
 
The Company may from time to time purchase additional Mortgage Assets out of proceeds received in connection with the repayment or disposition of Mortgage Assets, the issuance of additional shares of preferred stock or additional capital contributions with respect to the Common Stock. The Company may also issue additional series of preferred stock. However, pursuant to the Company’s Articles of Incorporation, as amended (the “Charter”), the Company may not issue additional shares of preferred stock senior to the Series A preferred shares either in the payment of dividends or in the distribution of assets on liquidation without the consent of holders of at least 67% of the outstanding shares of preferred stock at that time or without approval of a majority of the Company’s Independent Directors. The Company does not currently intend to issue any additional shares of preferred stock unless it simultaneously receives additional capital contributions from HCH or other affiliates sufficient to support the issuance of such additional shares of preferred stock.
 
Employees
 
As of December 31, 2010, the Company had no paid employees. All officers of the Company were employed by the Bank.
 
Environmental Matters
 
In the event that the Company is forced to foreclose on a defaulted Securing Mortgage Loan to recover its investment in such loan, the Company may be subject to environmental liabilities in connection with the underlying real property, which could exceed the value of the real property. Although the Company intends to exercise due diligence to discover potential environmental liabilities prior to the acquisition of any property through foreclosure, hazardous substances or wastes, contaminants, pollutants or sources thereof (as defined by state and federal laws and regulations) may be discovered on properties during the Company’s ownership or after a sale thereof to a third party. If such hazardous substances are discovered on a property which the Company has acquired through foreclosure or otherwise, the Company may be required to remove those substances and clean up the property. There can be no assurance that in such a case the Company would not incur full recourse liability for the entire costs of any removal and clean-up, that the cost of such removal and clean-up would not exceed the value of the property or that the Company could recoup any of such costs from any third party. The Company may also be liable to tenants and other users of neighboring properties. In addition, the Company may find it difficult or impossible to sell the property prior to or following any such clean-up. The Company has not foreclosed on any Securing Mortgage Loans during 2010 and 2009.
 
Qualification as a REIT
 
The Company elected to be taxed as a REIT commencing with its taxable year ended December 31, 1998 and intends to comply with the provisions of the Code with respect thereto. The Company will not be subject to Federal income tax to the extent it distributes 90% of its adjusted REIT ordinary taxable income to stockholders and as long as certain assets, income and stock ownership tests are met. For 2010 as well as 2009, the Company met all Code requirements for a REIT, including the asset, income, stock ownership and distribution tests. Beginning January 1, 2009, the state of Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single corporation. Management believes that the Company would be classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock is held by HCH, a wholly owned subsidiary of the Bank, (2) the Company’s Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. Management believes that the state tax expense to be incurred by the Company in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the preferred shares. This


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belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of our Common Stock. The Illinois statutory tax rate for 2010 was 7.3% and for 2011 will be 9.5%.
 
The following tables sets forth selected dividend information:
 
                                                 
    Year Ended December 31, 2010  
    Dividends
                            Amount in
 
    per share     # of Shares     Declared Date     Record Date     Paid Date     Thousands  
 
Preferred Dividends
  $ .46094       10,000,000       03/05/2010       03/15/2010       03/30/2010     $ 4,609  
      .46094       10,000,000       06/11/2010       06/15/2010       06/30/2010       4,609  
      .46094       10,000,000       09/02/2010       09/15/2010       09/30/2010       4,610  
      .46094       10,000,000       12/02/2010       12/15/2010       12/30/2010       4,610  
                                                 
                                            $ 18,438  
                                                 
 
No common dividends were paid in the year ended December 31, 2010
 
                                                 
    Year Ended December 31, 2009  
    Dividends
                            Amount in
 
    per share     # of Share     Declared Date     Record Date     Paid Date     Thousands  
 
Preferred Dividends
  $ .46094       10,000,000       03/05/2009       03/15/2009       03/30/2009     $ 4,609  
      .46094       10,000,000       06/11/2009       06/15/2009       06/30/2009       4,609  
      .46094       10,000,000       09/02/2009       09/15/2009       09/30/2009       4,610  
      .46094       10,000,000       12/02/2009       12/15/2009       12/30/2009       4,610  
                                                 
                                            $ 18,438  
                                                 
Common Stock Dividends
  $ 221       1,180       05/28/2009       06/15/2009       06/22/2009     $ 261  
      1,695       1,180       12/02/2009       12/15/2009       12/30/2009       2,000  
                                                 
                                            $ 2,261  
                                                 
 
ITEM 1A.   RISK FACTORS
 
Set forth below and elsewhere in this Report and in other documents filed with the SEC (including the February 5, 1998 Prospectus (the “1998 Prospectus”) for the Offering (SEC File No. 333-40257)), are risks and uncertainties with respect to the Company, the Preferred Shares and the Bank. This Report contains forward-looking statements that involve risks and uncertainties. The Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include those discussed below.
 
Declining interest rates will reduce earnings of the Company
 
The Company’s income will consist primarily of interest payments on the earning assets held by it. If there is a decline in interest rates during a period of time when the Company must reinvest payments of interest and principal in respect of its earning assets, the Company may find it difficult to purchase additional earning assets that generate sufficient income to support payment of dividends on the Preferred Shares.
 
Because the rate at which dividends, if, when and as authorized and declared, are payable on the Preferred Shares is fixed, there can be no assurance that an interest rate environment in which there is a decline in interest rates would not adversely affect the Company’s ability to pay dividends on the Preferred Shares.
 
Dividends may not be authorized quarterly by our Board of Directors and dividends not authorized will not be paid
 
Dividends on the Preferred Shares are not cumulative. Consequently, if the Board of Directors does not authorize a dividend on the Preferred Shares for any quarterly period, the holders of the Preferred Shares would not


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be entitled to recover such dividend whether or not funds are or subsequently become available. Quarterly dividends may not always be paid on the Preferred Shares. The Board of Directors may determine, in its business judgment, that it would be in the best interests of the Company to pay less than the full amount of the stated dividend on the Preferred Shares or no dividend for any quarter, notwithstanding that funds are available. Factors that may be considered by the Board of Directors in making this determination are the Company’s financial condition and capital needs, the impact of legislation and regulations as then in effect or as may be proposed, economic conditions, and such other factors as the Board of Directors may deem relevant. To remain qualified as a REIT, the Company must distribute annually at least 90% of its “REIT taxable income” (not including capital gains) to stockholders. See “Tax Risks.”
 
Dividends and operations of the Company restricted by regulation
 
Because the Company is a subsidiary of the Bank, bank regulatory authorities will have the right to examine the Company and its activities. Under certain circumstances, including any determination that the Bank’s relationship to the Company results in an unsafe and unsound banking practice, such regulatory authorities will have the authority to restrict the ability of the Company to transfer assets, to make distributions to its stockholders (including dividends to the holders of Preferred Shares, as described below), or to redeem Preferred Shares, or even to require the Bank to sever its relationship with, or divest its ownership of, the Company. Such actions could potentially result in the Company’s failure to qualify as a REIT.
 
Payment of dividends on the Preferred Shares could also be subject to regulatory limitations if the Bank became less than “adequately capitalized” for purposes of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). Less than “adequately capitalized” is currently defined as having (i) a total risk-based capital ratio of less than 8.0%, (ii) a Tier 1 risk-based capital ratio of less than 4.0%, or (iii) a Tier 1 leverage ratio of less than 4.0% (or 3.0% under certain circumstances not currently applicable to the Bank). At December 31, 2010, the Bank’s Total risk-based capital ratio was 17.87%, Tier 1 risk-based capital ratio was 15.98% and the Tier 1 leverage ratio was 9.64%. Consequently, the Bank was categorized as “well-capitalized” by its regulator at December 31, 2010.
 
In addition, the National Bank Act requires all national banks, including the Bank, to obtain prior approval from the OCC if dividends declared by the national bank (including subsidiaries of the national bank (except for dividends paid by such subsidiary to the national bank)) in any calendar year, will exceed its net income for that year, combined with its retained income (as defined in the applicable regulations) for the preceding two years. These provisions apply to a national bank and its subsidiaries on a consolidated basis, notwithstanding the earnings of any subsidiary on a stand-alone basis. Beginning in 2009, the Bank no longer had sufficient capacity to declare and pay dividends without prior regulatory approval of the OCC. As a result, the Company, as an indirect subsidiary of the Bank, became subject to the provisions relating to dividend approval, and the Bank must receive prior approval from the OCC before the Company declares dividends on the Preferred Shares. Prior approval from the OCC was received for the dividend declaration in September and December of 2010 and the most recent dividend declaration in March 2011. The Company anticipates the need to request similar approvals from the OCC for all quarters in 2011. At this time, the Company has no reason to expect that such approvals will not be received. There is no assurance that the Bank and the Company will not be subject to the requirement to receive prior regulatory approvals for Preferred Shares dividend payments in the future or that, if required, such approvals will be obtained.
 
Automatic exchange for Bank Preferred Shares could occur when value of Bank Preferred Shares is impaired
 
An investment in the Preferred Shares involves risk with respect to the performance and capital levels of the Bank. A decline in the performance and capital levels of the Bank or the placement of the Bank into conservatorship or receivership could result in the automatic exchange of the Preferred Shares for Bank Preferred Shares, which would be an investment in the Bank and not in the Company. As a result, holders of Preferred Shares would become preferred stockholders of the Bank at a time when the Bank’s financial condition was deteriorating or when the Bank had been placed into conservatorship or receivership. If an Exchange Event occurs, the Bank would likely be unable to pay dividends on the Bank Preferred Shares.


8


 

An investment in the Bank is also subject to certain risks that are distinct from the risks associated with an investment in the Company. For example, an investment in the Bank would involve risks relating to the capital levels of, and other federal regulatory requirements applicable to, the Bank, and the performance of the Bank’s loan portfolio. An investment in the Bank is also subject to the general risks inherent in equity investments in depository institutions. In the event of a liquidation of the Bank, the claims of depositors and secured, senior, general and subordinated creditors of the Bank would be entitled to a priority of payment over the claims of holders of equity interests such as the Bank Preferred Shares. As a result, if the Bank were to be placed into receivership, the holders of the Bank Preferred Shares likely would receive, if anything, substantially less than they would have received had the Preferred Shares not been exchanged for Bank Preferred Shares.
 
Bank Preferred Shares will not be listed on any exchange and markets may not be liquid
 
Although the Preferred Shares are listed on the New York Stock Exchange, the Bank does not intend to apply for listing of the Bank Preferred Shares on any national securities exchange. Consequently, there can be no assurance as to the liquidity of the trading markets for the Bank Preferred Shares, if issued, or that an active public market for the Bank Preferred Shares would develop or be maintained.
 
Adverse consequences of failure to qualify as a REIT
 
The Company intends to operate so as to qualify as a REIT under the Code. No assurance can be given that the Company will be able to continue to operate in a manner so as to qualify as a REIT. Qualification as a REIT involves the application of highly technical and complex Code provisions for which there are only limited judicial or administrative interpretations. The determination of various factual matters and circumstances, not entirely within the Company’s control, may affect the Company’s ability to continue to qualify as a REIT. Although the Company is not aware of any proposal in Congress to amend the tax laws in a manner that would materially and adversely affect the Company’s ability to operate as a REIT, no assurance can be given that new legislation or new regulations, administrative interpretations or court decisions will not significantly change the tax laws in the future with respect to qualification as a REIT or the federal income tax consequences of such qualification.
 
If, in any taxable year the Company fails to qualify as a REIT, the Company would not be allowed a deduction for distributions to stockholders in computing its taxable income and would be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. As a result, the amount available for distribution to the Company’s stockholders including the holders of the Preferred Shares, would be reduced for the year or years involved. In addition, unless entitled to relief under certain statutory provisions, the Company would be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost. A failure of the Company to qualify as a REIT would not necessarily give the Company the right to redeem the Preferred Shares, nor would it give the holders of the Preferred Shares the right to have their shares redeemed. Notwithstanding that the Company currently intends to operate in a manner designed to enable it to qualify as a REIT, future economic, market, legal, tax or other considerations may cause the Company to determine that it is in the best interest of the Company and the holders of its Common Stock and Preferred Shares to revoke the REIT election. As long as any Preferred Shares are outstanding, any such determination by the Company may not be made without the approval of a majority of the Independent Directors. The tax law prohibits the Company from electing treatment as a REIT for the four taxable years following the year of such revocation.
 
REIT requirements with respect to stockholder distributions
 
To qualify as a REIT under the Code, the Company generally will be required each year to distribute as dividends to its stockholders at least 90% of its “REIT taxable income” (excluding capital gains). Failure to comply with this requirement would result in the Company’s income being subject to tax at regular corporate rates. In addition, the Company will be subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions considered as paid by it with respect to any calendar year are less than the sum of 85% of its ordinary income for the calendar year, 95% of its capital gains net income for the calendar year and any undistributed taxable income from prior periods. Under certain circumstances, banking regulatory authorities may restrict the ability of the Company, as a subsidiary of the Bank, to make distributions to its stockholders. Such a restriction could subject


9


 

the Company to federal income and excise tax and result in the Company’s failure to meet REIT requirements with respect to stockholder distributions.
 
Redemption upon occurrence of a Tax Event
 
At any time following the occurrence of a Tax Event (as defined under “Description of Series A Preferred Shares — Redemption” in the 1998 Prospectus), the Company will have the right to redeem the Preferred Shares in whole but not in part. The occurrence of a Tax Event will not, however, give the holders of the Preferred Shares any right to have such shares redeemed.
 
Illinois Tax Law Change
 
Beginning January 1, 2009, Illinois required a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single corporation. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock are held by HCH, a wholly owned subsidiary of the Bank, (2) the Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. The 2010 Illinois statutory tax rate was 7.3% and for 2011 it will be 9.5%. Management believes that the Illinois state tax expense to be incurred by the Company has not and in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the Preferred Shares. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock.
 
Automatic exchange upon occurrence of the Exchange Event
 
Upon the occurrence of the Exchange Event, the outstanding Preferred Shares will be automatically exchanged on a one-for-one basis into Bank Preferred Shares. Assuming, as is anticipated to be the case, that the Bank Preferred Shares are nonvoting, the Automatic Exchange will be taxable, and each holder of Preferred Shares will have a gain or loss, as the case may be, measured by the difference between the basis of such holder in the Preferred Shares and the fair market value of the Bank Preferred Shares received in the Automatic Exchange. Assuming that such holder’s Preferred Shares were held as capital assets prior to the Automatic Exchange, any gain or loss will be capital gain or loss.
 
Relationship with the Bank and its affiliates; conflicts of interest
 
The Bank and its affiliates are involved in virtually every aspect of the Company’s existence. The Bank is the sole holder of the Common Stock of the Company and will administer the day-to-day activities of the Company in its role as Advisor under the Advisory Agreement. The Bank will also act as servicer of the Mortgage Loans on behalf of the Company under the Servicing Agreement. In addition, other than the Independent Directors and Non Bank Directors (as defined in Item 10), all of the officers and directors of the Company are also officers and/or directors of the Bank and/or affiliates of the Bank. Their compensation is paid by the Bank, and they have substantial responsibilities in connection with their work as officers of the Bank. As the holder of all of the outstanding voting stock of the Company, the Bank will have the right to elect all directors of the Company, including the Independent Directors.
 
The Bank and its affiliates may have interests which are not identical to those of the Company. Consequently, conflicts of interest may arise with respect to transactions, including without limitation, future acquisitions of Mortgage Assets from the Bank and/or affiliates of the Bank; servicing of Mortgage Loans; future dispositions of Mortgage Assets to the Bank; and the renewal, termination or modification of the Advisory Agreement or the Servicing Agreement. It is the intention of the Company and the Bank that any agreements and transactions between the Company, on the one hand, and the Bank and/or its affiliates, on the other hand, are fair to all parties and consistent with market terms, including prices paid and received for the Initial Mortgage Assets, on the acquisition or disposition of Mortgage Assets by the Company or in connection with the servicing of Mortgage Loans. The requirement in the terms of the Preferred Shares that certain actions of the Company be approved by a majority of


10


 

the Independent Directors is also intended to ensure fair dealings between the Company and the Bank and its affiliates. However, there can be no assurance that such agreements or transactions will be on terms as favorable to the Company as those that could have been obtained from unaffiliated third parties.
 
Risk of future revisions in policies and strategies by Board of Directors
 
The Board of Directors has established the investment policies and operating policies and strategies of the Company, all material aspects of which are described in this report. These policies may be amended or revised from time to time at the discretion of the Board of Directors (in certain circumstances subject to the approval of a majority of the Independent Directors) without a vote of the Company’s stockholders, including holders of the Preferred Shares. The ultimate effect of any change in the policies and strategies of the Company on a holder of Preferred Shares may be positive or negative.
 
Possible leverage
 
Although the Company does not currently intend to incur any indebtedness in connection with the acquisition and holding of Mortgage Assets, the Company may do so at any time (although indebtedness in excess of 25% of the Company’s total stockholders’ equity may not be incurred without the approval of a majority of the Independent Directors of the Company). To the extent the Company were to change its policy with respect to the incurrence of indebtedness, the Company would be subject to risks associated with leverage, including, without limitation, changes in interest rates and prepayment risk.
 
Additional issuances of preferred stock could have dilutive effect
 
The Charter of the Company authorizes 20,000,000 shares of preferred stock, 10,000,000 shares of which have been issued. The Company could issue additional preferred shares that rank equal to the Preferred Shares in the payment of dividends or in the distribution of assets on liquidation without the approval of the holders of the Preferred Shares. Such future issuances could have the effect of diluting the holders of the Preferred Shares.
 
RISK FACTORS RELATING TO THE BANK
 
Because of the possibility of the Automatic Exchange, an investment in Preferred Shares involves a high degree of risk with respect to the performance and capital levels of the Bank. Investors in the Preferred Shares should carefully consider the following risk factors and other considerations relating to the Bank before deciding whether to invest in such shares.
 
Possible adverse effects of economic conditions
 
Economic conditions beyond the Bank’s control may have a significant impact on the Bank’s operations, including changes in net interest income. Examples of such conditions include: (i) the strength of credit demand by customers; (ii) the introduction and growth of new investment instruments and transaction accounts by nonbank financial competitors; (iii) changes in the general level of interest rates, including changes resulting from the monetary activities of the Board of Governors of the Federal Reserve System; (iv) adverse changes in the economic net worth of loan customers; (v) decline in the general level of employment; and (vi) increased levels of Federal government support and equity infusions intended for banks and other commercial enterprises. Economic growth in the Bank’s market areas is dependent upon the local economy. Continued adverse changes in the economy of the Chicago metropolitan area and other market areas would likely reduce the Bank’s growth rate and could otherwise have a negative effect on its business, including the demand for new loans, the ability of customers to repay loans and the value of the collateral pledged as security. Additionally, current conditions in credit and funding markets serving both corporate and consumer segments have remained weak, thereby causing a material contraction in the availability of credit as a result of more stringent underwriting standards. The Bank’s housing sector loan portfolio and related losses have primarily been concentrated in its commercial residential developer portfolio, in higher loan-to-value and broker sourced home equity loans as well as in its residential mortgage loan portfolio. The Bank has no significant exposures to sub-prime or ALT-A mortgages. The reduction in credit availability has contributed to reduced demand for new and existing homes, exacerbating an environment characterized by declining home


11


 

prices and rising rates of foreclosure. A similar credit dynamic has adversely impacted the cost and availability of credit to corporate borrowers, notably in the highly leveraged lower rated credits. The ultimate severity and duration of these developments remain subject to considerable uncertainty and the attendant adverse feedback effects could deepen and exacerbate exposures to the general economic risk factors to which the Bank is exposed.
 
Planned Acquisition of Marshall and Isley Corporation
 
On December 17, 2010, BMO announced it had reached a definitive agreement to purchase Marshall & Isley Corporation (“M&I”) in a common stock for common stock transaction. The purchase price will depend on the number of M&I common shares outstanding at the closing date and is estimated at $4.1 billion. BMO intends that M&I will ultimately merge with and into HFC immediately upon acquisition. In addition, BMO has agreed to have its subsidiary, Harris Financial Corporation (“HFC”) purchase M&I’s Troubled Asset Relief Program (“TARP”) preferred shares and warrants from the U.S. Treasury. At the time of acquisition, it is anticipated that the commercial banking operations of M&I will be merged with those of the Bank. Subject to regulatory approval and M&I shareholders’ vote, the acquisition is expected to close prior to July 31, 2011. At December 31, 2010, M&I’s assets and deposits totaled $50.8 billion and $38.3 billion, respectively. This acquisition would substantially increase the Bank’s assets, geographic presence, scope of operations and customer base. There can be no assurance that the resulting bank will be profitable or that returns on equity and assets would be maintained at a level comparable to what the Bank would otherwise earn excluding the M&I operations.
 
Increase in interest rates may adversely affect operating results
 
The Bank’s operating results depend to a large extent on its net interest income, which is the difference between the interest the Bank receives from its loans, securities and other assets and the interest the Bank pays on its deposits and other liabilities. Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Conditions such as inflation, recession, unemployment, money supply, international disorders and other factors beyond the control of the Bank may affect interest rates. If generally prevailing interest rates increase, the “net interest spread” of the Bank, which is the difference between the rates of interest earned and the rates of interest paid by the Bank, is likely to contract, resulting in less net interest income. The Bank’s liabilities generally have shorter terms and are more interest-sensitive than its assets. There can be no assurance that the Bank will be able to adjust its asset and liability positions sufficiently to offset any negative effect of changing market interest rates.
 
Competition
 
The Bank faces strong direct competition for deposits, loans and other financial services from other commercial banks, thrifts, credit unions, stockbrokers and finance divisions of auto and farm equipment companies. Some of the competitors are local, while others are statewide or nationwide. Several major multibank holding companies currently operate in the Chicago metropolitan area. Some of these financial institutions are larger than the Bank and have greater access to capital and other resources. Some of the financial institutions and financial services organizations with which the Bank competes are not subject to the same degree of regulation as that imposed on bank holding companies, and federally insured, state-chartered banks and national banks. As a result, such nonbank competitors have advantages over the Bank in providing certain services. The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Bank’s future success will depend in part on its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in the Bank’s operations. Some of the Bank’s competitors have greater resources to invest in technological improvements. There can be no assurance that the Bank will be able to effectively implement such products and services or be successful in marketing such products and services to its customers.


12


 

Government regulation
 
The Bank is subject to extensive federal and state legislation, regulation and supervision. Recently enacted, proposed and future legislation and regulations have had, will continue to have or may have significant impact on the financial services industry. Some of the legislative and regulatory changes may benefit the Bank; others, however, may increase its costs of doing business and assist competitors of the Bank. In recent years, global regulators have proposed reforms that are intended to strengthen the banking sector regulatory capital and liquidity frameworks and strengthen the resilience of individual banking institutions in periods of stress, which are collectively referred to as Basel III. Based on regulatory guidance provided to date, the key building blocks of Basel III from a regulatory capital perspective include:
 
  •  raising the quality of capital that banks are required to hold to ensure banks are better able to absorb losses on both a going-concern and liquidation basis;
 
  •  increasing risk capital requirements, particularly for market risk, securitizations and counterparty credit risk;
 
  •  introducing new regulatory capital ratios — the Common Equity Ratio and the Leverage Ratio — to complement the existing Tier 1 Capital Ratio and Total Capital Ratio; and
 
  •  increasing minimum capital requirements.
 
The Basel III rules are expected to be implemented in a phased approach. The final requirements and transition period applicable to BMO and Harris NA have not been established. The final requirements may increase the amount of capital that BMO and Harris NA are required to hold, and may have a negative impact on their results of operations.
 
On July 21, 2010, U.S. President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is referred to as Dodd-Frank. Dodd-Frank is broad in scope and the Bank is currently assessing the impact of the legislation. The reforms include heightened consumer protection, regulation of the over-the-counter derivatives markets, restrictions on proprietary trading by banks, which is referred to as the Volcker Rule, imposition of heightened prudential standards and broader application of leverage and risk-based capital requirements, greater supervision of systemically significant payment, clearing or settlement systems, restrictions on interchange fees, and the creation of a new financial stability oversight council of regulators with the objective of increasing stability by monitoring systemic risks posed by financial services companies and their activities. Many aspects of Dodd-Frank are subject to rulemaking and will take effect over several years, making it difficult to anticipate at this time the overall impact on the Bank or the financial services industry more generally. However, Dodd-Frank is likely to result in an increase in compliance costs and regulatory enforcement, particularly on the Bank’s U.S. business, and could have a negative impact on the Bank’s results of operations.
 
There can be no assurance that state or federal regulators will not, in the future, impose further restriction or limits on the Bank’s activities.
 
ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.   PROPERTIES
 
None as of December 31, 2010.
 
ITEM 3.   LEGAL PROCEEDINGS
 
The Company is not currently involved in any material litigation nor, to the Company’s knowledge is any material litigation currently threatened against the Company or the Bank other than routine litigation arising in the ordinary course of business. See Note 10 to Consolidated Financial Statements.


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ITEM 4.   RESERVED
 
PART II
 
ITEM 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
HCH presently owns all 1,180 shares of the Common Stock of the Company, which are not listed or traded on any securities exchange. On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company sold 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash, the proceeds of which was used to purchase Mortgage Assets. HCH continues to own 100% of the shares of the Common Stock. On December 30, 2009, the Company paid a cash dividend of $2 million (declared on December 2, 2009), on the outstanding common shares to the stockholder of record on December 15, 2009. Part of this dividend ($17,291) was considered a return of capital to the Company’s common shareholder rather than ordinary income. This has no impact on holders of the Preferred Stock. On June 22, 2009, the Company paid a cash dividend of $261 thousand (declared on May 28, 2009), on the outstanding common shares to the stockholders of record on June 15, 2009. No cash dividends were paid on the outstanding common shares during 2010.
 
The Preferred Shares are traded on the New York Stock Exchange under the symbol “HBC Pr A”. During 2010 and 2009, the Company declared and paid $18.4 million in preferred dividends to preferred stockholders. Although the Company declared cash dividends on the Preferred Shares for 2010 and 2009, no assurances can be made as to the declaration of, or if declared, the amount of, future distributions since such distributions are subject to the Company’s financial condition and capital needs; the impact of legislation and regulations as then in effect or as may be proposed; economic conditions; and such other factors as the Board of Directors may deem relevant. Notwithstanding the foregoing, to remain qualified as a REIT, the Company must distribute annually at least 90% of its ordinary taxable income to preferred and /or common stockholders.
 
The Bank prepares notices relating to the Company’s dividend declaration on the Preferred Shares on the Bank’s website (www.harrisbank.com) under “Corporate Information/News Releases”. The information on the Bank’s website does not constitute a part of this Report.
 
The Company did not repurchase or redeem any Common Stock or Preferred Shares during 2010 or 2009. The Company did not authorize for issuance any securities of the Company under any equity compensation plans.


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ITEM 6.   SELECTED FINANCIAL DATA
 
The following table sets forth selected financial data for the Company and should be read in conjunction with the Consolidated Financial Statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Report.
 
                                         
    2010     2009     2008     2007     2006  
    (In thousands, except per share data)  
 
Statement of Operations Data:
                                       
Interest income
  $ 20,466     $ 22,635     $ 21,296     $ 22,524     $ 21,442  
Non-interest income
    326                          
                                         
Total income
  $ 20,792     $ 22,635     $ 21,296     $ 22,524     $ 21,442  
Operating expenses:
                                       
Loan servicing fees paid to Harris N.A. 
    11       12       15       18       23  
Advisory fees paid to Harris N.A. 
    167       196       208       119       127  
General and administrative
    351       399       374       300       342  
                                         
Total operating expenses
  $ 529     $ 607     $ 597     $ 437     $ 492  
Applicable state income taxes
    1,479       1,608                    
                                         
Net income
  $ 18,784     $ 20,420     $ 20,699     $ 22,087     $ 20,950  
Preferred stock dividends
    18,438       18,438       18,438       18,438       18,438  
                                         
Net income available to common stockholder
  $ 346     $ 1,982     $ 2,261     $ 3,649     $ 2,512  
                                         
Basic and diluted earnings per common share
  $ 293     $ 1,680     $ 2,261     $ 3,649     $ 2,512  
                                         
Distributions per preferred share
  $ 1.8438     $ 1.8438     $ 1.8438     $ 1.8438     $ 1.8438  
                                         
Balance Sheet Data (end of period):
                                       
Total assets
  $ 586,086     $ 583,574     $ 501,130     $ 492,923     $ 487,340  
                                         
Total liabilities
  $ 1,258     $ 1,084     $ 886     $ 3,129     $ 4,731  
                                         
Total stockholders’ equity
  $ 584,828     $ 582,490     $ 500,244     $ 489,794     $ 482,609  
                                         
Cash Flows Data:
                                       
Net cash provided by operating activities
  $ 18,579     $ 20,419     $ 20,326     $ 22,235     $ 20,760  
                                         
Net cash provided by (used in) investing activities
  $ 968     $ (63,483 )   $ (6,424 )   $ (3,603 )   $ 232  
                                         
Net cash (used in) provided by financing activities
  $ (18,438 )   $ 59,301     $ (24,088 )   $ (23,560 )   $ (16,408 )
                                         


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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion should be read in conjunction with the Consolidated Financial Statements and notes thereto appearing later in this Report.
 
Summary
 
Year Ended December 31, 2010 Compared to December 31, 2009
 
The Company’s net income for 2010 was $18.8 million. This represented an 8% decrease from 2009 net income of $20.4 million. Earnings decreased primarily because of a reduction in interest income on portfolio securities as market yields have declined significantly.
 
Interest income on securities purchased under agreement to resell for the year ended December 31, 2010 was $85 thousand on an average balance of $64 million with an average yield of .13% compared to interest income of $31 thousand on an average balance of $33 million with an average yield of .09% for 2009. Interest income on the Notes for 2010 totaled $222 thousand and yielded 6.4% on $3.5 million of average principal outstanding compared to $247 thousand and a 6.4% yield on $3.9 million average principal outstanding for 2009. The decrease in interest income from the Notes was attributable to a reduction in the Note balance because of customer payoffs in the Securing Mortgage Loans. The average outstanding balance of the Securing Mortgage Loans was $4 million for 2010 and $5 million for 2009. Interest income on securities available-for-sale for 2010 was $20.2 million, resulting in a yield of 4.0% on an average balance of $500 million compared to interest income of $22.4 million with a yield of 4.3% on an average balance of $518 million for 2009. There were no Company borrowings during either year.
 
Gains from investment securities sales were $326 thousand in 2010. There were no investment securities sales in 2009 or 2008.
 
Operating expenses for the year ended December 31, 2010 totaled $529 thousand compared to $607 thousand in 2009. Loan servicing expenses for 2010 totaled $11 thousand, a decrease of $1 thousand from 2009. This decrease was attributable to the reduction in the principal balance of the Notes. Advisory fees for the year ended December 31, 2010 were $167 thousand compared to $196 thousand, a 14.8% decrease from 2009, primarily due to certain charges for treasury services being assessed directly rather than as part of advisory fees in the current year. General and administrative expenses totaled $351 thousand for 2010 and $399 thousand for 2009, a 12.0% decrease from 2009 primarily as a result of decreased costs for insurance and legal fees offset by higher treasury costs.
 
Year Ended December 31, 2009 Compared to December 31, 2008
 
The Company’s net income for 2009 was $20.4 million. This represented a 1.3% decrease from 2008 net income of $20.7 million. Earnings decreased primarily because of the imposition of Illinois state income taxes on the Company beginning in 2009.
 
Interest income on securities purchased under agreement to resell for the year ended December 31, 2009 was $31 thousand on an average balance of $33 million with an average yield of .09% compared to interest income of $1 million on an average balance of $42 million with an average yield of 2.3% for 2008. Interest income on the Notes for 2009 totaled $247 thousand and yielded 6.4% on $3.9 million of average principal outstanding compared to $302 thousand and a 6.4% yield on $4.7 million average principal outstanding for 2008. The decrease in interest income from the Notes was attributable to a reduction in the Note balance because of customer payoffs in the Securing Mortgage Loans. The average outstanding balance of the Securing Mortgage Loans was $5 million for 2009 and $6 million for 2008. Interest income on securities available-for-sale for 2009 was $22.4 million, resulting in a yield of 4.3% on an average balance of $518 million compared to interest income of $20 million with a yield of 4.5% on an average balance of $444 million for 2008. There were no Company borrowings during either year.
 
Operating expenses for the year ended December 31, 2009 totaled $607 thousand compared to $597 thousand a year ago. Loan servicing expenses for 2009 totaled $12 thousand, a decrease of $3 thousand from 2008. This decrease was attributable to the reduction in the principal balance of the Notes. Advisory fees for the year ended December 31, 2009 were $196 thousand compared to $208 thousand, a 5.8% decrease from 2008, primarily due to


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certain charges for treasury services being assessed directly rather than as part of advisory fees in the current year. General and administrative expenses totaled $399 thousand for 2009 and $374 thousand for 2008, a 6.7% increase from 2008 primarily as a result of increased costs for legal and director fees and also due to change in assessing treasury costs.
 
Quarter Ended December 31, 2010 Compared to Quarter Ended December 31, 2009
 
The Company’s net income for the fourth quarter of 2010 was $4.6 million and for the fourth quarter of 2009 was $5.1 million.
 
Interest income on securities available-for-sale for the current quarter was $4.8 million resulting in a yield of 3.8% on an average balance of $508 million, compared to interest income of $5.6 million with a yield of 4.3% on an average balance of $523 million for the same period a year ago. The decrease in these assets largely reflected the lower interest rates. Interest income on securities purchased under agreement to resell for the current quarter was $23 thousand on an average balance of $63 million resulting in an average yield of 0.15% compared to interest income of $7 thousand on an average balance of $41 million with an average yield of .01% for the same period in the year-ago quarter.
 
There were no Company borrowings during the fourth quarter of 2010 or 2009.
 
Fourth quarter 2010 operating expenses totaled $154 thousand, a decrease of $22 thousand from the fourth quarter of 2009. Advisory fees for the fourth quarter of 2010 were $31 thousand compared to $60 thousand in the prior year’s fourth quarter due to deceased costs for investment advisory services and administration. Loan servicing fees for the fourth quarter of 2010 and 2009 were $3 thousand. General and administrative expenses totaled $122 thousand in the current quarter compared to $113 thousand for the same period in 2009, reflecting increased costs for printing and expert services.
 
Allowance for Loan Losses
 
The Company does not currently maintain an allowance for loan losses due to the over-collateralization of the Securing Mortgage Loans and the prior and expected credit performance of the collateral pool and because the Company can, under certain conditions, require the Bank to dispose of nonperforming Mortgage Loans.
 
Concentrations of Credit Risk
 
The MBS portfolio securities currently held by the Company are all various issues of federal agency guaranteed conventional pass-through securities. The credit guarantees extended by Fannie Mae and FHLMC are characterized as full modification guarantees whereby the timely payment of both interest and principal is assured by the respective sponsoring federal agency.
 
A majority of the collateral underlying the Securing Mortgage Loans is located in Illinois. The financial viability of customers in this state is, in part, dependent on the state’s economy. The collateral may be subject to a greater risk of default than other comparable loans in the event of adverse economic, political or business developments or natural hazards that may affect such region and the ability of property owners in such region to make payments of principal and interest on the underlying mortgages. The Company’s maximum risk of accounting loss, should all customers in Illinois fail to perform according to contract terms and all collateral prove to be worthless, was approximately $2.6 million at December 31, 2010 and $2.9 million at December 31, 2009.
 
Interest Rate Risk
 
The Company’s income consists primarily of interest payments on the Mortgage Assets and the securities it holds. If there is a decline in interest rates during a period of time when the Company must reinvest payments of interest and principal with respect to its Mortgage Assets and other interest earning assets, the Company may find it difficult to purchase additional earning assets that generate sufficient income to support payment of dividends on the Preferred Shares. Because the rate at which dividends, if, when and as authorized and declared, are payable on the Preferred Shares is fixed, there can be no assurance that an interest rate environment in which there is a decline in interest rates would not adversely affect the Company’s ability to pay dividends on the Preferred Shares.


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Competition
 
The Company does not engage in the business of originating mortgage loans. While the Company may acquire additional Mortgage Assets, it anticipates that such assets will be acquired from the Bank, affiliates of the Bank or unaffiliated parties. Accordingly, the Company does not expect to compete with mortgage conduit programs, investment banking firms, savings and loan associations, banks, thrift and loan associations, finance companies, mortgage bankers or insurance companies in originating Mortgage Assets.
 
Liquidity Risk Management
 
The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company’s financial commitments. In managing liquidity, the Company takes into account various legal limitations placed on a REIT.
 
The Company’s principal liquidity needs are to maintain the current portfolio size through the acquisition of additional qualifying assets and to pay dividends to its stockholders after satisfying obligations to creditors. The acquisition of additional qualifying assets is funded with the proceeds obtained from repayment of principal balances by individual mortgages or maturities of securities held for sale on a reinvested basis. The payment of dividends on the Preferred Shares will be made from legally available funds, principally arising from operating activities of the Company. The Company’s cash flows from operating activities principally consist of the collection of interest on short term qualifying investments, the Notes and mortgage-backed securities. The Company does not have and does not anticipate having any material capital expenditures.
 
In order to remain qualified as a REIT, the Company must distribute annually at least 90% of its adjusted REIT ordinary taxable income, as provided for under the Code, to its common and preferred stockholders. The Company currently expects to distribute dividends annually equal to 90% or more of its adjusted REIT ordinary taxable income.
 
The Company anticipates that cash and cash equivalents on hand and the cash flow from the Notes, short-term investments and mortgage-backed securities will provide adequate liquidity for its operating, investing and financing needs including the capacity to continue preferred dividend payments on an uninterrupted basis.
 
As presented in the accompanying consolidated Statement of Cash Flows, the primary sources of funds in addition to the $18.6 million provided from operations during 2010 were $395.3 million from the maturities and sales of securities available-for-sale. In 2009, the primary sources of funds other than $20.4 million provided from operations were $272.5 million from the maturities of securities available-for-sale and $80 million from the purchase of the Company’s common stock by HCH. The primary uses of funds for 2010 were $394.5 million in purchases of securities available-for-sale and $18.4 million in Preferred Share dividends. In 2009, the primary uses of funds were $336.7 million in purchases of securities available-for-sale and $18.4 million and $2.3 million in Preferred Share dividends and Common Stock dividends paid, respectively.
 
Accounting Pronouncements
 
The Company adopted Accounting Standards Update (“ASU”) 2010-06, “Improving Disclosures About Fair Value Measurements”, as of January 1, 2010. The standard amends ASC 820-10 to require new disclosures about transfers in and out of Level 1 and Level 2 fair value measurements. ASU 2010-06 clarifies existing disclosure requirements regarding the level of disaggregation of each class of assets and liabilities within a line item in the statement of financial condition and the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements that fall in either Level 2 or Level 3 fair value measurements. The adoption of the standard had no impact on the corporation’s financial position or results of operations. See Note 6 to the Consolidated Financial Statements for additional information on fair value of financial instruments. The standard also requires new disclosures about the roll forward of activity in Level 3 fair value measurements which will be effective January 1, 2011.


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Tax Matters
 
As of December 31, 2010, the Company believes that it is in full compliance with the REIT federal income tax rules, and expects to qualify as a REIT under the provisions of the Code. The Company expects to meet all REIT requirements regarding the ownership of its stock and anticipates meeting the annual distribution requirements. Beginning January 1, 2009, Illinois requires a “captive” REIT to increase its state taxable income by the amount of dividends paid. Under this law, a captive REIT includes a REIT of which 50% of the voting power or value of the beneficial interest or shares is owned by a single corporation. Management believes that the Company is classified as a “captive” REIT under Illinois law, in light of the fact that (1) all of the outstanding Common Stock is held by HCH a wholly-owned subsidiary of the Bank, (2) the Common Stock represents more than 50% of the voting power of the Company’s equity securities and (3) the Common Stock is not listed for trading on an exchange. Management believes that the state tax expense to be incurred by the Company in future years should not have a material adverse effect upon the Company’s ability to declare and pay future dividends on the preferred shares. This belief is based upon the ownership interest of the Company, whereby any tax expense incurred is expected to primarily reduce the net earnings available to the holder of the Company’s Common Stock. The Illinois statutory tax rate for 2010 was 7.3% and the tax rate for 2011 will be 9.5%. For the fourth quarter and twelve months of 2010, $366 thousand and $1.5 million of Illinois income tax expense was recorded, respectively.
 
Ratings Adjustment
 
On January 22, 2010, Moody’s Investors Services, Inc. (“Moody’s”) downgraded its long-term ratings for Bank of Montreal (“BMO”) (the Company’s ultimate parent). BMO’s deposit rating dropped to Aa2 from Aa1 and its bank financial strength rating (BFSR) fell to B- from B. Further, Moody’s downgraded BMO’s preferred stock securities (which include non-cumulative preferred shares and other hybrid capital instruments) four notches to BaaI from Aa3. The first notch reflected the BFSR downgrade. The other three notches were a consequence of Moody’s implementing a revised methodology for rating bank hybrid securities. At that time, Moody’s downgraded the bank financial strength rating of the Bank to C+ from B-. In addition, Moody’s lowered its rating for the Company’s Preferred Stock from A2 to Baa1 and described this action as reflecting both the BFSR downgrade and Moody’s implementation of the aforementioned revised methodology.
 
ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
As of December 31, 2010, the Company had $3.4 million invested in Notes, a decrease of $215 thousand from December 31, 2009. The decline was attributable to customer payoffs in the Securing Mortgage Loans. At December 31, 2010, the Company held $517 million in residential mortgage-backed securities compared to $515 million at December 31, 2009. At December 31, 2010 and 2009, the Company had $40 million in U.S. Treasury Securities. At December 31, 2010, the Company held an investment of $24 million in securities purchased from the Bank under agreement to resell compared to $22 million at December 31, 2009. The Company is subject to exposure for fluctuations in interest rates. Adverse changes in interest rates could impact negatively the value of mortgage-backed securities, as well as the levels of interest income to be derived from these assets.
 
The following table stratifies the Company’s available-for-sale securities as of December 31, 2010 by maturity date (in thousands of dollars):
 
                                                                 
    Year Ending December 31                 Fair Value at
 
    2011     2012     2013     2014     2015     Thereafter     Total     December 31, 2010  
 
Residential mortgage-backed
                                                       
Amortized cost
  $ 7,993     $     $ 7,380     $ 4,150     $ 1,701     $ 480,211     $ 501,435     $ 516,911  
Average Yield
    4.00%             4.00%       4.00%       4.00%       4.22%       4.21%          
US Treasuries
                                                               
Amortized cost
  $ 40,000                                   $ 40,000     $ 40,000  
Average Yield
    0.01%                                     0.01%          
 
The Company’s investments held in residential mortgage-backed securities are secured by adjustable and fixed interest rate residential mortgage loans. The yield to maturity on each security depends on, among other things, the


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price at which each such security is purchased, the rate and timing of principal payments (including prepayments, repurchases, defaults and liquidations), the pass-through rate and interest rate fluctuations. Changes in interest rates could impact prepayment rates as well as default rates, which in turn would impact the value and yield to maturity of the Company’s residential mortgage-backed securities.
 
The Company currently has no outstanding borrowings.
 
ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Refer to the Index to Consolidated Financial Statements for the required information.
 
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
There have been no disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure.
 
ITEM 9A.   CONTROLS AND PROCEDURES
 
Disclosure Controls and Procedures
 
As of December 31, 2010, Paul R. Skubic, the Chairman of the Board, Chief Executive Officer and President of the Company, and Pamela C. Piarowski, the Chief Financial Officer of the Company, evaluated the effectiveness of the disclosure controls and procedures of the Company (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) and concluded that these disclosure controls and procedures are effective to ensure that material information for the Company required to be included in this Report has been made known to them in a timely fashion.
 
Management’s Report on Internal Control over Financial Reporting
 
The management of Harris Preferred Capital Corporation is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
Harris Preferred Capital Corporation’s management, including the Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our internal control over financial reporting using the framework and criteria established in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that internal control over financial reporting was effective as of December 31, 2010.
 
This report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s


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registered public accounting firm pursuant to an exemption for non-accelerated filers under Section 989G of the Dodd-Frank Wall Street Return and Consumer Protection Act.
 
Changes in Internal Control over Financial Reporting
 
There were no changes in the Company’s internal controls over financial reporting identified in connection with such evaluations that occurred during the quarter ended December 31, 2010 that have materially affected or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
ITEM 9B.   OTHER INFORMATION
 
Not applicable.
 
PART III
 
ITEM 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
The Company’s Board of Directors consists of five members. The Company does not anticipate that it will require any employees because it has retained the Bank to perform certain functions pursuant to the Advisory Agreement described above. Each officer of the Company currently is also an officer of the Bank and/or affiliates of the Bank. The Company maintains corporate records and audited financial statements that are separate from those of the Bank or any of the Bank’s affiliates. None of the officers, directors or employees of the Company will have a direct or indirect pecuniary interest in any Mortgage Asset to be acquired or disposed of by the Company or in any transaction in which the Company has an interest or will engage in acquiring, holding and managing Mortgage Assets.
 
Pursuant to terms of the Preferred Shares, the Company’s Independent Directors (as defined in Item 13 (c) below) will consider the interests of the holders of both the Preferred Shares and the Common Stock in determining whether any proposed action requiring their approval is in the best interests of the Company.
 
The persons who are directors and executive officers of the Company are as follows:
 
             
Name
 
Age
 
Position and Offices Held
 
Paul R. Skubic
    62     Chairman of the Board, President
Pamela C. Piarowski
    51     Chief Financial Officer, Treasurer
Margaret M. Sulkin
    52     Assistant Treasurer
Delbert J. Wacker
    79     Director
David J. Blockowicz
    68     Director
Forrest M. Schneider
    63     Director
Frank M. Novosel
    64     Director
 
The following is a summary of the business experience of the directors of the Company:
 
Mr. Skubic has been a director of the Company since inception, January 2, 1998. Mr. Skubic has been Vice President and Controller of the Bank and Chief Accounting Officer for Harris Bankcorp, Inc. and the Bank since 1990. Prior to joining Harris Bankcorp, Inc., Mr. Skubic was employed by Arthur Andersen & Co. He is a certified public accountant. Based primarily upon Mr. Skubic’s extensive 20 year management and leadership experience as the Vice President and Controller of a national banking association and as the Chief Accounting Officer for Harris Bankcorp, Inc.; strong strategic planning, accounting, financial, banking and risk analysis skills and experience; and tenure and contributions as a current officer, Board member and Board committee member, the Board determined that Mr. Skubic should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.
 
Mr. Wacker has been a director of the Company since inception, January 2, 1998. Mr. Wacker is a retired partner from Arthur Andersen & Co. since 1987 after 34 years. From July 1988 to November 1990, he was Vice President -Treasurer, Parkside Medical Services, a subsidiary of Lutheran General Health System. From November 1990 to September 1993, he completed various financial consulting projects for Lutheran General. He is a Certified


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Public Accountant. Based primarily upon Mr. Wacker’s extensive 40-year management and leadership experience as a former partner of a national accounting firm and as former Vice President-Treasurer and financial consultant for a health care system; strong accounting, financial and risk analysis skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board determined that Mr. Wacker should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.
 
Mr. Blockowicz has been a director of the Company since inception, January 2, 1998. Mr. Blockowicz is a Certified Public Accountant and is a partner with Blockowicz & Tognocchi LLC. Prior to forming his firm, Mr. Blockowicz was a partner with Arthur Andersen & Co. through 1990. Blockowicz & Tognocchi LLC is a professional tax consulting firm and is not a parent, subsidiary or other affiliate of the Company. Based primarily upon Mr. Blockowicz’s extensive 33-year management and leadership experience as a former partner of a national accounting firm and as a partner of a professional tax consulting firm; strong taxation, accounting and financial skills and experience; and tenure and contributions as a current Board member and Board committee chairperson, the Board determined that Mr. Blockowicz should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.
 
Mr. Schneider has been a director of the Company since 2000. Mr. Schneider is Vice President of Lane Industries, Inc (until September 30, 2010 Mr. Schneider served as President and Chief Executive Officer of Lane Industries). Mr. Schneider has been a director of Lane Industries, a diversified holding company from 2000 until September 30, 2010. He has been employed by Lane Industries since 1976. Lane Industries is not a parent, subsidiary or other affiliate of the Company. He is a graduate of the University of Illinois at Chicago, where he received his B.S. in Finance. He also holds a M.S. in Finance from the University of Illinois at Urbana, Champaign. Mr. Schneider served as a director of General Binding Corporation (NASDAQ) from 2000 until 2005 and served on the governance and compensation committees. Mr. Schneider served as a director of ACCO Brands Corporation (NYSE) from 2005 until 2006. Based primarily upon Mr. Schneider’s extensive 10 year executive management and leadership experience as a President, Chief Executive Officer and director of a diversified holding company; strong strategic planning, financial, risk analysis and administrative skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board determined that Mr. Schneider should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.
 
Mr. Novosel has been a director of the Company since inception, January 2, 1998. Mr. Novosel was a Vice President in the Treasury Group of the Bank from 1995 and served as Treasurer of the Company until his retirement from the Bank in November, 2008. Previously, he served as Treasurer of Harris Bankcorp, Inc. Mr. Novosel is a Chartered Financial Analyst and a member of the CFA Society of Chicago. Based primarily upon Mr. Novosel’s extensive 25-year management and leadership experience as a former Vice President of the Bank and former Treasurer of the Company; strong strategic planning, financial, banking and risk analysis skills and experience; and tenure and contributions as a current Board member and Board committee member, the Board determined that Mr. Novosel should serve as a director of the Company at the time of filing of this Annual Report on Form 10-K.
 
The following is a summary of the business experience of the executive officers who are not directors of the Company:
 
Ms. Piarowski has been Chief Financial Officer of the Company since May 31, 2006 and Treasurer since 2008, although she previously served as Chief Financial Officer of the Company and Senior Vice-President and Chief Financial Officer of Harris Bankcorp, Inc. from June 2001 through July 2003. In 2003, she was appointed Vice-President, Financial Performance Management, Bank of Montreal. In April, 2006 she was appointed Vice-President and Chief Financial Officer, BMO US. She is a certified public accountant.
 
Ms. Sulkin has been a Vice President in the Taxation Department of the Bank since 1992. Ms. Sulkin has been employed by the Bank since 1984. Prior to joining the Bank, she was employed by KPMG LLP. She is a certified public accountant.
 
Independent Directors
 
The terms of the Preferred Shares require that, as long as any Preferred Shares are outstanding, certain actions by the Company be approved by a majority of the Company’s Independent Directors (as defined in Item 13


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(c) below). Delbert J. Wacker, David J. Blockowicz and Forrest M. Schneider are the Company’s Independent Directors.
 
If at any time the Company fails to declare and pay a quarterly dividend payment on the Preferred Shares, the number of directors then constituting the Board of Directors of the Company will be increased by two at the Company’s next annual meeting and the holders of Preferred Shares, voting together with the holders of any other outstanding series of preferred stock as a single class, will be entitled to elect two additional directors to serve on the Company’s Board of Directors. Any member of the Board of Directors elected by holders of the Company’s Preferred Shares will be deemed to be an Independent Director for purposes of the actions requiring the approval of a majority of the Independent Directors.
 
Audit Committee
 
The Board of Directors of the Company has established an Audit Committee, with an approved Audit Committee Charter, which will review the engagement of an independent registered public accounting firm and review their independence. The Audit Committee will also review the adequacy of the Company’s internal accounting controls. The Audit Committee is comprised of Delbert J. Wacker, David J. Blockowicz and Forrest M. Schneider. David J.Blockowicz is the chairperson of the Audit Committee. The Company’s Board of Directors has determined that each member of the Audit Committee is an Audit Committee financial expert as defined in rules of the Securities and Exchange Commission. Each Audit Committee member is an Independent Director (as defined in Item 13 (c) below).
 
Investment Committee
 
In November 2008, the Board of Directors of the Company established an Investment Committee, with an approved Investment Committee Charter, which will assist the Board of Directors in discharging its oversight responsibilities in reviewing the Company’s investment policies, strategies, transactions and performance, and in overseeing the Company’s capital and financial resources. The Investment Committee is required to be composed of at least two members of the Board of Directors, with one appointed chairperson. The Investment Committee is comprised of the Committee chairperson, Frank M. Novosel and Paul R. Skubic.
 
Compensation of Directors
 
The Company pays directors who are not currently officers of the Bank or its affiliates (“Non Bank Director”) and Independent Directors (as defined in Item 13 (c) below) fees for their services as directors. For the Company’s 2010 fiscal year, Non Bank Directors and Independent Directors received a fee of $3,000 per quarter, and $4,000 per quarter for services to the Investment Committee. Directors also received $1,000 for each meeting of the Board of Directors and Audit Committee that they attended. The following table shows the compensation received in 2010. The Company has not paid and does not currently intend to pay any compensation to directors who are not Independent Directors or to Non Bank Directors or who are active Bank officers.
 
                                                         
                            Non-Qualified
             
                      Non-Equity
    Deferred
             
    Fees Earned
    Stock
    Option
    Incentive Plan
    Compensation
    All Other
       
    or Paid in
    Awards
    Awards
    Compensation
    Earnings
    Compensation
       
Name
  Cash     ($)     ($)     ($)     ($)     ($)     Total  
 
Delbert J. Wacker *
  $ 20,000                                   $ 20,000  
David J. Blockowicz *
    20,000                                     20,000  
Forrest M. Schneider *
    20,000                                     20,000  
Frank M. Novosel **
    32,000                                     32,000  
                                                         
    $ 92,000                                   $ 92,000  
 
 
* Represents $16,000 in compensation received as Independent Director and $4,000 in compensation received as an Audit Committee Member.
 
** Represents $16,000 in compensation received as a Non Bank Director and $16,000 in compensation received as an Investment Committee Member.


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The Company has adopted a code of ethics for its senior officers, including the executive officers, which is filed as an Exhibit hereto.
 
Section 16(a) Beneficial Ownership Reporting Compliance
 
Based on a review of reports filed with respect to the year ended December 31, 2010, the Company believes that all ownership reports were filed on a timely basis.
 
ITEM 11.   EXECUTIVE COMPENSATION
 
The Company has not paid and does not currently intend to pay any compensation to its officers or employees or to directors who are not Independent Directors or Non Bank Directors or who are active Bank officers.
 
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
(a)   Security ownership of certain beneficial owners
 
No person owns of record or is known by the Company to own beneficially more than 5% of the outstanding 73/8% Noncumulative Exchangeable Preferred Stock, Series A.
 
(b)   Security Ownership of Management
 
The following table shows the ownership as of March 30, 2011 of 73/8% Noncumulative Exchangeable Preferred Stock, Series A, by the officers or directors who own any such shares.
 
                 
    Name of
  Amount of
  Percent
Title of Class
 
Beneficial Owner
 
Beneficial Ownership
 
of Class
 
Preferred Stock
  Paul R. Skubic   8,625 Shares     .032 %
Preferred Stock
  Forrest Schneider   8,965 Shares     .033 %
Preferred Stock
  David J. Blockowicz   3,300 Shares     .012 %
Preferred Stock
  Frank M. Novosel   3,500 Shares     .013 %
Preferred Stock
  Delbert Wacker   3,000 Shares     .011 %
 
ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
(a)   Transactions with Related Persons
 
The Bank, through its wholly-owned subsidiary, HCH, indirectly owns 100% of the Common Stock of the Company. Paul R. Skubic, Chairman of the Board of the Company, its executive officers, Pamela C. Piarowski, and Margaret M. Sulkin, are also officers of the Bank.
 
A substantial portion of the assets of the Company initially consisted of Notes issued by the Bank. The Notes mature on October 1, 2027 and pay interest at 6.4% per annum. During 2010, the Company received repayments on the Notes of $215 thousand compared to 2009 repayments of $700 thousand. In years ended December 31, 2010, 2009 and 2008, the Bank paid interest on the Notes in the amount of $222 thousand, $246 thousand and $302 thousand, respectively, to the Company.
 
The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. At December 31, 2010, the Company held $24 million of such assets and earned $85 thousand of interest from the Bank during 2010. At December 31, 2009, the Company held $22 million of such assets and earned $31 thousand of interest for 2009. The Company receives rates on these assets comparable to the rates that the Bank offers to unrelated counterparties under similar circumstances.
 
The Bank and the Company have entered into a Servicing Agreement and an Advisory Agreement, the terms of which are described in further detail on page 5 of this report. In 2010, the Bank received payments of $11 thousand and $167 thousand, respectively, compared to $12 thousand and $196 thousand for 2009, under the terms of these agreements.


24


 

(b)   Review, Approval or Ratification of Transactions with Related Persons
 
The terms of the Preferred Shares require that, as long as any Preferred Shares are outstanding, certain actions by the Company, including transactions with the Bank and other related persons, be approved by a majority of the Independent Directors (as defined in the following paragraph). Each of the transactions described in Item 13(a) above was approved by a majority of the Independent Directors.
 
(c)   Director Independence
 
The Articles of Incorporation (the “Charter”) of the Company defines an “Independent Director” as one who is not a current officer or employee of the Company or a current director, officer or employee of the Bank or of its affiliates. In addition, pursuant to the Charter, so long as the Preferred Shares are listed for trading on the New York Stock Exchange, a director shall not be deemed to be an “Independent Director” unless he or she meets the applicable requirements for independence as set forth under New York Stock Exchange rules and regulations.
 
ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES
 
Audit Fees
 
For the years ended December 31, 2010 and 2009, the Company’s principal accountant billed $65 thousand and $67 thousand, respectively for the audit of the Company’s annual financial statements and review of financial statements included in Form 10-Q filings.
 
Audit-Related Fees
 
There were no fees billed for services reasonably related to the performance of the audit or review of the Company’s financial statements outside of those fees disclosed above under “Audit Fees” for the years ended December 31, 2010 and 2009.
 
Tax Fees
 
There were no fees billed for tax-related services for the years ended December 31, 2010 and 2009.
 
All Other Fees
 
There were no other fees billed to the Company by the Company’s principal accountants other than those disclosed above for the years ended December 31, 2010 and 2009.
 
Pre-Approval Policies and Procedures
 
Prior to engaging accountants to perform a particular service, the Board of Directors obtains an estimate for the service to be performed. All of the services described above were approved by the Audit Committee and Board of Directors in accordance with its procedures.
 
PART IV
 
ITEM 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES
 
(a) Documents filed with Report:
 
(1) Consolidated Financial Statements (See page 27 for a listing of all financial statements included in Item 8)
 
(2) Financial Statement Schedules
 
All schedules normally required by Form 10-K are omitted since they are either not applicable or because the required information is shown in the financial statements or notes thereto.


25


 

(3) Exhibits:
 
     
*3(a)(I)
  Articles of Incorporation of the Company, as amended
**3(b)
  Bylaws of the Company
***4
  Specimen of certificate representing Series A Preferred Shares
***10(a)
  Form of Servicing Agreement between the Company and the Bank
***10(b)
  Form of Advisory Agreement between the Company and the Bank
***10(c)
  Form of Bank Loan Agreement between the Company and the Bank
***10(d)
  Form of Mortgage Loan Assignment Agreement between the Company and the Bank
14
  Code of Ethics for Senior Officers (Incorporated by reference to Exhibit 14 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003)
24
  Power of attorney
31.1
  Certification of Pamela C. Piarowski pursuant to Rule 13a — 14(a)
31.2
  Certification of Paul R. Skubic pursuant to Rule 13a — 14(a)
32.1
  Certification pursuant to 18 U.S.C. Section 1350
 
 
* Incorporated by reference to Exhibit 3.1 filed with the Company’s Form 8-K dated March 4, 2009.
 
** Incorporated by reference to Exhibit 3.1 filed with the Company’s Form 8-K dated August 31, 2007.
 
*** Incorporated by reference to the exhibit of the same number filed with the Company’s Registration Statement on Form S-11 (Securities and Exchange Commission file number 333-40257)


26


 

Index to Consolidated Financial Statements
 
The following consolidated financial statements are included in Item 8 of this Annual Report on Form 10-K:
 
 
Harris Preferred Capital Corporation
Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income and Comprehensive Income
Consolidated Statements of Changes in Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Harris N.A.
Financial Review
Consolidated Financial Statements
Independent Auditors’ Report
Consolidated Statements of Condition
Consolidated Statements of Operations
Consolidated Statements of Comprehensive Income (Loss)
Consolidated Statements of Changes in Stockholder’s Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
 
All schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements and notes hereof.


27


 

 
SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Harris Preferred Capital Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 31st day of March, 2011.
 
/s/  PAUL R. SKUBIC
Paul R. Skubic
Chairman of the Board and President
 
/s/  PAMELA C. PIAROWSKI
Pamela C. Piarowski
Chief Financial Officer
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by Paul R. Skubic, Chairman of the Board and President of the Company, as attorney-in-fact for the following Directors on behalf of Harris Preferred Capital Corporation of the 31st day of March 2011.
 
     
David J. Blockowicz
  Forrest M. Schneider
Frank M. Novosel
  Delbert J. Wacker
     
Paul R. Skubic
   
Attorney-In-Fact
   
 
Supplemental Information
 
No proxy statement will be sent to security holders in 2011.


28


 

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Stockholders and Board of Directors
of Harris Preferred Capital Corporation:
 
We have audited the accompanying consolidated balance sheets of Harris Preferred Capital Corporation and subsidiary (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harris Preferred Capital Corporation and subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
 
/s/KPMG LLP
 
Chicago, Illinois
March 31, 2011


29


 

Harris Preferred Capital Corporation
 
Consolidated Balance Sheets
 
                 
    December 31
    December 31
 
    2010     2009  
    (In thousands, except share data)  
 
ASSETS
Cash on deposit with Harris N.A.
  $ 525     $ 916  
Securities purchased from Harris N.A. under agreement to resell
    23,500       22,000  
                 
Total cash and cash equivalents with Harris N.A.
  $ 24,025     $ 22,916  
Notes receivable from Harris N.A.
    3,369       3,584  
Securities available for sale, at fair value
               
Mortgage-backed
    516,911       515,190  
U.S. Treasury Bills
    40,000       39,999  
Other assets
    1,781       1,885  
                 
Total assets
  $ 586,086     $ 583,574  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accrued expenses
  $ 114     $ 116  
Accrued taxes payable and deferred tax liabilities
    1,144       968  
                 
Total liabilities
  $ 1,258     $ 1,084  
                 
Stockholders’ Equity
               
73/8% Noncumulative Exchangeable Preferred Stock, Series A ($1 par value); liquidation value of $250,000; 20,000,000 shares authorized; 10,000,000 shares issued and outstanding
  $ 250,000     $ 250,000  
Common stock ($1 par value); 5,000 shares authorized; 1,180 issued and outstanding
    1       1  
Additional paid-in capital
    320,733       320,733  
Earnings less than distributions
    (255 )     (601 )
Accumulated other comprehensive income — net unrealized gains on available-for-sale securities, net of tax
    14,349       12,357  
                 
Total stockholders’ equity
  $ 584,828     $ 582,490  
                 
Total liabilities and stockholders’ equity
  $ 586,086     $ 583,574  
                 
 
The accompanying notes are an integral part of these financial statements.


30


 

Harris Preferred Capital Corporation
 
Consolidated Statements of Income
and Comprehensive Income
 
                         
    For the Years Ended
 
    December 31  
    2010     2009     2008  
    (In thousands)  
 
Interest income:
                       
Securities purchased from Harris N.A. under agreement to resell
  $ 85     $ 31     $ 963  
Notes receivable from Harris N.A.
    222       246       302  
Securities available for sale:
                       
Mortgage-backed
    20,152       22,356       20,011  
U.S. Treasury Bills
    7       2       20  
                         
Total interest income
  $ 20,466     $ 22,635     $ 21,296  
                         
Noninterest income:
                       
Gain on sale of securities
    326              
                         
Total income
  $ 20,792     $ 22,635     $ 21,296  
                         
Operating expenses:
                       
Loan servicing fees paid to Harris N.A.
  $ 11     $ 12     $ 15  
Advisory fees paid to Harris N.A.
    167       196       208  
General and administrative
    351       399       374  
                         
Total operating expenses
  $ 529     $ 607     $ 597  
                         
Income before income taxes
  $ 20,263     $ 22,028     $ 20,699  
Applicable state income taxes
    1,479       1,608        
                         
Net Income
  $ 18,784     $ 20,420     $ 20,699  
Preferred stock dividends
    18,438       18,438       18,438  
                         
Net income available to common stockholder
  $ 346     $ 1,982     $ 2,261  
                         
Basic and diluted earnings per common share
  $ 293     $ 1,680     $ 2,261  
                         
Average number of common shares outstanding
    1,180       1,148       1,000  
Net income
  $ 18,784     $ 20,420     $ 20,699  
Other comprehensive income:
                       
Available-for-sale securities:
                       
Unrealized holding gains arising during the period, net of deferred state taxes
    2,294       2,525       10,839  
Less reclassification adjustment for realized gains included in net income, net of state tax effect
    (302 )            
                         
Comprehensive income
  $ 20,776     $ 22,945     $ 31,538  
                         
 
The accompanying notes are an integral part of these financial statements.


31


 

Harris Preferred Capital Corporation
 
Consolidated Statements of Changes in Stockholders’ Equity
For the Years Ended December 31, 2010, 2009 and 2008
 
                                                 
                      (Distributions in
             
                      Excess of
    Accumulated
       
                Additional
    Earnings) Earnings
    Other
    Total
 
    Preferred
    Common
    Paid-in
    in Excess of
    Comprehensive
    Stockholders’
 
    Stock     Stock     Capital     Distributions     Income (Loss)     Equity  
    (In thousands except per share data)  
 
Balance at December 31, 2007
  $ 250,000     $ 1     $ 240,733     $ 67     $ (1,007 )   $ 489,794  
                                                 
Net income
  $     $     $     $ 20,699     $     $ 20,699  
Other comprehensive income
                            10,839       10,839  
Dividends declared on common stock ($2,650 per share)
                      (2,650 )           (2,650 )
Dividends declared on preferred stock ($1.8438 per share)
                      (18,438 )           (18,438 )
                                                 
Balance at December 31, 2008
  $ 250,000     $ 1     $ 240,733     $ (322 )   $ 9,832     $ 500,244  
                                                 
Net income
  $     $     $     $ 20,420     $     $ 20,420  
Other comprehensive income
                            2,525       2,525  
Capital contribution and issuance of common stock
                80,000                   80,000  
Dividends declared on common stock ($2,261 per share)
                      (2,261 )             (2,261 )
Dividends declared on preferred stock ($1.8438 per share)
                      (18,438 )           (18,438 )
                                                 
Balance at December 31, 2009
  $ 250,000     $ 1     $ 320,733     $ (601 )   $ 12,357     $ 582,490  
                                                 
Net income
  $     $     $     $ 18,784     $     $ 18,784  
Other comprehensive income
                            1,992       1,992  
Dividends declared on preferred stock ($1.8438 per share)
                      (18,438 )           (18,438 )
                                                 
Balance at December 31, 2010
  $ 250,000     $ 1     $ 320,733     $ (255 )   $ 14,349     $ 584,828  
                                                 
 
The accompanying notes are an integral part of these financial statements.


32


 

Harris Preferred Capital Corporation
 
Consolidated Statements of Cash Flows
 
                         
    For the Years Ended December 31  
    2010     2009     2008  
    (In thousands)  
 
Operating Activities:
                       
Net income
  $ 18,784     $ 20,420     $ 20,699  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Gain on sale of securities
    (326 )            
Net decrease (increase) in other assets
    104             (356 )
Net increase (decrease) in accrued expenses and taxes
    17       (1 )     (17 )
                         
Net cash provided by operating activities
  $ 18,579     $ 20,419     $ 20,326  
                         
Investing Activities:
                       
Repayments of notes receivable from Harris N.A.
  $ 215     $ 700     $ 1,051  
Purchases of securities available-for-sale
    (394,504 )     (336,736 )     (265,238 )
Proceeds from maturities/redemptions of securities available-for-sale
    389,564       272,553       257,763  
Proceeds from sales of securities available-for-sale
    5,693              
                         
Net cash provided by (used in) investing activities
  $ 968     $ (63,483 )   $ (6,424 )
                         
Financing Activities:
                       
Cash dividends paid on preferred stock
  $ (18,438 )   $ (18,438 )   $ (18,438 )
Cash dividends paid on common stock
          (2,261 )     (5,650 )
Capital contribution and issuance of common stock
          80,000        
                         
Net cash (used in) provided by financing activities
  $ (18,438 )   $ 59,301     $ (24,088 )
                         
Net increase (decrease) in cash and cash equivalents with Harris N.A.
  $ 1,109     $ 16,237     $ (10,186 )
Cash and cash equivalents with Harris N.A. at beginning of year
    22,916       6,679       16,865  
                         
Cash and cash equivalents with Harris N.A. at end of year
  $ 24,025     $ 22,916     $ 6,679  
                         
Supplemental Disclosures of Cash Flow Information:
                       
Cash paid during the year for:
                       
State Income Taxes
  $ 24              
 
The accompanying notes are an integral part of these financial statements.


33


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements
 
1.   Organization and Basis of Presentation
 
Harris Preferred Capital Corporation (the “Company”) is a Maryland corporation whose principal business objective is to acquire, hold, finance and manage qualifying real estate investment trust (“REIT”) assets (the “Mortgage Assets”), consisting of a limited recourse note or notes (the “Notes”) issued by Harris N.A. (the “Bank”) secured by real estate mortgage assets (the “Securing Mortgage Loans”) and other obligations secured by real property, as well as certain other qualifying REIT assets. The Company holds its assets through a Maryland real estate investment trust subsidiary, Harris Preferred Capital Trust. The Company has elected to be a REIT under sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), and will generally not be subject to Federal income tax to the extent that it meets all of the REIT requirements in the Code Sections 856-860. All of the 1,180 shares of the Company’s common stock, par value $1.00 per share (the “Common Stock”), are owned by Harris Capital Holdings, Inc. (“HCH”), a wholly-owned subsidiary of the Bank. On December 30, 1998, the Bank transferred its ownership of the common stock of the Company to HCH. The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any 73/8% Noncumulative Exchangeable Preferred Stock, Series A (the “Preferred Shares”), $1.00 par value, is outstanding. The Company was formed to provide the opportunity to invest in residential mortgages and other real estate assets and to provide the Bank with a cost-effective means of raising capital for federal regulatory purposes.
 
On February 11, 1998, the Company completed an initial public offering (the “Offering”) of 10,000,000 shares of the Company’s Preferred Shares, receiving proceeds of $242,125,000, net of underwriting fees. The Preferred Shares are traded on the New York Stock Exchange. Concurrent with the issuance of the Preferred Shares, the Bank contributed additional capital of $250 million to the Company.
 
On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company entered into a contribution agreement with HCH pursuant to which the Company agreed to issue and sell 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash. HCH acquired the shares on March 5, 2009 and continues to own 100% of the shares of the Common Stock. The Company utilized proceeds from the Common Stock issuance to acquire assets in a manner consistent with Company investment guidelines.
 
Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements.
 
2.   Summary of Significant Accounting Policies
 
Cash and Cash Equivalents
 
Cash and cash equivalents include cash on deposit with the Bank and securities purchased from the Bank under agreement to resell.
 
Allowance for Loan Losses
 
The allowance for probable loan losses is maintained at a level considered adequate to provide for probable loan losses or losses on Notes Receivable collateralized by loans. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Known losses of principal on impaired loans are charged off. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio securing the Mortgage Assets under current economic conditions and management’s estimate of anticipated, but as yet not specifically identified, loan losses. Such estimates are reviewed periodically and adjustments, if necessary, are recorded during the periods in which they become known. At December 31, 2010 and 2009, no allowance for loan losses was recorded under this policy.


34


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
Income Taxes
 
The Company has elected to be taxed as a REIT commencing with its taxable year ended December 31, 1998 and intends to comply with the provisions of the Code with respect thereto. The Company does not expect to be subject to Federal income tax because assets, income distribution and stock ownership tests in Code Sections 856-860 are met. Accordingly, no provision for federal income taxes is included in the accompanying financial statements. Beginning January 1, 2009 the Company is classified as a “captive” REIT for Illinois tax purposes. As a captive REIT, the Company will not claim a deduction for dividends paid and will accrue Illinois income tax on Illinois taxable income. At December 31, 2010 the Company has provided $1.1 million of deferred Illinois taxes on unrealized holdings gains recognized in comprehensive income. At December 31, 2009 the Company provided $973 thousand of deferred Illinois taxes on unrealized holdings gains recognized in comprehensive income.
 
The REIT Modernization Act, which took effect on January 1, 2001, modified certain provisions of the Code with respect to the taxation of REITs. A key provision of this tax law change reduced the required level of distributions by a REIT from 95% to 90% of ordinary taxable income.
 
At December 31, 2010 and 2009, the Company recorded deferred state income taxes related to unrealized holding gains in its investment portfolio. These taxes would be payable in future periods, assuming such gains were realized. During 2010, a security was sold with a gain of $326 thousand and related state tax payment of $24 thousand.
 
Securities
 
The Company classifies all securities as available-for-sale, even if the Company has no current plans to divest. Available-for-sale securities are reported at fair value with unrealized gains and losses included as a separate component of stockholders’ equity net of related tax effects.
 
Interest income on securities, including amortization of discount or premium on an effective yield basis, is included in earnings. Realized gains and losses, as a result of securities sales, are included in gain or loss on sale of securities in the consolidated statement of income, with the cost of securities sold determined on the specific identification basis.
 
The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. The amounts advanced under these agreements represent short-term assets and are reflected as securities purchased under agreement to resell in the consolidated balance sheet. Securities purchased under agreement to resell totaled $24 million at December 31, 2010 compared to $22 million at December 31, 2009. The securities underlying the agreements are book-entry securities. Securities are transferred by appropriate entry into the Company’s account with the Bank under a written custodial agreement with the Bank that explicitly recognizes the Company’s interest in these securities.
 
The Company’s investment securities are exposed to various risks such as interest rate, market and credit. Due to the level of risk associated with certain investment securities and the level of uncertainty related to changes in the value of investment securities, it is at least reasonably possible that changes in risks in the near term would materially affect the carrying value of investments in securities available-for-sale currently reported in the consolidated balance sheet.
 
Available-for-sale securities and other investments are subject to ongoing other-than-temporary impairment reviews. In determining whether a loss is temporary, factors considered include the extent of the unrealized loss, the length of time that the security has been in an unrealized loss position, the financial condition and near-term prospects of the issuer, and whether the Company has the intent to sell the security or it is more likely than not that the Company will be required to sell the investment before the recovery of the investment’s amortized cost basis. If a decline is considered to be other-than-temporary, a write-down is recorded in the Consolidated Statements of


35


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
Income as other-than-temporary impairment on securities, and a new cost basis is established. In the event an available-for-sale debt security is considered to be other-than-temporarily impaired and the Company does not intend to sell the security, then the amount of the impairment charge equal to the credit loss is recorded in earnings and the remaining non credit-related impairment charge is recorded in other comprehensive income.
 
New Accounting Pronouncements
 
The Company adopted Accounting Standards Update (“ASU”) 2010-06, “Improving Disclosures About Fair Value Measurements”, as of January 1, 2010. The standard amends ASC 820-10 to require new disclosures about transfers in and out of Level 1 and Level 2 fair value measurements. ASU 2010-06 clarifies existing disclosure requirements regarding the level of disaggregation of each class of assets and liabilities within a line item in the statement of financial condition and the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements that fall in either Level 2 or Level 3 fair value measurements. The adoption of the standard had no impact on the corporation’s financial position or results of operations. See Note 6 to the Consolidated Financial Statements for additional information on fair value of financial instruments. The standard also requires new disclosures about the roll forward of activity in Level 3 fair value measurements which will be effective January 1, 2011.
 
Management’s Estimates
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
3.   Notes Receivable from the Bank
 
On February 11, 1998, proceeds received from the Offering were used in part to purchase $356 million of Notes at a fixed rate of 6.4%. The Notes are secured by mortgage loans originated by the Bank. The principal amount of the Notes equals approximately 80% of the aggregate outstanding principal amount of the Securing Mortgage Loans. During 2010, the Company received repayments on the Notes of $215 thousand compared to 2009 repayments of $700 thousand. For years ended December 31, 2010, 2009 and 2008, the Bank paid interest on the Notes in the amount of $222 thousand, $246 thousand and $302 thousand, respectively, to the Company.
 
The Notes are recourse only to the Securing Mortgage Loans that are secured by real property. The Notes mature on October 1, 2027. Payments of principal and interest on the Notes are recorded monthly from payments received on the Securing Mortgage Loans. The Company has a security interest in the real property securing the underlying mortgage loans and is entitled to enforce payment on the Securing Mortgage Loans in its own name if a mortgagor should default. In the event of default, the Company has the same rights as the original mortgagee to foreclose the mortgaged property and satisfy the obligations of the Bank out of the proceeds. The Securing Mortgage Loans are serviced by the Bank, as agent of the Company.
 
The Company intends that each mortgage loan securing the Notes will represent a first lien position and will be originated in the ordinary course of the Bank’s real estate lending activities based on the underwriting standards generally applied (at the time of origination) for the Bank’s own account. The Company also intends that all Mortgage Assets held by the Company will meet market standards, and servicing guidelines promulgated by the Company, and Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“FHLMC”) guidelines and procedures.


36


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
The balance of Securing Mortgage Loans at December 31, 2010 and 2009 was $4.2 million and $4.7 million, respectively. The weighted average interest rate on those loans at December 31, 2010 and 2009 was 5.7% and 5.9%, respectively.
 
None of the Securing Mortgage Loans collateralizing the Notes were on nonaccrual status at December 31, 2010 or 2009.
 
A majority of the collateral securing the underlying mortgage loans is located in Illinois. The financial viability of customers in Illinois is, in part, dependent on that state’s economy. The Company’s maximum risk of accounting loss, should all customers in Illinois fail to perform according to contract terms and all collateral prove to be worthless, was approximately $2.6 million at December 31, 2010 and $2.9 million at December 31, 2009.
 
4.   Securities
 
The amortized cost and estimated fair value of securities available-for-sale were as follows:
 
                                                                 
    December 31, 2010     December 31, 2009  
    Amortized
    Unrealized
    Unrealized
    Fair
    Amortized
    Unrealized
    Unrealized
    Fair
 
    Cost     Gains     Losses     Value     Cost     Gains     Losses     Value  
    (In thousands)  
 
Available-for-Sale Securities
                                                               
Residential mortgage-backed
  $ 501,435     $ 17,439     $ 1,963     $ 516,911     $ 501,861     $ 14,214     $ 885     $ 515,190  
U.S. Treasury Bills
    40,000                   40,000       40,000             1       39,999  
                                                                 
Total Securities
  $ 541,435     $ 17,439     $ 1,963     $ 556,911     $ 541,861     $ 14,214     $ 886     $ 555,189  
                                                                 
 
The following table summarizes residential mortgage-backed securities with unrealized losses as of December 31, 2010 and 2009, the amount of the unrealized loss and the related fair value of the securities with unrealized losses. The unrealized losses have been further segregated by residential mortgage-backed securities that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 or more months. As of December 31, 2010 there were no securities that were in a loss position for 12 or more months. Management believes that all of the unrealized losses are temporary, since the unrealized losses on investments in mortgage-backed securities and U.S. Treasuries reflect changes in interest rates rather than credit deterioration. The contractual cash flows of these securities are guaranteed by a U.S. government-sponsored enterprise. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired. There was a $302 thousand reclassification adjustment for realized securities gains to other comprehensive income during 2010. There were no reclassification adjustments to other comprehensive income during 2009 or 2008.
 
December 31, 2010
 
                                                 
    Length of Continuous Unrealized Loss Position  
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
    Fair Value     Loss     Fair Value     Losses     Fair Value     Losses  
    (In thousands)  
 
Residential
mortgage-backed
  $ 79,133     $ 1,963     $     $     $ 79,133     $ 1,963  
                                                 
Total
  $ 79,133     $ 1,963     $     $     $ 79,133     $ 1,963  


37


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
December 31, 2009
 
                                                 
    Length of Continuous Unrealized Loss Position  
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
    Fair Value     Losses     Fair Value     Losses     Fair Value     Losses  
    (In thousands)  
 
Residential
mortgage-backed
  $ 104,988     $ 885     $     $     $ 104,988     $ 885  
U.S. Treasury bills
    39,999       1                   39,999       1  
                                                 
Total
  $ 144,987     $ 886     $     $     $ 144,987     $ 886  
 
The amortized cost and estimated fair value of total available-for-sale securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities can differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
                 
    December 31, 2010  
    Amortized
    Fair
 
    Cost     Value  
    (In thousands)  
 
Maturities:
               
Within 1 year
  $ 47,993     $ 48,053  
1 to 5 years
    13,231       13,703  
5 to 10 years
    120,155       128,564  
Over 10 years
    360,056       366,591  
                 
Total Securities
  $ 541,435     $ 556,911  
                 
 
5.   Fair Value Measurements
 
The Company follows the guidance within FASB ASC 820, “Fair Value Measurements and Disclosures”, in determining the accounting for and disclosure of fair values of its assets and liabilities. The pronouncement provides methods for measuring fair value, establishes a fair value hierarchy and requires expanded disclosure. It applies when other standards require or permit assets or liabilities to be measured at fair value.
 
Fair value represents the estimate of the proceeds to be received, or paid in the case of a liability, in a current transaction between willing parties. ASC 820 establishes a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Inputs are either observable or unobservable in the marketplace. Observable inputs are based on market data from independent sources and unobservable inputs reflect the reporting entity’s assumptions about market participant assumptions used to value an asset or liability. Level 1 includes quoted prices in active markets for identical instruments. Level 2 includes quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in inactive markets; and model-derived valuations using observable market information for significant inputs. Level 3 includes valuation techniques where one or more significant inputs are unobservable. Financial instruments are classified according to the lowest level input that is significant to their valuation. A financial instrument that has a significant unobservable input along with significant observable inputs may still be classified Level 3.
 
The Company uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Level 1 relies on the use of quoted market prices. Level 2 relies on internal models using observable market information as inputs and Level 3 relies on internal models without observable market information. The Company has investments in U.S. Treasury securities that are classified as Level 1, and has U.S. government sponsored residential mortgage-backed securities that are classified in Level 2 of the fair value hierarchy. External vendors


38


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
typically use pricing models to determine fair values for the securities. Standard market inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets and additional market reference data.
 
The valuations of assets that are measured at fair value on a recurring basis at December 31, 2010 and 2009 are presented in the following table.
 
                                 
    Fair Value
    Fair Value Measurements Using  
    12/31/10     Level 1     Level 2     Level 3  
          (In thousands)  
 
Available-for-sale securities:
                               
Residential mortgage-backed
  $ 516,911     $     $ 516,911     $  
U.S. Treasury
    40,000       40,000              
                                 
    $ 556,911     $ 40,000     $ 516,911     $  
                                 
 
                                 
    Fair Value
    Fair Value Measurements Using  
    12/31/09     Level 1     Level 2     Level 3  
          (In thousands)  
 
Available-for-sale securities:
                               
Residential mortgage-backed
  $ 515,190     $     $ 515,190     $  
U.S. Treasury
    39,999       39,999              
                                 
    $ 555,189     $ 39,999     $ 515,190     $  
                                 
 
6.   Fair Value of Financial Instruments
 
FASB ASC 825, “Financial Instruments”, requires the disclosure of estimated fair values for both on and off-balance-sheet financial instruments. The Company’s fair values are based on quoted market prices when available. For financial instruments not actively traded, such as certain loans, deposits, off-balance-sheet transactions and long-term borrowings, fair values have been estimated using various valuation methods and assumptions. The fair value estimates presented herein are not necessarily indicative of the amounts the Company could realize in an actual transaction. The fair value estimation methodologies employed by the Company were as follows:
 
Fair value was assumed to equal carrying value for cash on deposit with the Bank, securities purchased under agreement to resell and accrued interest receivable, due to their short term nature.
 
The fair value of notes receivable from the Bank was estimated using a discounted cash flow calculation utilizing current market rates offered by the Bank as the discount rates.
 
The fair value of securities available-for-sale and the methods used to determine fair value are provided in Notes 4 and 5.


39


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
The estimated fair values of the Company’s financial instruments at December 31, 2010 and 2009 are presented in the following table:
 
                                 
    December 31, 2010     December 31, 2009  
    Carrying
    Fair
    Carrying
    Fair
 
    Value     Value     Value     Value  
    (In thousands)  
 
Assets
                               
Cash on deposit with Harris N.A.
  $ 525     $ 525     $ 916     $ 916  
Securities purchased from Harris N.A. under agreement to resell
    23,500       23,500       22,000       22,000  
Notes receivable from Harris N.A.
    3,369       4,758       3,584       4,908  
Securities available-for-sale
    556,911       556,911       555,189       555,189  
Accrued interest receivable
    1,781       1,781       1,885       1,885  
                                 
Total on-balance-sheet financial assets
  $ 586,086     $ 587,475     $ 583,574     $ 584,898  
                                 
 
7.   Common and Preferred Stock
 
On February 11, 1998, the Company issued 10,000,000 Preferred Shares, Series A, at a price of $25 per share pursuant to its Registration Statement on Form S-11. Proceeds from this issuance, net of underwriting fees, totaled $242,125,000. The liquidation value of each Preferred Share is $25 plus any authorized, declared and unpaid dividends. The Preferred Shares are redeemable at the option of the Company, in whole or in part, at the liquidation preference thereof, plus the quarterly accrued and unpaid dividends, if any, to the date of redemption. The Company may not redeem the Preferred Shares without prior approval from the Office of the Comptroller of the Currency or the appropriate successor or other federal regulatory agency. Except under certain limited circumstances, as defined, the holders of the Preferred Shares have no voting rights. The Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events.
 
Holders of Preferred Shares are entitled to receive, if declared by the Board of Directors of the Company, noncumulative dividends at a rate of 73/8% per annum of the $25 per share liquidation preference (an amount equivalent to $1.84375 per share per annum). Dividends on the Preferred Shares, if authorized and declared, are payable quarterly in arrears on March 30, June 30, September 30, and December 30 each year. Dividends declared to the holders of the Preferred Shares for the years ended December 31, 2010 and 2009 were $18,438,000 in both years. The allocations of the distributions declared and paid for income tax purposes for the year ended December 31, 2010 were 100% ordinary income for the dividends paid in Quarters 1, 2 and 3 and 92.99% ordinary and 7.01% capital gain for the dividend paid in the 4th quarter of 2010. For year ended December 31, 2009, the dividends were 100% of ordinary income.
 
On December 30, 1998, the Bank contributed the Common Stock of the Company to HCH. The Bank is required to maintain direct or indirect ownership of at least 80% of the outstanding Common Stock of the Company for as long as any Preferred Shares are outstanding. Dividends on Common Stock are paid if and when authorized and declared by the Board of Directors out of funds legally available after all preferred dividends have been paid. On March 4, 2009, the Company amended its Articles of Incorporation to increase the number of authorized shares of Common Stock from 1,000 shares to 5,000 shares. On March 5, 2009, the Company sold 180 shares of Common Stock to HCH for a purchase price of $444,444.44 per share, or $80,000,000 in cash to bring the number of shares outstanding to 1,180. On December 30, 2009, the Company paid a cash dividend of $2 million (declared on December 2, 2009), on the outstanding common shares to the stockholder of record on December 15, 2009. Part of this dividend ($17,291) will be considered a return of capital to the Company’s common shareholder rather than ordinary income. This has no impact on holders of the Preferred Stock. On June 22, 2009, the Company paid a cash dividend of $261 thousand (declared on May 28, 2009), on the outstanding common shares to the stockholders of


40


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
record on June 15, 2009. The Company made the election under Internal Revenue Code Section 858(a) to treat this dividend as having been paid in 2008.
 
8.   Transactions with Affiliates
 
The Company entered into an advisory agreement (the “Advisory Agreement”) with the Bank pursuant to which the Bank administers the day-to-day operations of the Company. The Bank is responsible for (i) monitoring the credit quality of Mortgage Assets held by the Company; (ii) advising the Company with respect to the reinvestment of income from and payments on, and with respect to, the acquisition, management, financing, and disposition of the Mortgage Assets held by the Company; and (iii) monitoring the Company’s compliance with the requirements necessary to qualify as a REIT.
 
The Advisory Agreement in effect for 2010, 2009 and 2008 entitled the Bank to receive advisory fees of $167 thousand, $196 thousand, and $208 thousand, respectively for processing, recordkeeping, legal, management and other services.
 
The Securing Mortgage Loans are serviced by the Bank pursuant to the terms of a servicing agreement (the “Servicing Agreement”). The Bank receives a fee equal to 0.25% per annum on the principal balances of the loans serviced. The Servicing Agreement requires the Bank to service the mortgage loans in a manner generally consistent with accepted secondary market practices, and servicing guidelines promulgated by the Company and with Fannie Mae and FHLMC guidelines and procedures. In 2010, 2009 and 2008 the Bank received payments of $11 thousand, $12 thousand and $15 thousand, respectively.
 
The Company purchases U.S. Treasury and Federal agency securities from the Bank under agreements to resell identical securities. At December 31, 2010, the Company held $24 million of such assets and earned $85 thousand of interest from the Bank during 2010. At December 31, 2009, the Company held $22 million of such assets and earned $31 thousand of interest for 2009. The Company receives rates on these assets comparable to the rates that the Bank offers to unrelated counterparties under similar circumstances.
 
9.   Operating Segment
 
The Company’s operations consist of monitoring and evaluating the investments in mortgage assets. Accordingly, the Company operates in only one segment. The Company has no external customers and transacts most of its business with the Bank.
 
10.   Commitments and Contingencies
 
Legal proceedings in which the Company is a defendant may arise in the normal course of business. At December 31, 2010 and 2009, there was no pending litigation against the Company.


41


 

Harris Preferred Capital Corporation
 
Notes to consolidated Financial Statements — (Continued)
 
11.   Quarterly Financial Information (unaudited)
 
The following table sets forth selected quarterly financial data for the Company:
 
                                                                 
    Year Ended December 31, 2010     Year Ended December 31, 2009  
    First
    Second
    Third
    Fourth
    First
    Second
    Third
    Fourth
 
    Quarter     Quarter     Quarter     Quarter     Quarter     Quarter     Quarter     Quarter  
    (In thousands except per share data)  
 
Total interest income
  $ 5,350     $ 5,211     $ 5,062     $ 4,843     $ 5,456     $ 5,683     $ 5,860     $ 5,636  
Total noninterest income
                      326                          
Total operating expenses
    195       119       61       154       179       118       134       176  
                                                                 
Net income before income taxes
  $ 5,155     $ 5,092     $ 5,001     $ 5,015     $ 5,277     $ 5,565     $ 5,726     $ 5,460  
Applicable state income taxes
    376       371       365       367       385       406       418       399  
                                                                 
Net Income
  $ 4,779     $ 4,721     $ 4,636     $ 4,648     $ 4,892     $ 5,159     $ 5,308     $ 5,061  
Preferred dividends
    4,609       4,609       4,610       4,610       4,609       4,609       4,610       4,610  
                                                                 
Net income available to common stockholder
  $ 170     $ 112     $ 26     $ 37     $ 283     $ 550     $ 698     $ 451  
                                                                 
Basic and diluted earnings per common share
  $ 144     $ 94     $ 23     $ 32     $ 268     $ 466     $ 593     $ 381  
                                                                 
 
Financial Statements of Harris N.A.
 
The following unaudited financial information and audited financial statements for the Bank are included because the Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events.


42


 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
2010 Compared to 2009
 
Summary
 
For 2010, Harris N.A. and subsidiaries (“Bank”) reported net income available for common stockholder of $110 thousand, compared to a net loss of $112.8 million for 2009, reflecting a significant reduction in the provision for loan losses. Results for 2010 also include the impact associated with both the Diners Club North American (“Diners Club”) franchise purchased from an unrelated bank, which closed on December 31, 2009, and the acquisition of certain assets and liabilities of Rockford, IL based AMCORE Bank, N.A. (“AMCORE”) from the Federal Deposit Insurance Corporation (“FDIC”) on April 23, 2010.
 
Net interest income was $878.6 million, down $14.2 million or 1.6 percent from a year ago, as lower earnings on loans and securities available-for-sale were largely offset by a reduction in the cost of deposits and the additional net interest income associated with the acquisition of AMCORE and Diners Club. Average earning assets of $40.5 billion in 2010 were up slightly from 2009, as a $3.2 billion increase in interest bearing deposits placed at the Federal Reserve Bank was offset by a $1.5 billion decrease in loan balances and a $1.4 billion decline in securities and money market assets. The impact on interest income from a $0.3 billion increase in earning assets was more than offset by a 6 basis point decline in the net interest margin to 2.23 percent from 2.29 percent for 2009. The lower margin reflects reduced yield on loans and a lower rate of return on securities available-for-sale as well as an increase in the level of low-yielding interest bearing deposits placed at the Federal Reserve Bank, partially offset by lower interest costs of deposits.
 
Provision for loan losses for 2010 was $312.7 million, a decrease of $231.7 million from last year. The decline is attributed to decreases in both commercial and consumer net charge-offs as well as a reduction in the general provision for consumer loan losses, partially offset by provisions of $39.1 million for the Diners Club card portfolio and $22.4 million for modified mortgages. Net loan charge-offs for the year were $295.5 million compared to $437.9 million in 2009 primarily due to lower commercial charge-offs. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio.
 
Noninterest income for 2010 was $568.5 million, an increase of $85.5 million or 17.7 percent from 2009. The $113.4 million of additional charge card income associated with the Diners Club credit card portfolio and higher trust fees ($11.4 million) and trading income ($9.3 million) were partially offset by decreases in net gains on equity securities and securities other than trading ($29.4 million), service charges and fees ($9.0 million) and foreign exchange trading gains ($6.6 million).
 
Noninterest expenses were $1,166.4 million during 2010, an increase of $124.1 million or 11.9 percent from 2009. Higher costs associated with the Diners Club credit card portfolio ($45.0 million) and the acquisition of AMCORE ($82.8 million — of which $26.4 million is directly related to integration activities) drove the increase. Excluding these costs, noninterest expenses decreased $3.1 million or 0.3 percent as a reduction in FDIC insurance ($17.1 million), charges for intercompany services ($7.8 million), and net occupancy costs ($6.2 million) were largely offset by higher costs associated with recent marketing campaigns ($16.8 million) and credit reserves for off-balance sheet risks ($10.6 million). The income tax benefit decreased $65.9 million from 2009 primarily due to the increase in pre-tax income between periods. The tax benefit also includes the benefit of certain tax exempt loans and investments as well as bank owned life insurance.
 
Nonperforming loans at December 31, 2010 totaled $896 million or 4.00 percent of total loans, up from $486 million or 2.20 percent of total loans at December 31, 2009. The increase was mainly in commercial real estate loans partially offset by sales of loans in 2009 and 2010 to psps Holdings, LLC (“psps”), a subsidiary of Harris Financial Corp., in the amount of $503 million and $272 million, respectively. At December 31, 2010, the allowance for loan losses was $706.1 million, equal to 3.16 percent of loans outstanding compared to $680.8 million or 2.94 percent of loans outstanding at December 31, 2009. Coverage of nonperforming loans by the allowance for loan losses decreased from 140 percent at December 31, 2009 to 79 percent at December 31, 2010


43


 

At December 31, 2010, consolidated stockholder’s equity of the Bank amounted to $5.2 billion, up $960 million from December 31, 2009, mainly due to capital contributions from Harris Bankcorp, Inc. of approximately $1.0 billion during the year. Return (loss) on equity was nil for the year compared to (2.94) percent last year. Return (loss) on assets was also nil compared to (0.25) percent a year ago. The Bank did not declare any dividends on common stock in either 2010 or 2009.
 
At December 31, 2010, Tier 1 capital of the Bank amounted to $4.4 billion, up $0.9 billion from a year ago, while risk-weighted assets declined by $3.0 billion to $27.7 billion. The Bank’s December 31, 2010 Tier 1 and total risk-based capital ratios were 15.98 percent and 17.87 percent compared to respective ratios of 11.46 percent and 13.55 percent at December 31, 2009. The regulatory leverage capital ratio was 9.64 percent as of December 31, 2010 and 8.82 percent at year-end 2009. The Bank’s capital ratios significantly exceed the prescribed regulatory minimum for “well-capitalized” banks.
 
2009 Compared to 2008
 
Summary
 
For 2009, Harris N.A. and subsidiaries (“Bank”) reported a net loss of $112.8 million, $9.6 million more than the 2008 loss of $103.2 million. The Bank’s results continue to be affected by higher levels of provision for loan losses reflecting the challenging credit environment.
 
Net interest income was $892.8 million, down $111.7 million or 11.1 percent from a year ago, largely due to a 27 basis point decline in the net interest margin to 2.29 percent from 2.56 percent for 2008. The lower margin reflects reduced income due to a higher level of non-accrual loans, a lower rate of return on securities available-for-sale and an increase in low-yield deposits placed at the Federal Reserve Bank. Average earning assets of $40.2 billion in 2009 were essentially unchanged from 2008, as a $3.1 billion decrease in loan balances and a $1.8 billion decline in securities and money market assets were offset by a $4.9 billion increase in interest bearing deposits placed at the Federal Reserve Bank.
 
Provision for loan losses for 2009 was $544.4 million, a decrease of $44.7 million from last year. The decline is attributed to decreases in reserves for specific commercial credits, partially offset by increases in general reserves in the retail portfolio as well as elevated retail charge-offs. Net loan charge-offs for the year were $437.9 million compared to $414.1 million in the same period last year primarily due to higher retail charge-offs. In 2009, Harris N.A. sold $503 million (net of $110 million in charge-offs) of commercial non-performing loans to psps Holdings, LLC (“psps”), a subsidiary of Harris Financial Corp. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio.
 
Noninterest income for 2009 was $483.0 million, an increase of $19.7 million or 4.3 percent from 2008. This reflects higher gains on sale of loans ($26.7 million), increased trading income ($12.5 million) and letter of credit fees ($4.6 million) partially offset by decreases in net gains on equity securities and securities other than trading ($14.2 million), trust fees ($8.4 million), and bank-owned life insurance income ($7.0 million) during the year.
 
Noninterest expenses were $1,042.2 million during 2009, a decrease of $17.5 million or 1.7 percent from 2008. While 2009 included an increase in FDIC insurance costs of $45.8 million and a $3.0 million reversal of Visa indemnification charges, 2008 reflected charges of $21.8 million related to auction rate securities and a $16.3 million reversal of Visa indemnification charges. Excluding these items, expenses decreased $54.8 million or 5.3 percent year over year primarily as a result of lower charges for intercompany services ($21.9 million), professional fees ($14.9 million), marketing costs ($6.2 million), and outside information processing, database and network fees ($5.1 million). Total income tax benefit increased $20.3 million for the year, primarily due to the increase in the level of pre-tax loss.
 
Nonperforming loans at December 31, 2009 totaled $486 million or 2.20 percent of total loans, up from $318 million or 1.21 percent of total loans at December 31, 2008 and reflect the sale of loans in 2008 and 2009 to BMO Chicago Branch and psps in the amount of $472 million and $503 million respectively. At December 31, 2009, the allowance for loan losses was $680.8 million, equal to 2.94 percent of loans outstanding compared to


44


 

$574.2 million or 2.18 percent of loans outstanding at December 31, 2008. Coverage of nonperforming loans by the allowance for loan losses decreased from 181 percent at December 31, 2008 to 140 percent at December 31, 2009.
 
At December 31, 2009, consolidated stockholder’s equity of the Bank amounted to $4.3 billion, up $150 million from December 31, 2008, mainly due to a capital contribution from Harris Bankcorp of $150 million in 2009. Loss on equity was (2.94) percent for the year, compared to (2.51) percent last year. Loss on assets was (0.25) percent compared to (0.23) percent a year ago. The Bank did not declare any dividends on common stock in 2009; $38 million was declared and paid in 2008.
 
At December 31, 2009, Tier 1 capital of the Bank amounted to $3.5 billion, down $0.1 billion from a year ago, while risk-weighted assets declined by $3.2 billion to $30.7 billion. The Bank’s December 31, 2009 Tier 1 and total risk-based capital ratios were 11.46 percent and 13.55 percent compared to respective ratios of 10.57 percent and 12.69 percent at December 31, 2008. The regulatory leverage capital ratio was 8.82 percent as of December 31, 2009 and 7.24 percent at year-end 2008. The Bank’s capital ratios significantly exceed the prescribed regulatory minimum for “well-capitalized” banks.


45


 

Independent Auditors’ Report
 
The Stockholder and Board of Directors
Harris N.A.:
 
We have audited the accompanying consolidated statements of condition of Harris N.A. and subsidiaries (the Company), an indirect wholly-owned subsidiary of Bank of Montreal, as of December 31, 2010 and 2009, and the related consolidated statements of income, comprehensive income (loss), changes in stockholder’s equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Harris N.A. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
 
/s/KPMG LLP
 
Chicago, Illinois
March 31, 2011


46


 

Harris N.A. and Subsidiaries
 
Consolidated Statements of Condition
 
                 
    December 31  
    2010     2009  
    (In thousands except share date)  
 
Assets
               
Cash and demand balances due from banks
  $ 734,907     $ 904,865  
Money market assets:
               
Interest-bearing deposits at banks ($14.1 billion and $8.4 billion held at Federal Reserve Bank at December 31, 2010 and 2009, respectively)
    15,014,090       9,231,581  
Federal funds sold and securities purchased under agreement to resell
    1,255,313       174,979  
                 
Total cash and cash equivalents
  $ 17,004,310     $ 10,311,425  
Securities available-for-sale at fair value
    5,674,981       5,898,831  
Trading account assets and derivative instruments
    1,161,940       1,353,509  
Loans, net of unearned income
    22,372,665       23,175,717  
Allowance for loan losses
    (706,101 )     (680,782 )
                 
Net loans
  $ 21,666,564     $ 22,494,935  
Loans held for sale
    29,915       29,974  
Premises and equipment, net
    547,567       526,623  
Bank-owned insurance
    1,373,099       1,339,657  
Goodwill and other intangible assets, net
    894,074       817,507  
Other assets
    1,673,910       1,199,166  
                 
Total assets
  $ 50,026,360     $ 43,971,627  
                 
Liabilities
               
Deposits in domestic offices — noninterest-bearing
  $ 9,204,496     $ 9,704,773  
                             — interest-bearing (includes $1.3 billion and $0.7 billion measured at fair value at December 31, 2010 and 2009, respectively)
    23,021,378       18,968,058  
Deposits in foreign offices — noninterest-bearing
    2,718,059        
                            — interest-bearing
    1,518,884       1,622,410  
                 
Total deposits
  $ 36,462,817     $ 30,295,241  
Federal funds purchased
    194,251       236,099  
Securities sold under agreement to repurchase
    864,918       2,512,490  
Short-term borrowings
    1,427,794       717,050  
Accrued interest, taxes and other
    197,434       172,618  
Accrued pension and post-retirement
    26,753       58,393  
Other liabilities
    648,413       643,289  
Long-term notes — senior/unsecured
    2,396,500       2,396,500  
Long-term notes — senior/secured
    2,375,000       2,375,000  
Long-term notes — subordinated
    200,000       292,750  
                 
Total liabilities
  $ 44,793,880     $ 39,699,430  
                 
Stockholder’s Equity
               
Common stock ($10 par value); authorized 40,000,000 shares; issued and outstanding 19,989,512 and 17,534,512 shares at December 31, 2010 and December 31, 2009, respectively
  $ 199,895     $ 175,345  
Surplus
    3,297,290       2,322,917  
Retained earnings
    1,621,829       1,621,719  
Accumulated other comprehensive loss
    (136,534 )     (97,784 )
                 
Stockholder’s equity before noncontrolling interest — preferred stock of subsidiary
  $ 4,982,480     $ 4,022,197  
Noncontrolling interest — preferred stock of subsidiary
    250,000       250,000  
                 
Total stockholder’s equity
  $ 5,232,480     $ 4,272,197  
                 
Total liabilities and stockholder’s equity
  $ 50,026,360     $ 43,971,627  
                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


47


 

Harris N.A. and Subsidiaries
 
Consolidated Statements of Operations
 
                         
    For The Years Ended December 31  
    2010     2009     2008  
    (In thousands)  
 
Interest Income
                       
Loans
  $ 1,036,732     $ 1,152,281     $ 1,452,034  
Money market assets:
                       
Deposits at banks
    29,051       19,418       30,469  
Federal funds sold and securities purchased under agreements to resell
    333       151       16,326  
Trading account assets
    10,267       9,009       20,338  
Securities available-for-sale:
                       
U.S. Treasury and federal agency
    48,927       100,689       246,674  
State and municipal
    49,284       54,174       52,387  
Other
    14,025       15,427       19,473  
                         
Total interest income
  $ 1,188,619     $ 1,351,149     $ 1,837,701  
                         
Interest Expense
                       
Deposits
  $ 176,506     $ 307,166     $ 609,830  
Short-term borrowings
    6,359       7,982       61,295  
Short-term senior notes
    4       1,726       15,483  
Long-term notes — senior/unsecured
    91,656       88,276       68,190  
Long-term notes — senior/secured
    33,927       49,183       67,621  
Long-term notes — subordinated
    1,587       4,005       10,795  
                         
Total interest expense
  $ 310,039     $ 458,338     $ 833,214  
                         
Net Interest Income
  $ 878,580     $ 892,811     $ 1,004,487  
Provision for loan losses
    312,741       544,413       589,108  
                         
Net Interest Income after Provision for Loan Losses
  $ 565,839     $ 348,398     $ 415,379  
                         
Noninterest Income
                       
Trust and investment management fees
  $ 90,112     $ 78,724     $ 87,164  
Net money market and bond trading income, including derivative activity
    29,585       20,270       7,737  
Foreign exchange trading gains, net
    4,821       11,462       6,900  
Service charges and fees
    193,185       202,156       202,362  
Charge card income
    113,395       416       439  
Equity securities gains, net
    7,490       8,365       49,884  
Net securities gains, other than trading
    6,504       35,037       10,956  
Other-than-temporary impairment of securities
    (5,112 )     (1,350 )     (4,571 )
Bank-owned insurance
    46,160       45,047       52,054  
Letter of credit fees
    22,341       20,674       16,035  
Net gains on loans held for sale
    19,031       21,680       4,471  
Net losses on loan sales to affiliates
                (9,453 )
Other
    40,993       40,555       39,355  
                         
Total noninterest income
  $ 568,505     $ 483,036     $ 463,333  
                         
Noninterest Expenses
                       
Salaries and other compensation
  $ 440,811     $ 407,958     $ 409,751  
Pension and other employee benefits
    100,625       103,006       103,887  
Net occupancy
    101,231       100,651       99,149  
Equipment
    76,345       68,055       69,137  
Marketing
    59,801       41,411       47,655  
Communication and delivery
    33,510       29,546       31,458  
Professional fees
    106,466       90,855       105,724  
Outside information processing, database and network fees
    38,933       34,803       39,927  
FDIC insurance
    45,767       61,977       16,165  
Intercompany services, net
    (7,088 )     (1,503 )     20,384  
Restructuring reversal
          (702 )     (2,664 )
Visa indemnification reversal
    (7,500 )     (3,000 )     (16,300 )
Charge card expense
    26,637              
Provision for off-balance sheet credit losses
    10,253       (314 )     381  
Auction rate security charge
                21,825  
Amortization of intangibles
    25,966       25,409       27,865  
Other
    114,602       84,094       85,391  
                         
Total noninterest expenses
  $ 1,166,359     $ 1,042,246     $ 1,059,735  
                         
Loss before income tax benefit
  $ (32,015 )   $ (210,812 )   $ (181,023 )
Applicable income tax benefit
    (50,563 )     (116,497 )     (96,219 )
                         
Net income (loss)
  $ 18,548     $ (94,315 )   $ (84,804 )
Less: noncontrolling interest — dividends on preferred stock of subsidiary
    18,438       18,438       18,438  
                         
Net Income (Loss) Available for Common Stockholder
  $ 110     $ (112,753 )   $ (103,242 )
                         
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


48


 

 
Harris N.A. and Subsidiaries
 
Consolidated Statements of Comprehensive Income (Loss)
 
                         
    For The Years Ended December 31  
    2010     2009     2008  
    (In thousands)  
 
Net income (loss)
  $ 18,548     $ (94,315 )   $ (84,804 )
Other comprehensive (loss) income:
                       
Cash flow hedges:
                       
Net unrealized (loss) gain on derivative instruments, net of tax (benefit) expense of ($7,118) in 2010, $31,935 in 2009 and ($68,427) in 2008
    (13,219 )     59,307       (127,075 )
Reclassification adjustment for realized loss included in net income (loss), net of tax benefit of $2,134 in 2010, $3,447 in 2009 and $5,090 in 2008
    3,962       6,402       9,452  
Pension and postretirement medical benefit plans:
                       
Net (loss) gain and net prior service cost, net of tax (benefit) expense of ($10,015) in 2010, $18,182 in 2009 and ($54,953) in 2008
    (15,027 )     33,764       (102,256 )
Amortization included in net periodic benefit cost, net of tax benefit of $2,652 in 2010, $1,466 in 2009 and $431 in 2008
    4,924       2,723       800  
Securities available-for-sale:
                       
Unrealized holding (losses) gains arising during the period, net of tax (benefit) expense of ($10,813) in 2010, $9,844 in 2009 and $24,931 in 2008
    (18,329 )     28,833       47,283  
Reclassification adjustment for realized gains included in net income (loss), net of tax expense of $571 in 2010, $12,263 in 2009 and $3,835 in 2008
    (1,061 )     (22,774 )     (7,121 )
                         
Other comprehensive (loss) income
  $ (38,750 )   $ 108,255     $ (178,917 )
                         
Comprehensive (loss) income
  $ (20,202 )   $ 13,940     $ (263,721 )
Comprehensive income related to noncontrolling interest
    18,438       18,438       18,438  
                         
Comprehensive loss available for common stockholder
  $ (38,640 )   $ (4,498 )   $ (282,159 )
                         
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


49


 

 
Harris N.A. and Subsidiaries
 
Consolidated Statements of Changes in Stockholder’s Equity
 
                                                 
                      Accumulated
    Noncontrolling
       
                      Other
    Interest -
    Total
 
    Common
          Retained
    Comprehensive
    Preferred Stock
    Stockholder’s
 
    Stock     Surplus    
Earnings
    Loss     Of Subsidiary     Equity  
                (In thousands except per share data)                    
 
Balance at December 31, 2007
  $ 155,148     $ 1,780,609     $ 1,879,907     $ (27,322 )   $ 250,000     $ 4,038,342  
Stock option exercise
          1,972                         1,972  
Tax benefit from stock option exercise
          1,779                         1,779  
Net (loss) income
                (103,242 )           18,438       (84,804 )
Dividends — ($2.37 per common share)
                (38,000 )                 (38,000 )
Dividends — preferred stock of subsidiary
                            (18,438 )     (18,438 )
Other comprehensive loss
                      (178,917 )           (178,917 )
Issuance of common stock and contribution to capital surplus
    16,347       387,669                         404,016  
Adoption to initially apply FASB ASC 715-60
                (313 )                 (313 )
Adoption of measurement date provisions of FASB ASC 715, net of tax of $2,090
                (3,880 )     200             (3,680 )
                                                 
Balance at December 31, 2008
  $ 171,495     $ 2,172,029     $ 1,734,472     $ (206,039 )   $ 250,000     $ 4,121,957  
Stock option exercise
          1,824                         1,824  
Tax benefit from stock option exercise
          2,914                         2,914  
Net (loss) income
                (112,753 )           18,438       (94,315 )
Dividends — preferred stock of subsidiary
                            (18,438 )     (18,438 )
Other comprehensive income
                      108,255             108,255  
Issuance of common stock and contribution to capital surplus
    3,850       146,150                         150,000  
                                                 
Balance at December 31, 2009
  $ 175,345     $ 2,322,917     $ 1,621,719     $ (97,784 )   $ 250,000     $ 4,272,197  
Stock option exercise
          1,628                         1,628  
Tax benefit from stock option exercise
          4,295                         4,295  
Net income
                110             18,438       18,548  
Dividends — preferred stock of subsidiary
                            (18,438 )     (18,438 )
Other comprehensive loss
                      (38,750 )           (38,750 )
Issuance of common stock and contribution to capital surplus
    24,550       968,450                         993,000  
                                                 
Balance at December 31, 2010
  $ 199,895     $ 3,297,290     $ 1,621,829     $ (136,534 )   $ 250,000     $ 5,232,480  
                                                 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


50


 

 
Harris N.A. and Subsidiaries
 
Consolidated Statements of Cash Flows
 
                         
    For The Years Ended December 31  
    2010     2009     2008  
 
Cash Flows from Operating Activities:
                       
Net income (loss)
  $ 18,548     $ (94,315 )   $ (84,804 )
Less: noncontrolling interest — dividends on preferred stock of subsidiary
    18,438       18,438       18,438  
                         
Net income (loss) available for common stockholder
  $ 110     $ (112,753 )   $ (103,242 )
Adjustments to determine net cash flows provided by (used in)
operating activities:
                       
Provision for loan losses
    312,741       544,413       589,108  
Depreciation and amortization, including intangibles
    111,617       99,123       94,602  
Deferred tax (benefit) expense
    (74,929 )     33,256       1,505  
Tax benefit from stock options exercise
    4,295       2,914       1,779  
Other-than-temporary impairment on securities
    5,112       1,350       4,571  
Net gains on securities, other than trading
    (6,504 )     (35,037 )     (10,956 )
Net equity investment gains
    (7,490 )     (8,365 )     (49,884 )
Increase in bank-owned insurance
    (33,442 )     (35,342 )     (39,359 )
Net decrease (increase) in trading securities
    182,365       (6,367 )     (1,231,304 )
Decrease in accrued interest receivable
    21,567       42,958       42,695  
Increase in prepaid expenses
    (47,979 )     (111,301 )     (3,417 )
Decrease in accrued interest payable
    (777 )     (62,672 )     (25,945 )
Increase (decrease) in other accrued expenses
    158,454       34,167       (91,244 )
Net change in pension and post retirement benefits
    (49,106 )     (57,405 )     (72,462 )
Origination of loans held for sale
    (821,386 )     (1,379,863 )     (417,250 )
Proceeds from sale of loans held for sale
    840,476       1,401,113       454,872  
Net gains on loans held for sale
    (19,031 )     (21,680 )     (4,471 )
Net (gains) losses on sale of premises and equipment
    (866 )     (2,605 )     399  
Net losses on loan sales to affiliates
                9,453  
Net change in due from parent
    (2,701 )     3,845       741  
Visa indemnification reversal
    (7,500 )     (3,000 )     (16,300 )
Other, net
    (91,188 )     (13,969 )     91,115  
                         
Net cash provided by (used in) operating activities
  $ 473,838     $ 312,780     $ (774,994 )
                         
Cash Flows from Investing Activities:
                       
Proceeds from sales of securities available-for-sale
  $ 523,168     $ 3,454,572     $ 1,263,951  
Proceeds from maturities of securities available-for-sale
    4,323,687       4,469,289       10,869,711  
Purchases of securities available-for-sale
    (4,665,027 )     (4,777,802 )     (11,805,326 )
Net decrease (increase) in loans
    1,826,178       2,984,252       (172,613 )
Proceeds from loans sold to affiliates
    273,522       502,711       472,477  
Net proceeds from FDIC loss share agreement
    75,706              
Purchases of premises and equipment
    (81,224 )     (84,782 )     (84,062 )
Proceeds from sales of premises and equipment
    4,726       28,699       15,154  
Proceeds from Visa redemption
                37,800  
Acquisitions, net of cash acquired
    176,492       (681,442 )     (285,214 )
                         
Net cash provided by investing activities
  $ 2,457,228     $ 5,895,497     $ 311,878  
                         
Cash flows from Financing Activities:
                       
Net increase (decrease) in deposits
  $ 3,386,598     $ (23,695,855 )   $ 22,182,025  
Net increase in deposits measured at fair value
    608,436       629,767        
Net (decrease) increase in Federal funds purchased and securities sold under agreement to repurchase
    (1,689,420 )     (831,694 )     1,784,129  
Net increase (decrease) in other short-term borrowings
    710,744       357,574       (584,916 )
Net decrease in short-term senior notes
          (75,000 )     (5,000 )
Proceeds from issuance long-term notes — senior/unsecured
          550,000        
Repayment of long-term notes — senior/unsecured
    (137,409 )     (250,000 )      
Proceeds from issuance long-term notes — senior/secured
                375,000  
Repayment of long-term notes — subordinated
    (92,750 )            
Net proceeds from stock options exercise
    1,628       1,824       1,972  
Excess tax expense from stock options exercise
    (570 )     (639 )     (1,183 )
Issuance of common stock
    24,550              
Capital contributions from parent
    968,450       150,000       404,016  
Cash dividends paid on common stock
                (38,000 )
Cash dividends paid on preferred stock
    (18,438 )     (18,438 )     (18,438 )
                         
Net cash provided by (used in) financing activities
  $ 3,761,819     $ (23,182,461 )   $ 24,099,605  
                         
Net increase (decrease) in cash and cash equivalents
  $ 6,692,885     $ (16,974,184 )   $ 23,636,489  
Cash and cash equivalents at January 1
    10,311,425       27,285,609       3,649,120  
                         
Cash and cash equivalents at December 31
  $ 17,004,310     $ 10,311,425     $ 27,285,609  
                         


51


 

 
Harris N.A. and Subsidiaries
 
Consolidated Statements of Cash Flows — (Continued)
 
                         
    For The Years Ended December 31  
    2010     2009     2008  
 
Supplemental Disclosures of Cash Flow Information:
                       
Cash paid (received) during the year for:
                       
Interest
  $ 310,816     $ 521,010     $ 825,709  
Income taxes
  $ (135,893 )   $ (167,848 )   $ 92,410  
Financing activity affecting assets and liabilities but not resulting in cash flows:
                       
Net (decrease) increase in assets and liabilities due to contribution of parent’s banking assets
  $ (176,492 )   $ 681,442     $ 285,214  
Supplemental Disclosures of Noncash Activities:
                       
In 2010, the fair values of noncash assets acquired and liabilities assumed were $2.1 billion and $2.3 billion, respectively, in the acquisition of AMCORE
In 2009, the fair values of noncash assets acquired and liabilities assumed were $0.4 million and zero, respectively, in the acquisition of Pierce Givens, $654.0 million and $82.3 million, in the acquisition of Diners Club.
In 2008, the fair values of noncash assets acquired and liabilities assumed were $1.4 billion and $1.3 billion, respectively, in the acquisition of Merchants and Manufacturers Bancorporation, $807.5 million and $688.0 million, respectively, in the acquisition of Ozaukee Bank.
Noncash transfers to OREO totaled $64.1 million, $7.8 million and $10.0 million in 2010, 2009 and 2008, respectively.
 
The accompanying notes to consolidated financial statements are an integral part of these statements.


52


 

HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements
 
1.   Summary of Significant Accounting Policies
 
Principles of consolidation and nature of operations
 
Harris N.A. (“HNA”) is a wholly-owned subsidiary of Harris Bankcorp, Inc. (“Bankcorp”), a Delaware corporation which is a wholly-owned subsidiary of Harris Financial Corp. (“HFC”), a Delaware Corporation which is a wholly-owned subsidiary of Bank of Montreal (“BMO”). Throughout these Notes to Consolidated Financial Statements, the term “Bank” refers to Harris N.A. and subsidiaries.
 
The consolidated financial statements include the assets, liabilities, revenues and expenses of the Bank and its wholly-owned subsidiaries. Significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to conform prior year’s consolidated financial statements to the current year’s presentation. See Note 23 to the Consolidated Financial Statements for additional information on business combinations and Note 24 to the Consolidated Financial Statements for additional information on related party transactions.
 
The Bank provides banking, trust and other services domestically and internationally through the main banking facility and four active nonbank subsidiaries. The Bank provides a variety of banking and financial services to commercial and industrial companies, financial institutions, governmental units, not-for-profit organizations and individuals throughout the U.S., primarily the Midwest, and abroad. Services rendered and products sold to customers include demand and time deposit accounts and certificates; various types of loans; sales and purchases of foreign currencies; interest rate management products; cash management services; investment banking services; underwriting of municipal bonds; financial consulting; and personal trust and trust-related services.
 
Basis of accounting
 
The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and conform to practices within the banking industry.
 
Noncontrolling interest in subsidiaries
 
The Bank adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB 51,” (subsequently codified in Accounting Standards Codification (“ASC”) Topic 810-10-65) on January 1, 2009. The standard requires noncontrolling interests held by parties other than the parent to be reported as equity in the consolidated financial statements. Included in noncontrolling interests at December 31, 2010 and 2009 was preferred stock issued by a subsidiary of the Bank. The noncontrolling interest in the subsidiaries is included within stockholder’s equity in the Consolidated Statements of Condition. Net income (loss) attributable to the noncontrolling interest is separately presented in the Consolidated Statements of Operations, outside of net income (loss) and is not included in net income (loss) available for common stockholder.
 
Foreign currency and foreign exchange contracts
 
Assets and liabilities denominated in foreign currencies have been translated into United States dollars at respective period-end rates of exchange. Foreign exchange trading positions are revalued monthly using prevailing market rates. Exchange adjustments are included with noninterest income in the Consolidated Statements of Operations.
 
Derivative financial instruments
 
All derivative instruments are recognized at fair value in the Bank’s Consolidated Statements of Condition. All derivative instruments are designated either as hedging or trading.


53


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Trading derivatives are marked to fair value. Realized and unrealized gains and losses are recognized in noninterest income in the Bank’s Consolidated Statements of Operations. Unrealized gains on trading derivatives are recorded as assets and unrealized losses are recorded as liabilities in the Bank’s Consolidated Statements of Condition.
 
Derivative instruments that are used in the management of the Bank’s risk strategy may qualify for hedge accounting if the derivatives are designated as hedges and applicable hedge criteria are met. In order for a derivative to qualify as an accounting hedge, the hedging relationship must be designated and formally documented at its inception, detailing the particular risk management objective and strategy for the hedge and the specific asset, liability or cash flow being hedged, as well as how its effectiveness is being assessed. Changes in the fair value of the derivative must be highly effective in offsetting either changes in the fair value of on-balance sheet items caused by the risk being hedged or changes in the amount of future cash flows.
 
Hedge effectiveness is evaluated at the inception of the hedging relationship and on an ongoing basis, retrospectively and prospectively, primarily using quantitative statistical measures of correlation. Any ineffectiveness in the hedging relationship is recognized in other noninterest income in the Bank’s Consolidated Statements of Operations as it arises.
 
The Bank records interest receivable or payable on the derivative as an adjustment to interest income/expense in the Bank’s Consolidated Statements of Operations over the life of the hedge.
 
For cash flow hedges, to the extent that changes in the fair value of the derivative offset changes in the fair value of the hedged item, they are recorded in other comprehensive income. Any portion of the change in fair value of the derivative that does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge) is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.
 
For cash flow hedges that are discontinued before the end of the original hedge term, the unrealized gain or loss in accumulated other comprehensive income (loss) is amortized to interest income/expense in the Bank’s Consolidated Statements of Operations consistent with how the hedged item affects earnings. If the hedged item is sold or settled, the entire unrealized gain or loss is recognized in interest income/expense in the Bank’s Consolidated Statements of Operations.
 
For fair value hedges, the hedging derivative is recorded at fair value and the related hedge item, either fixed rate assets or liabilities, is adjusted for the changes in value of the risk being hedged. To the extent that the change in the fair value of the derivative does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge), the net amount is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.
 
For fair value hedges that are discontinued, the Bank stops adjusting the hedged item for changes in fair value that are attributable to the hedged risk. The fair value adjustment of the hedged item is amortized to the interest income/expense on the hedged item over its remaining term to maturity. If the hedged item is sold or settled, any remaining fair value adjustment is included in the determination of the gain or loss on sale or settlement.
 
Securities
 
The Bank classifies marketable securities as either trading account assets or available-for-sale. Trading account assets include securities acquired as part of trading activities and are typically purchased with the expectation of near-term profit on disposition. These assets consist primarily of municipal bonds and U.S. government securities. Available-for-sale securities consist of debt and equity securities that may be sold in response to or in anticipation of changes in interest rates, changes in internal regulatory capital requirements, changes in foreign currency risk, changes in funding sources or terms, or to meet liquidity needs. Nonmarketable securities are classified as other assets on the Bank’s Consolidated Statements of Condition. See Note 27 to the Consolidated Financial Statements for additional information on other assets.


54


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Trading account assets are reported at fair value with unrealized gains and losses included in noninterest income, which also includes realized gains and losses from closing such positions.
 
Available-for-sale securities are reported at fair value with unrealized gains and losses included, on an after-tax basis, as a separate component of stockholder’s equity. Purchase premiums and discounts are recognized in interest income using the interest method over the terms to maturity of the securities. Realized gains and losses, as a result of securities sales, are included in net securities gains (losses) in the Consolidated Statements of Operations, with the cost of securities sold determined on the specific identification basis.
 
Available-for-sale securities and other investments are subject to ongoing other-than-temporary impairment reviews. In determining whether a loss is temporary, factors considered include the extent of the unrealized loss, the length of time that the security has been in an unrealized loss position, the financial condition and near-term prospects of the issuer, and whether the Bank has the intent to sell the security or it is more likely than not that the Bank will be required to sell the investment before the recovery of the investment’s amortized cost basis. If a decline is considered to be other-than-temporary, a write-down is recorded in the Consolidated Statements of Operations as other-than-temporary impairment on securities, and a new cost basis is established. In the event an available-for-sale debt security is considered to be other-than-temporarily impaired and the Bank does not intend to sell the security, then the amount of the impairment charge equal to the credit loss is recorded in earnings and the remaining non credit-related impairment charge is recorded in other comprehensive income.
 
Loans
 
Loans held for investment are recorded at the principal amount outstanding, net of unearned income, deferred fees and deferred origination costs. Origination fees collected and origination costs incurred on commercial loans, loan commitments, mortgage loans, consumer loans and standby letters of credit (except loans held for sale) are generally deferred and amortized over the life of the related facility. Other loan-related fees that are not the equivalent of yield adjustments are recognized as income when received or earned. The Bank’s Consolidated Statements of Condition included approximately $10 million of deferred origination costs net of deferred loan-related fees at December 31, 2010 and $22 million at December 31, 2009.
 
In conjunction with its mortgage and commercial banking activities, the Bank will originate loans with the intention of selling them in the secondary market. These loans are classified as held for sale and are included in “Loans held for sale” on the Bank’s Consolidated Statements of Condition. The loans are carried at the lower of cost or current fair value, on a portfolio basis. Deferred origination fees and costs associated with these loans are not amortized and are included as part of the basis of the loan at time of sale. Realized gains and unrealized and realized losses are included in other noninterest income.
 
The Bank engages in the servicing of mortgage loans and acquires mortgage servicing rights (“MSR”) by originating mortgage loans and then selling those loans with servicing rights retained. See Note 6 to the Consolidated Financial Statements for additional information on mortgage servicing rights.
 
Written loan commitments on mortgage loans that the Bank intends to sell are accounted for as derivative instruments and recorded at fair value through earnings. The expected net future cash flows related to loan servicing are included in the fair value measurement of the written loan commitments. See Note 12 to the Consolidated Financial Statements for additional information on derivative instruments.
 
Commercial and commercial real estate loans are placed on nonaccrual status when the collection of interest is doubtful or when principal or interest is 90 days past due, unless the credit is adequately collateralized and the loan is in process of collection. Consumer real estate secured loans are generally placed on nonaccrual status when principal or interest is 90 days past due. When a loan is placed on nonaccrual status, all interest accrued but not yet collected which is deemed uncollectible is charged against interest income in the current year. Interest on nonaccrual loans is recognized as income only when cash is received and the Bank expects to collect the entire principal balance of the loan; otherwise, cash collections reduce the recorded investment. Loans are returned to


55


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
Commercial and commercial real estate loans are charged off when, in management’s opinion, the loan is deemed uncollectible. Consumer installment loans are charged off when 120 days past due. Consumer revolving loans, including credit card loans, and consumer real estate secured loans are charged off when 180 days past due. Consumer installment and consumer revolving loans, including credit card loans, are not normally placed on non-accrual status. Accrued interest on these loans is charged against interest income at the time of charge-off.
 
Commercial loan commitments and letters of credit are executory contracts and the notional balances are not reflected on the Bank’s Consolidated Statements of Condition. Fees collected are earned over the life of the facility.
 
Impaired loans (primarily commercial credits) are measured based on the present value of expected future cash flows (discounted at the loan’s effective interest rate) or, alternatively, at the loan’s observable market price or the fair value of supporting collateral. Impaired loans are defined as those where it is probable that amounts due for principal or interest according to contractual terms will not be collected. Nonaccrual and certain restructured loans meet this definition. Large groups of smaller-balance, homogeneous loans, primarily residential real estate and consumer installment loans, are excluded from this definition of impairment. The Bank measures loan impairment as part of assessing the adequacy of the allowance for loan losses.
 
Restructured loans include loans modified in troubled debt restructurings where the Bank grants contractual concessions to borrowers that are experiencing financial difficulties. Impairment is measured based on the present value of restructured future cash flows discounted at the loan’s original effective interest rate. Probable losses are recorded through the allowance for loan losses.
 
The Bank accounts for impaired loans that are acquired in a transfer or business combination in accordance with FASB ASC 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality”. As defined, acquired impaired loans exhibit a deterioration of credit quality from their origination date to the acquisition date and a probability at acquisition that the Bank will be unable to collect all contractually required payments due according to the contractual terms of the loan agreements. Impaired loans that the Bank acquires in a business combination are initially recorded at fair value, which is based on the fair value of supporting collateral or the present value of expected cash flows. Expected cash flows include consideration of prepayments and estimations of the amount and timing of principal and interest. Loans acquired as of the same acquisition date that have common risk characteristics may be aggregated and accounted for as a pool of loans. Management elected to apply ASC 310-30 by analogy to all other loans acquired from the FDIC in the AMCORE transaction. Undiscounted expected cash flows in excess of the initial valuation are accreted into interest income over the estimated life of the loans or pools. If the Bank cannot reasonably estimate the timing and amount of expected cash flows, then the loans are considered nonaccreting and placed on nonaccrual status. Any allowance for loan losses related to the impaired loans is not carried over at acquisition. If it is probable, upon subsequent evaluation, that the Bank will be unable to collect the expected cash flows, then the loans are considered further impaired and probable losses are recorded through the allowance for loan losses. Subsequent increases in the expected cash flows are used to reverse any allowance for those loans or pools and then recognized prospectively as an adjustment to yield.
 
Allowance for loan losses / Losses on commitments
 
The allowance for loan losses recorded in the Consolidated Statements of Condition is maintained at a level considered adequate to absorb probable losses. The allowance is increased by charges to the provision for loan losses and reduced by net charge-offs. Known losses of principal on impaired loans are charged off. The provision for loan losses is based on past loss experience, management’s evaluation of the loan portfolio under current economic conditions and management’s estimate of losses inherent in the portfolio. Such estimates are reviewed periodically and adjustments, if necessary, are recorded during the periods in which they become known.


56


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Letters of credit and commitments to extend credit are reviewed periodically for probable losses. A liability for probable losses on letters of credit and commitments to extend credit is recorded in other liabilities on the Bank’s Consolidated Statements of Condition. The liability is periodically revised for changes in estimates and actual losses or recoveries with charges to other noninterest expense.
 
Premises and Equipment
 
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed on the straight-line basis over the estimated useful lives of the assets. Estimated useful lives range from 3 years to 39 years. Certain costs of internally developed software are capitalized and depreciated over an estimated useful life of 5 years. Leasehold improvements are amortized over the lesser of the lease term or the useful life of the asset, not to exceed a maximum that ranges from 10 years to 39 years depending on the type of improvement. The maximum estimated useful life for buildings is 39 years.
 
Leases
 
Rental expense associated with operating leases is recognized on a straight-line basis over the lease term. Escalation clauses that specify scheduled rent increases over the lease term are recognized on a straight-line basis over the lease term.
 
Bank-owned insurance
 
The Bank has purchased life insurance coverage on certain officers. The one-time premiums paid for the policies, which coincide with the initial cash surrender value, are recorded as assets on the Consolidated Statements of Condition. Increases or decreases in cash surrender value (other than proceeds from death benefits) are recorded as bank-owned insurance income in the Consolidated Statements of Operations. Proceeds from death benefits first reduce the cash surrender value attributable to the individual policy and any additional proceeds are recorded as noninterest income.
 
Intangible Assets
 
Intangible assets with finite lives are amortized on either an accelerated or straight-line basis depending on the character of the acquired asset. Original lives range from 3 to 15 years. Intangible assets subject to amortization are reviewed for impairment when events or future assessments of profitability indicate that the carrying value may not be recoverable. If the carrying value is not expected to be recovered and the carrying value exceeds the fair value, an impairment loss is recognized. Intangible assets with indefinite useful lives are not amortized and are reviewed for impairment annually or more frequently if events indicate impairment. The excess of carrying value over fair value, if any, is recorded as an impairment loss.
 
FDIC Indemnification Asset
 
The acquisition of AMCORE Bank N.A. (“AMCORE”) from the Federal Deposit Insurance Corporation (“FDIC”) includes a loss share agreement with the FDIC. The loss share agreement provides for reimbursement from the FDIC for a portion of losses on loans and foreclosed real estate (covered assets, collectively) over a defined period of time subsequent to the acquisition date. An indemnification asset was recorded at fair value at acquisition based on the present value of expected cash flows to be received from the FDIC for loss reimbursements covered by the agreement. The loss assumptions used in determining the FDIC indemnification asset are consistent with those used in valuing the related covered loans. Subsequent to acquisition, the indemnification asset is adjusted for changes in estimated cash flows and reduced for payments for reimbursement of losses from the FDIC. The indemnification asset is separate from the covered assets, is not contractually embedded in the covered assets and is not transferrable with the covered assets in the event of a sale or disposition of the covered assets. It is included in Other Assets on the Consolidated Statements of Condition and accretion is recognized in other noninterest income


57


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
in the Bank’s Consolidated Statements of Operations. See Note 27 to the Consolidated Financial Statements for additional information.
 
Diners Club Liability
 
The Diners Club Rewards program provides cardholders the opportunity to earn points that can be redeemed for a variety of rewards including air and travel, retail certificates and merchandise. The rewards liability represents the estimated cost of points earned to date that are expected to be redeemed. The rewards liability is included in Other Liabilities on the Consolidated Statements of Condition and the associated cost is recorded as an offset to charge card income.
 
Income Taxes
 
The Bank is included in the consolidated Federal income tax return of HFC. Federal income tax return liabilities or benefits for all the consolidated entities are not materially different than they would have been if computed on a separate return basis.
 
The Bank files separate state tax returns in certain states and is included in combined state tax returns with other affiliates in other states.
 
Deferred tax assets and liabilities, as determined by the temporary differences between financial reporting and tax bases of assets and liabilities, are computed using enacted tax rates and laws. The effect on deferred tax assets and liabilities of a change in tax rates or law is recognized as income or expense in the period including the enactment date. In addition, the Bank assesses the likelihood that deferred tax assets will be realized in future periods and recognizes a valuation allowance for those assets unlikely to be realized. Management’s assessment of the Bank’s ability to realize these deferred tax assets includes the use of management’s judgment and estimates of items such as future taxable income, future reversal of existing temporary differences, carrybacks to prior years and, if appropriate, the use of future tax planning strategies.
 
Cash flows
 
In the Consolidated Statements of Cash Flows, cash and cash equivalents include cash and demand balances due from banks, interest-bearing deposits at banks and federal funds sold and securities purchased under agreement to resell, as these meet the definition of cash and cash equivalents.
 
Management’s estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The areas requiring significant management judgment include provision and allowance for loan losses, valuation of income tax assets and liabilities, pension cost, postretirement and postemployment benefits, valuation of goodwill and intangible assets, valuation of Diners Club rewards liability, estimation of expected cash flows for purchased credit-impaired loans and loss reimbursements, fair values of derivatives, mortgage servicing rights, and securities, and temporary vs. other-than-temporary impairment of securities.
 
Recent accounting standards
 
The Bank adopted SFAS No. 166, “Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140,” (subsequently codified in ASC 860) as of January 1, 2010. The standard removes the concept of a qualifying special-purpose entity (“QSPE”). It also creates more stringent conditions for reporting a transfer of a


58


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
portion of a financial asset as a sale. The adoption of the standard did not have a material impact on the Bank’s financial position or results of operations.
 
The Bank adopted SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” (subsequently codified in ASC 810) as of January 1, 2010. The standard changes the criteria by which an enterprise determines whether it must consolidate a variable interest entity (“VIE”). It amends the existing guidance to require an enterprise to consolidate a VIE if it has both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses or the right to receive benefits from the VIE. Existing guidance requires an enterprise to consolidate a VIE if it absorbs a majority of the expected losses or residual returns, or both. A continuous assessment of which party must consolidate a VIE is required, rather than an assessment only when certain trigger events occur. In addition, the new standard requires an enterprise to assess if VIEs that were previously QSPEs must be consolidated by the enterprise. The adoption of the standard did not have a material impact on the Bank’s financial position or results of operations.
 
The Bank adopted Accounting Standards Update(“ASU”) 2010-06, “Improving Disclosures About Fair Value Measurements”, as of January 1, 2010. The standard amends ASC 820-10 to require new disclosures about transfers in and out of Level 1 and Level 2 fair value measurements. ASU 2010-06 clarifies existing disclosure requirements regarding the level of disaggregation of each class of assets and liabilities within a line item in the statement of financial condition and the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements that fall in either Level 2 or Level 3 fair value measurements. The adoption of the standard had no impact on the Bank’s financial position or results of operations. See Note 10 to the Consolidated Financial Statements for additional information on fair value of financial instruments. The standard also requires new disclosures about the roll forward of activity in Level 3 fair value measurements which will be effective January 1, 2011.
 
The FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”, in July 2010. This ASU amended ASC 310-10-50, “Receivables — Overall — Disclosure”, in order to expand the requirements for separate reporting and disclosure of allowances for credit losses and the policies for managing credit exposures. The standard requires companies to significantly increase disclosures about the credit quality of financing receivables and the credit reserves held against them. The additional disclosures include aging of past due receivables, credit quality information such as credit risk scores or external credit agency ratings and the modification of financing receivables. Further disaggregation of information by certain classification of the total portfolio will also be required. The objective of enhancing these disclosures is to improve financial statement users’ understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The disclosures will be effective for the Bank for the annual reporting period ending December 31, 2011. The Bank does not expect the adoption of this standard to impact it’s financial position or results of operations.


59


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
2.   Securities
 
The amortized cost and estimated fair value of securities available-for-sale were as follows:
 
                                                                 
    December 31, 2010     December 31, 2009  
    Amortized
    Unrealized
    Unrealized
    Fair
    Amortized
    Unrealized
    Unrealized
    Fair
 
    Cost     Gains     Losses     Value     Cost     Gains     Losses     Value  
    (In thousands)  
 
U.S. Treasury
  $ 388,761     $ 5     $ (3 )   $ 388,763     $ 40,250     $     $ (1 )   $ 40,249  
U.S. government agency
    1,985,293       11,449       (397 )     1,996,345       2,869,073       15,850       (494 )     2,884,429  
U.S. government sponsored mortgage-backed
    628,678       23,764       (2,060 )     650,382       712,912       21,629       (894 )     733,647  
State and municipal
    1,578,403       31,600       (9,532 )     1,600,471       1,549,003       44,685       (2,996 )     1,590,692  
Non-mortgage asset backed
    726,677       1,929       (158 )     728,448       36,489       8,237             44,726  
Corporate debt securities
    10,253                   10,253                          
Foreign corporate debt securities
    300,000       69             300,069       500,000       1,440             501,440  
Foreign government debt securities
    250                   250       499       1             500  
Other
                            103,148                   103,148  
                                                                 
Total securities
  $ 5,618,315     $ 68,816     $ (12,150 )   $ 5,674,981     $ 5,811,374     $ 91,842     $ (4,385 )   $ 5,898,831  
                                                                 
 
The following table summarizes, for available-for-sale securities with unrealized losses as of December 31, 2010 and 2009, the amount of the unrealized loss and the related fair value of the securities with unrealized losses. As of December 31, 2010, the Bank had 1,013 available-for-sale securities (413 in 2009) with unrealized losses totaling $12.2 million (unrealized losses of $4.4 million in 2009). Of these available-for-sale securities, 22 have been in an unrealized loss position continuously for more than twelve months (101 in 2009), amounting to an unrealized loss position of $0.4 million (unrealized loss position of $1.7 million in 2009). These unrealized losses are primarily attributable to changes in interest rates and not from deterioration in the creditworthiness of the issuers. It is the Bank’s intention to not sell and it does not believe it will be required to sell these securities before any anticipated recovery of their amortized cost basis. Based on these factors, management has determined that the


60


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
unrealized losses are not other-than-temporary in nature. However, due to market and economic conditions there is the potential for other-than-temporary impairment charges in future periods.
 
                                                         
    Length of Continuous Unrealized Loss Position  
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
    Number of
          Unrealized
 
    Fair Value     Losses     Fair Value     Losses     Securities     Fair Value     Losses  
    (In thousands)  
 
December 31, 2010
                                                       
U.S. Treasury
  $ 105,773     $ (3 )   $     $           $ 105,773     $ (3 )
U.S. government agency
    149,810       (191 )     224,794       (206 )     1       374,604       (397 )
U.S. government sponsored mortgage-backed
    82,301       (2,060 )                       82,301       (2,060 )
State and municipal
    455,935       (9,300 )     6,093       (232 )     21       462,028       (9,532 )
Non-mortgage asset backed
    163,574       (158 )                       163,574       (158 )
                                                         
Temporarily impaired securities — available-for-sale
  $ 957,393     $ (11,712 )   $ 230,887     $ (438 )     22     $ 1,188,280     $ (12,150 )
                                                         
December 31, 2009
                                                       
U.S. Treasury
  $ 40,249     $ (1 )   $     $           $ 40,249     $ (1 )
U.S. government agency
    184,279       (20 )     514,526       (474 )     6       698,805       (494 )
U.S. government sponsored mortgage-backed
    105,003       (885 )     1,237       (9 )     7       106,240       (894 )
State and municipal
    144,519       (1,768 )     24,179       (1,228 )     88       168,698       (2,996 )
                                                         
Temporarily impaired securities — available-for-sale
  $ 474,050     $ (2,674 )   $ 539,942     $ (1,711 )     101     $ 1,013,992     $ (4,385 )
                                                         
 
During 2010, the Bank recorded other-than-temporary impairment of $0.6 million on 24 municipal bonds and $4.3 million on 18 auction rate securities. The losses were all credit-related and recorded in the Consolidated Statements of Operations as other-than-temporary impairment on securities. All impairment losses in 2010 and 2009 were recorded on securities determined to be newly impaired. See Note 27 to the Consolidated Financial Statements for additional information on other-than-temporary impairment losses on other investments.
 
The amortized cost and estimated fair value of available-for-sale securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities can differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
                 
    December 31, 2010  
    Amortized
    Fair
 
    Cost     Value  
    (In thousands)  
 
Maturities:
               
Within 1 year
  $ 2,298,638     $ 2,301,603  
1 to 5 years
    2,052,533       2,077,298  
5 to 10 years
    659,812       679,642  
Over 10 years
    607,332       616,438  
                 
Total securities
  $ 5,618,315     $ 5,674,981  
                 
 
Auction-rate securities (“ARS”) are typically short-term notes issued in the United States to fund long-term, fixed rate debt instruments (corporate or municipal bonds primarily issued by municipalities, student loan authorities and other sponsors). The interest rate on ARS is regularly reset every 7 to 35 days through auctions managed by financial institutions. A disruption in the market for ARS occurred in 2008. Certain customer-managed portfolios held these securities, which were no longer liquid. Certain of the Bank’s subsidiaries voluntarily offered to purchase such securities from customers, at par value.


61


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
In addition, in 2008 a settlement with the Financial Industry Regulatory Authority (“FINRA”) required Harris Investor Services, Inc. (“HIS”), a wholly owned subsidiary of Bankcorp, to purchase specific holdings of ARS from certain client accounts at par value plus accrued interest and levied a penalty of $150 thousand. As noted above, in addition to what was required by the FINRA settlement, management of HIS and three other legal entities within HFC offered to purchase certain other customer ARS holdings under similar terms. The gross par value of ARS holdings purchased during 2008 was $93.1 million plus accrued interest. A discounted cash flow valuation methodology was applied to estimate the fair value of the securities. The methodology included management assumptions about future cash flows, discount rates, market liquidity and credit spreads. The difference between the estimated fair values and the par values paid by the Bank resulted in a pre-tax charge of $21.8 million for the year ended December 31, 2008 in addition to the legal costs of $185 thousand. The charge was recorded in noninterest expense on the Consolidated Statements of Operation.
 
The ARS purchased are classified as available-for-sale and are included within the “state and municipal” and “non-mortgage asset back” categories.
 
Remaining ARS were purchased during 2009 and had a gross par value of $8.6 million. A minimal pre-tax charge was recorded for the year ended December 31, 2009 for the difference between the estimated fair values and the par values paid by the Bank. The charge was recorded in noninterest expense on the Consolidated Statements of Operations. There was no liability relating to the purchase of ARS as of December 31, 2010 and 2009.
 
For the year ended December 31, 2009, gains of $3.3 million were recorded on ARS securities held as available-for-sale which were called either at par or at amounts that exceeded carrying value. Redemptions of ARS totaled $12.2 million for the year ended December 31, 2009. The carrying value of ARS was $73.6 million as of December 31, 2009.
 
For the year ended December 31, 2010, ARS held as available-for-sale with a gross par value of $54.0 million were either sold or called and a gain of $6.2 million was recorded to net securities gains, other than trading in the Consolidated Statements of Operations. During 2010 a credit-related impairment charge of $4.3 million was recorded to other-than-temporary impairment on securities in the Consolidated Statements of Operations. The carrying value of remaining ARS was $14.5 million as of December 31, 2010.
 
At December 31, 2010, 2009 and 2008, available-for-sale and trading account securities having a carrying amount of $5.3 billion and $3.3 billion, and $4.6 billion, respectively, were pledged as collateral for certain liabilities, securities sold under agreement to repurchase, public and trust deposits, trading account activities and for other purposes where permitted or required by law. The Bank maintains effective control over the securities sold under agreement to repurchase and accounts for the transactions as secured borrowings.
 
In 2010, 2009 and 2008, proceeds from the sale of securities available-for-sale amounted to $0.5 billion, $3.5 billion and $1.3 billion, respectively. Gross gains of $6.6 million and gross losses of $50 thousand were realized on these sales in 2010, gross gains of $36.8 million and gross losses of $1.8 million were realized in 2009, while gross gains of $11.5 million and gross losses of $0.6 million were realized in 2008. Net realized and unrealized gains on trading securities during 2010, 2009 and 2008 were $29.6 million, $20.3 million and $9.3 million, respectively. $2.8 million and $1.3 million of net unrealized gains were related to trading securities still held as of December 31, 2010 and 2009, respectively.


62


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
3.   Loans
 
The following table summarizes loan balances by category:
 
                 
    December 31  
    2010     2009  
    (In thousands)  
 
Domestic loans:
               
Commercial, financial, agricultural, brokers and dealers
  $ 3,140,584     $ 3,366,723  
Real estate construction
    365,446       561,351  
Real estate mortgages
    13,487,760       13,985,641  
Installment
    4,708,319       4,517,429  
Credit card
    641,314       704,604  
Lease financing, net (unearned discount of $0.1 million and $0.1 million at December 31, 2010 and December 31, 2009, respectively)
    12,699       15,603  
Foreign loans:
               
Other, primarily commercial and industrial
    22,982       30,637  
                 
Total loans(1)
  $ 22,379,104     $ 23,181,988  
Less unearned income
    6,439       6,271  
                 
Loans, net of unearned income
  $ 22,372,665     $ 23,175,717  
Less allowance for loan losses
    706,101       680,782  
                 
Loans, net of allowance for loan losses
  $ 21,666,564     $ 22,494,935  
                 
 
 
(1) Includes $1.2 billion of acquired loans subject to loss share agreement.
 
Nonaccrual loans, restructured loans and other nonperforming assets are summarized below:
 
                 
    December 31  
    2010     2009  
    (In thousands)  
 
Nonaccrual loans
  $ 785,600     $ 485,996  
Nonperforming restructured loans
    110,395       22,070  
                 
Total nonperforming loans
  $ 895,995     $ 508,066  
Other real estate owned
    39,374       10,868  
                 
Total nonperforming assets
  $ 935,369     $ 518,934  
                 
Gross amount of interest income that would have been recorded if nonperforming loans had been accruing interest at their original terms
  $ 27,300     $ 23,660  
Interest income actually recognized
    4,811       4,743  
                 
Interest shortfall
  $ 22,489     $ 18,917  
                 
90-day past due loans, still accruing interest
  $ 144,981     $ 116,107  
                 
Nonperforming loans to total loans at year-end
    4.00 %     2.20 %
Nonperforming assets to total loans at year-end
    4.18 %     2.25 %
 
Commitments to lend additional funds on nonperforming restructured loans totaled $22.6 million at December 31, 2010.


63


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
At December 31, 2010 and 2009, the Bank had no aggregate public or private sector outstandings to any single foreign country experiencing liquidity problems which exceeded one percent of the Bank’s consolidated assets. At December 31, 2010 and 2009 commercial loans with a carrying value of $5.4 billion and $2.9 billion, respectively, were pledged to secure potential borrowings with the Federal Reserve. At December 31, 2010 and 2009, first mortgage loans on 1-4 family homes with a carrying value of $3.9 billion and $4.5 billion, respectively, were pledged to secure borrowings from the Federal Home Loan Bank.
 
Loans that are acquired with evidence of deterioration of credit quality between origination date and acquisition date and where it is probable that not all amounts due according to contractual terms will be collected are subject to certain recognition and reporting requirements in accordance with ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality.” On April 23, 2010, the Bank acquired certain assets and liabilities of AMCORE Bank N.A. (“AMCORE”) from the FDIC that included loans within the scope of ASC 310-30. Management elected to apply ASC 310-30 by analogy to all other loans acquired from the FDIC in the AMCORE transaction. The following information includes both credit-impaired loans and other loans purchased from the FDIC. On December 31, 2009, BMO and the Bank completed the acquisition of the net cardholder receivables of the Diners Club North American franchise from an unrelated bank. The cardholder receivables within the scope of ASC 310-30 were not material to the Bank’s financial statements and, as a result, are not included in the following information about purchased credit-impaired loans. See Note 23 to the Consolidated Financial Statements for additional information on business combinations.
 
The carrying amount of loans acquired from the FDIC include credit-impaired loans and other acquired loans as summarized below.
 
                         
    December 31, 2010  
    Purchased
    Other
       
    Credit-Impaired
    Acquired
       
    Loans     Loans     Total  
    (In thousands)  
 
Commercial
  $ 257,189     $ 740,454     $ 997,643  
Consumer
    4,475       224,740       229,215  
                         
Total loans
  $ 261,664     $ 965,194     $ 1,226,858  
                         
 
The following table provides details on the purchased credit-impaired loans and other loans acquired from the FDIC as of the acquisition date.
 
         
    2010  
    (In thousands)  
 
Contractually required payments including interest
  $ 2,231,354  
Nonaccretable difference
    509,753  
         
Cash flows expected to be collected (undiscounted)
  $ 1,721,601  
Accretable yield
    195,975  
         
Fair value of purchased loans
  $ 1,525,626  
         


64


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The following table presents the change in accretable yield related to the purchased credit-impaired loans and other loans acquired from the FDIC for the year ended December 31, 2010.
 
         
    2010  
    (In thousands)  
 
Accretable yield, acquisition date
  $ 195,975  
Additions
    7,315  
Removals
    (15,022 )
Accretion
    (44,689 )
Reclassification from nonaccretable difference
    49,766  
         
Accretable yield, end of year
  $ 193,345  
         
 
The carrying amount and outstanding balance of purchased credit-impaired loans and other loans acquired from the FDIC together with acquired loans from prior acquisitions are presented in the table below.
 
                 
    December 31  
    2010     2009  
    (In thousands)  
 
Contractual outstanding balance
  $ 1,911,784     $ 42,372  
Carrying amount
  $ 1,239,445     $ 29,170  
 
The carrying amount of nonaccreting purchased credit-impaired loans (excluding other loans) acquired in the AMCORE transaction was $309.4 million at acquisition date. The carrying amount of all nonaccreting purchased credit-impaired loans at December 31, 2010 and 2009 was $12.6 million and $29.2 million, respectively, representing non-AMCORE transactions because AMCORE loans were classified accreting based on subsequent evaluations of expected cash flows.
 
The following table reflects the changes in the allowance for loan losses associated with purchased credit-impaired loans and other acquired loans.
 
         
    2010  
    (In thousands)  
 
Balance, beginning of year
  $ 6,679  
Provisions charged to expense
    2,018  
Reductions
    (4,047 )
Losses partially recoverable under loss share agreement
    8,072  
         
Balance, end of year
  $ 12,722  
         


65


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
4.   Allowance for Loan Losses
 
The changes in the allowance for loan losses are as follows:
 
                         
    Years Ended December 31  
    2010     2009     2008  
    (In thousands)  
 
Balance, beginning of year
  $ 680,782     $ 574,224     $ 367,525  
Charge-offs
    (373,997 )     (510,773 )     (462,256 )
Recoveries
    78,503       72,918       48,160  
                         
Net charge-offs
  $ (295,494 )   $ (437,855 )   $ (414,096 )
Provisions charged to expense
    312,741       544,413       589,108  
Acquired reserves from acquisition
                31,687  
Losses partially recoverable under loss share agreement
    8,072              
                         
Balance, end of year
  $ 706,101     $ 680,782     $ 574,224  
                         
 
The following table presents details on impaired loans and the related allowance. The table does not include purchased impaired loans that are recognized in accordance with ASC 310-30.
 
                         
    Impaired Loans
    Impaired Loans
       
    for Which There
    for Which There
    Total
 
    is a Related
    is No Related
    Impaired
 
    Allowance     Allowance     Loans  
    (In thousands)  
 
December 31, 2010
                       
Balance
  $ 220,419     $ 186,168     $ 406,587  
Related allowance
    99,936             99,936  
                         
Balance, net of allowance
  $ 120,483     $ 186,168     $ 306,651  
                         
December 31, 2009
                       
Balance
  $ 128,665     $ 130,260     $ 258,925  
Related allowance
    58,479             58,479  
                         
Balance, net of allowance
  $ 70,186     $ 130,260     $ 200,446  
                         
 
                 
    Years Ended December 31  
    2010     2009  
    (In thousands)  
 
Average impaired loans
  $ 324,093     $ 401,150  
                 
Total interest income on impaired loans recorded on a cash basis
  $ 4,811     $ 4,743  
                 
 
The reserve for off-balance-sheet credit losses was $16.1 million and $6.0 million at December 31, 2010 and 2009, respectively. The reserve is recorded in other liabilities on the Consolidated Statements of Condition.


66


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
5.   Premises and Equipment
 
Premises and equipment are stated at cost less accumulated depreciation and amortization. A summary of these accounts is set forth below:
 
                 
    December 31  
    2010     2009  
    (In thousands)  
 
Land
  $ 107,840     $ 104,370  
Buildings
    328,188       325,559  
Computer equipment and software
    517,673       501,767  
Other equipment
    94,207       111,514  
Leasehold improvements
    99,853       99,035  
                 
Total
  $ 1,147,761     $ 1,142,245  
Accumulated depreciation and amortization
    600,194       615,622  
                 
Premises and equipment
  $ 547,567     $ 526,623  
                 
 
Depreciation and amortization expense was $71.9 million in 2010, $67.2 million in 2009 and $69.9 million in 2008.
 
The Bank recognized gains in noninterest income of $0.9 million in 2010 and $2.6 million in 2009 and losses in noninterest income of $0.4 million in 2008 from the sale of property previously held for use.
 
6.   Goodwill and Other Intangible Assets
 
The Bank records acquisitions by allocating the purchase price paid to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their fair values at the date of acquisition. Any excess of the amount paid over the fair value of those net assets is considered to be goodwill.
 
Goodwill is not amortized; however, it is assessed for impairment at least annually. The impairment test consists of allocating goodwill to the Bank’s reporting units (groups of businesses with similar characteristics) and then comparing the book value of the reporting units, including goodwill, to their fair values. Fair value is determined primarily using discounted cash flows. If the carrying value of a reporting unit is determined to be in excess of its fair value, a second test is required to measure the amount of impairment. There were no write-downs of goodwill due to impairment during the years ended December 31, 2010, 2009 and 2008.
 
The valuation of goodwill requires significant management judgment. Management makes estimates and assumptions in performing goodwill impairment analyses and actual results could differ from the estimates. While the potential impact from a noncash goodwill impairment loss could be material, such a charge would not affect the ongoing operation of the Bank, its liquidity or its regulatory Tier 1 capital or total capital ratios since goodwill is generally excluded from regulatory capital.
 
Changes in the carrying amount of the Bank’s goodwill for the years ended December 31, 2010 and 2009 are included in the following table:
 
                 
    2010     2009  
    (In thousands)  
 
Goodwill at beginning of year
  $ 705,291     $ 689,158  
Acquisitions during the year
    84,572       17,807  
Other(1)
    (6,553 )     (1,674 )
                 
Goodwill at end of year
  $ 783,310     $ 705,291  
                 


67


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
 
(1) Includes the effect of accounting adjustments related to non-current year acquisitions.
 
There were no write-downs of intangible assets due to impairment during the years ended December 31, 2010, 2009 and 2008.
 
The total amount of intangible assets acquired during the year ended December 31, 2010 is $22.4 million (see Note 23 to the Consolidated Financial Statements for additional information on intangible assets acquired). The weighted-average amortization periods for intangible assets acquired during 2010 are as follows: 9.9 years for core deposit premium and 12.9 years for a customer relationship intangible asset.
 
As of December 31, 2010 and 2009, the gross carrying amount and accumulated amortization of the Bank’s amortizable intangible assets are included in the following tables:
 
                         
    December 31, 2010  
    Gross Carrying
    Accumulated
    Net Carrying
 
 
  Amount     Amortization     Value  
    (In thousands)  
 
Branch network
  $ 145,000     $ (140,167 )   $ 4,833  
Core deposits
    167,833       (108,692 )     59,141  
Purchased credit card relationships
    46,311       (2,002 )     44,309  
Customer relationships
    4,300       (1,819 )     2,481  
Other
    1,310       (1,310 )      
                         
Total finite life intangibles
  $ 364,754     $ (253,990 )   $ 110,764  
                         
 
                         
    December 31, 2009  
    Gross Carrying
    Accumulated
    Net Carrying
 
    Amount     Amortization     Value  
    (In thousands)  
 
Branch network
  $ 145,000     $ (130,500 )   $ 14,500  
Core deposits
    124,924       (73,631 )     51,293  
Purchased credit card relationships
    44,340             44,340  
Customer relationships
    3,000       (917 )     2,083  
Other
    1,310       (1,310 )      
                         
Total finite life intangibles
  $ 318,574     $ (206,358 )   $ 112,216  
                         
 
Total amortization expense for the Bank’s intangible assets was $26.0 million, $25.4 and $27.9 million in 2010, 2009 and 2008, respectively.


68


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
At December 31, 2010, estimated intangible asset amortization expense for existing intangible assets, excluding mortgage servicing rights, in each of the next five years and thereafter is as follows:
 
         
Year
  Amount  
    (In thousands)  
 
2011
  $ 24,070  
2012
    19,520  
2013
    16,821  
2014
    13,459  
2015
    9,881  
Thereafter
    27,013  
         
Total
  $ 110,764  
         
 
Mortgage servicing rights
 
The Bank engages in the servicing of mortgage loans and acquires mortgage servicing rights (“MSR”) by purchasing or originating mortgage loans and then selling those loans with servicing rights retained. The Bank initially records MSR at estimated fair value and then measures the MSR using the amortization method. Fair value of MSR is estimated using discounted cash flow analyses. The analyses consider portfolio characteristics, servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenues, costs to service and other economic factors such as levels of supply and demand for servicing and interest rate trends. The estimated fair value of MSR is sensitive to changes in interest rates, including their effect on prepayment speeds. Prepayment assumptions are based on dealer consensus prepayment estimates and adjusted for geographical factors. The Bank stratifies its portfolio on the basis of loan type, term and origination date. MSR are amortized in proportion to, and over the period of, estimated net servicing income. MSR are periodically evaluated for impairment (and subsequent write-down) based on the fair value of those rights.
 
Serviced loans were $3.7 billion and $3.6 billion at December 31, 2010 and 2009, respectively. Servicing fees, late fees and ancillary fees are recorded in other noninterest income and totaled $9.0 million, $7.9 million and $6.5 million in 2010, 2009 and 2008, respectively. As additions to MSR from loan sales are recorded, income from these sales is recognized as other noninterest income Amortization of MSR is recorded to other noninterest expense. MSR impairment is recognized as other noninterest expense through a valuation allowance to the extent that the carrying value exceeds estimated fair value.


69


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Changes in the carrying amount of the Bank’s MSR for the years ended December 31, 2010, 2009 and 2008 are included in the following table:
 
                         
    2010     2009     2008  
    (In thousands)  
 
MSR at beginning of year
  $ 30,598     $ 22,063     $ 17,813  
Originations
    8,426       14,309       4,690  
Acquired in acquisitions
                4,195  
Disposals
                (249 )
Amortization
    (6,842 )     (5,774 )     (4,386 )
                         
MSR at end of year
  $ 32,182     $ 30,598     $ 22,063  
                         
Valuation allowance at beginning of year
  $     $     $  
Addition, net
    3,898              
                         
Valuation allowance at end of year
  $ 3,898     $     $  
                         
MSR, net
  $ 28,284     $ 30,598     $ 22,063  
                         
Fair value at beginning of year
  $ 31,210     $ 26,129     $ 22,721  
Fair value at end of year
    30,526       31,210       26,129  
 
7.   Deposits
 
The following table summarizes deposit balances by category:
 
                 
    December 31  
    2010     2009  
    (In thousands)  
 
Demand deposits
  $ 9,204,496     $ 9,704,773  
Demand deposits in foreign offices
    2,718,059        
Interest-bearing checking deposits
    281,266       236,172  
Money market accounts
    13,497,676       10,728,563  
Statement savings accounts
    2,391,755       2,233,326  
Savings certificates
    5,512,334       5,003,757  
Time deposits
    1,338,347       766,240  
Time deposits in foreign offices
    1,518,884       1,622,410  
                 
Total deposits
  $ 36,462,817     $ 30,295,241  
                 
 
At December 31, 2010, the scheduled maturities of total time deposits are as follows:
 
         
Year
  Amount  
    (In thousands)  
 
2011
  $ 5,723,912  
2012
    750,579  
2013
    416,591  
2014
    312,566  
2015
    351,852  
Thereafter
    814,065  
         
Total
  $ 8,369,565  
         


70


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Time deposits, including certificates of deposit, in denominations of $100,000 or more issued by domestic offices totaled $2.5 billion and $2.9 billion at December 31, 2010 and 2009, respectively. All time deposits in foreign offices were in denominations of $100,000 or more and totaled $1.5 billion and $1.6 billion at December 31, 2010 and 2009, respectively.
 
The Bank issues structured interest rate certificates of deposit and records these instruments at fair value, consistent with the election allowed under GAAP. The Bank enters into interest rate derivatives, which manage exposure to changes in the fair value of structured certificates of deposit caused by changes in interest rates. Structured interest rate certificates of deposit may have callable features that provide for higher returns to the investor, step-up features that provide for one or more increases in the interest rate, adjustments to the interest rate based on a predetermined benchmark rate or a link to the performance of a reference index. The Bank also issues structured certificates of deposit that are interest rate, equity-linked, foreign currency-linked, debt-linked and commodity-linked and the Bank holds equity derivatives and foreign exchange derivatives and commodity derivates in order to economically hedge changes in the fair value of the structured certificates of deposit. See Note 12 to the Consolidated Financial Statements for additional information on derivatives. The Bank elected the fair value option for all of the structured certificates of deposit in order to align the economic impact of changes in fair value of the structured certificates of deposits with the related derivative instruments. See Note 10 to the Consolidated Financial Statements for additional information on fair value measurements. The structured certificates of deposit are classified as deposits and interest is measured based on contractual interest rates and recorded as interest expense. At December 31, 2010, the fair value of the structured certificates of deposit was $3.5 million greater than the principal balance of $1.3 billion. At December 31, 2009, the fair value and principal balance of the structured certificates of deposit were $707.4 million and $706.9 million, respectively. The impact of recording the structured certificates of deposit at fair value was a decrease in noninterest revenue of $6.5 million for the year ended December 31, 2010 and an increase in noninterest revenue of $1.2 million for year ended December 31, 2009. There was no change in fair value attributable to changes in the Bank’s credit risk for the years ended December 31, 2010 and 2009.
 
8.   Securities Purchased Under Agreement to Resell, Securities Sold Under Agreement to Repurchase, Federal Funds, Commercial Paper and Securities Lending Activities
 
The Bank enters into purchases of securities, primarily U.S. Treasury and Federal agency securities under agreements to resell identical securities. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the Consolidated Statements of Condition. Securities purchased under agreement to resell totaled $1.2 billion and $145.0 million at December 31, 2010 and 2009, respectively.
 
The Bank also enters into sales of securities, primarily U.S. Treasury and Federal agency securities under agreements to repurchase identical securities. The amounts received under these agreements represent short-term borrowings and are reflected as liabilities in the Consolidated Statements of Condition. Securities sold under agreement to repurchase totaled $864.9 million and $2.5 billion at December 31, 2010 and 2009, respectively.
 
The Bank monitors the market value of the securities on a daily basis and adjusts the level of collateral, as appropriate. The Bank’s policy is to take possession of securities purchased under agreements to resell.
 
The Bank purchases and sells federal funds to other banks, typically in unsecured transactions. Federal funds sold are recorded as assets and federal funds purchased are recorded as liabilities in the Consolidated Statements of Condition. Federal funds sold totaled $9.5 million and $30.0 million at December 31, 2010 and 2009, respectively. Federal funds purchased totaled $194.3 million and $236.1 million at December 31, 2010 and 2009, respectively.


71


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
9.   Long-Term Notes
 
The following table summarizes the Bank’s long-term notes:
 
                         
    December 31          
    2010     2009    
Rate
  Reprice
    (In thousands)          
 
Floating rate senior note to BMO subsidiary due June 13, 2011
  $ 746,500     $ 746,500     14bps + 90 day LIBOR   Quarterly
Floating rate senior note to BMO branch due August 14, 2012
    1,100,000       1,100,000     14bps + 90 day LIBOR   Quarterly
Floating rate senior note to BMO subsidiary due September 29, 2011
    550,000       550,000     14bps + 90 day LIBOR   Quarterly
                         
Total long-term notes — senior/unsecured
  $ 2,396,500     $ 2,396,500          
                         
Floating rate secured note to FHLB due October 30, 2017
  $ 1,000,000     $ 1,000,000     30 day LIBOR   Monthly
Floating rate secured note to FHLB due November 13, 2017
    500,000       500,000     30 day LIBOR   Monthly
Floating rate secured note to FHLB due November 28, 2017
    500,000       500,000     30 day LIBOR   Monthly
Floating rate secured note to FHLB due February 20, 2018
    375,000       375,000     30 day LIBOR   Monthly
                         
Total long-term notes — senior/secured
  $ 2,375,000     $ 2,375,000          
                         
Floating rate subordinated note to Bankcorp due December 23, 2012
  $     $ 28,500     50bps + 90 day LIBOR   Quarterly
Floating rate subordinated note to Bankcorp due May 30, 2013
          34,000     50bps + 90 day LIBOR   Quarterly
Floating rate subordinated note to Bankcorp due November 26, 2013
          24,000     50bps + 90 day LIBOR   Quarterly
Floating rate subordinated note to Bankcorp due February 26, 2014
          6,250     50bps + 90 day LIBOR   Quarterly
Floating rate subordinated note to Bankcorp due May 31, 2014
    100,000       100,000     35bps + 90 day LIBOR   Quarterly
Floating rate subordinated note to Bankcorp due May 31, 2016
    100,000       100,000     38bps + 90 day LIBOR   Quarterly
                         
Total long-term notes — subordinated
  $ 200,000     $ 292,750          
                         
Total long-term notes
  $ 4,971,500     $ 5,064,250          
                         
 
At December 31, 2010 and 2009, the current portion of total long-term notes was $1.3 billion and zero, respectively.
 
The scheduled principal payments on long-term notes for the years ending December 31, 2011, 2012, 2013, 2014, 2015 and thereafter are $1.3 billion, $1.1 billion, $0, $100 million, $0 and $2.5 billion, respectively.
 
The Bank’s subordinated notes are unsecured obligations, ranking on parity with all unsecured and subordinated indebtedness of the Bank. The Bank’s notes are prepayable at any time at the option of the Bank, subject to regulatory approval. In addition, both the Bank and the notes’ holder may extend maturity of the notes for up to five years subject to approval. At year-end 2010, 30-day and 90-day LIBOR rates were 0.26 percent and 0.30 percent, respectively.


72


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The interest rate on the long-term secured notes due from HNA to the Federal Home Loan Bank of Chicago (“FHLB”) reprices monthly at 30 day LIBOR, with a weighted average rate of 0.27 percent at December 31, 2010. The notes are not prepayable. At December 31, 2010 and 2009, first mortgage loans on 1-4 family homes with a carrying value of $3.3 billion and $4.5 billion, respectively, were pledged to secure these borrowings.
 
The Bank offers to institutional investors from time to time, unsecured short-term and medium-term bank notes in an aggregate principal amount of up to $1.5 billion outstanding at any time. The term of each note could range from 14 days to 15 years. These senior notes are subordinated to deposits and rank on parity as per above with all other unsecured senior indebtedness of the Bank. There were no notes outstanding as of December 31, 2010 or 2009
 
10.   Fair Value of Financial Instruments and Fair Value Measurements
 
Fair Value of Financial Instruments
 
FASB ASC 825, “Financial Instruments”, requires the disclosure of estimated fair values for both on and off-balance-sheet financial instruments. The Bank’s fair values are based on quoted market prices when available. For financial instruments not actively traded, such as certain loans, deposits, off-balance-sheet transactions and long-term borrowings, fair values have been estimated using various valuation methods and assumptions. The fair value estimates presented herein are not necessarily indicative of the amounts the Bank could realize in an actual transaction. The fair value estimation methodologies employed by the Bank were as follows:
 
Fair value was assumed to equal carrying value for cash and demand balances due from banks along with short-term money market assets and liabilities (including interest-bearing deposits at banks, Federal funds sold, Federal funds purchased, securities purchased under agreement to resell and securities sold under agreement to repurchase), securities borrowed and loaned, accrued interest receivable and payable, commercial paper outstanding, short-term borrowings and short-term senior notes due to their short term nature.
 
The fair value of trading account assets and liabilities, securities available-for-sale, and derivative assets and liabilities and the methods used to determine fair value are provided in the Fair Value Measurements section of this Note.
 
Changes in estimated fair value of loans reflect changes in credit risk and general interest rates which have occurred since the loans were originated. Fair value of floating rate loans was assumed to equal carrying value since the loans’ interest rates automatically reprice to market. Fair value of residential mortgages was based on current prices for securities backed by similar loans. For other fixed rate loans, fair value was estimated based on future cash flows discounted at current rates at which the Bank would have originated the loan at December 31. Additionally, management considered estimated values of collateral for nonperforming loans secured by real estate. The estimated fair values are not intended to represent estimated exit price fair values as defined under ASC 820.
 
The fair value of loans held for sale was based on current mortgage-backed security prices corresponding to the mortgage loan pools. See the Fair Value Measurements section of this Note for additional information on the methods used to determine fair value.
 
The fair value of demand deposits, savings accounts, interest-bearing checking deposits, and money market accounts was the amount payable on demand at the reporting date, or the carrying amount. The fair value of time deposits was estimated using a discounted cash flow calculation at current market rates offered by the Bank. See the Fair Value Measurements section of this Note for information on the fair value of structured certificates of deposits for which the fair value option has been elected.
 
The fair value of floating rate long-term notes was assumed to equal carrying value since the notes’ interest rates automatically reprice to market. The fair value of fixed rate junior subordinated notes was estimated using a discounted cash flow calculation at current market rates.


73


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The fair values of loan commitments and standby letters of credit approximates their carrying value (i.e. deferred income) or estimated cost that would be incurred to induce third parties to assume these commitments.
 
The estimated fair values of the Bank’s financial instruments at December 31, 2010 and 2009 are presented in the following table. See Note 11 to the Consolidated Financial Statements for additional information regarding fair values of off-balance-sheet financial instruments, Note 12 for additional information regarding fair values of derivatives and Note 7 for additional information on the fair value option elected for certain certificates of deposit.
 
                                 
    December 31  
    2010     2009  
    Carrying
    Fair
    Carrying
    Fair
 
    Value     Value     Value     Value  
          (In thousands)        
 
Assets
                               
Cash and demand balances due from banks
  $ 734,907     $ 734,907     $ 904,865     $ 904,865  
Money market assets:
                               
Interest-bearing deposits at banks
    15,014,090       15,014,090       9,231,581       9,231,581  
Federal funds sold and securities purchased under agreement to resell
    1,255,313       1,255,313       174,979       174,979  
Securities available-for-sale
    5,674,981       5,674,981       5,898,831       5,898,831  
Trading account assets
    866,719       866,719       1,113,460       1,113,460  
Loans, net of unearned income and allowance for loan losses
    21,666,564       21,805,208       22,494,935       22,661,518  
Accrued interest receivable
    88,893       88,893       29,974       30,553  
Loans held for sale
    29,915       30,223       105,169       105,169  
Derivative instruments
    298,532       298,532       254,417       254,417  
                                 
Total on-balance-sheet financial assets
  $ 45,629,914     $ 45,768,866     $ 40,208,211     $ 40,375,373  
                                 
Liabilities
                               
Deposits:
                               
Demand deposits
  $ 28,093,252     $ 28,093,252     $ 22,902,834     $ 22,902,834  
Time deposits
    8,369,565       8,446,864       7,392,407       7,507,644  
Federal funds purchased
    194,251       194,251       236,099       236,099  
Securities sold under agreement to repurchase
    864,918       864,918       2,512,490       2,512,490  
Short-term borrowings
    1,427,794       1,427,794       717,050       717,050  
Derivative instruments
    432,289       432,289       387,517       387,517  
Trading account liabilities
    74,033       74,033       144,657       144,657  
Accrued interest payable
    23,904       23,904       24,681       24,681  
Long-term notes — senior/unsecured
    2,396,500       2,396,500       2,396,500       2,396,500  
Long-term notes — senior/secured
    2,375,000       2,375,000       2,375,000       2,375,000  
Long-term notes — subordinated
    200,000       200,000       292,750       292,750  
                                 
Total on-balance-sheet financial liabilities
  $ 44,451,506     $ 44,528,805     $ 39,381,985     $ 39,497,222  
                                 
Off-Balance-Sheet Credit Facilities ((obligations)/positive positions)
                               
Loan commitments
  $ 11,961     $ 11,961     $ 24,063     $ 24,063  
Standby letters of credit
    (1,520 )     (1,520 )     (1,775 )     (1,775 )
                                 
Total off-balance-sheet credit facilities
  $ 10,441     $ 10,441     $ 22,288     $ 22,288  
                                 


74


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Assets and liabilities measured at fair value on a recurring basis are presented in the following table:
 
                                 
    December 31, 2010  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Level 3     Fair Value  
    (In thousands)  
 
Assets
                               
Securities available-for-sale
                               
U.S. Treasury
  $ 388,763     $     $     $ 388,763  
U.S. government agency
          1,996,345             1,996,345  
U.S. government sponsored mortgage-backed
          650,382             650,382  
State and municipal
          1,586,744       13,727       1,600,471  
Non-mortgage asset backed
          727,674       774       728,448  
Foreign corporate debt securities
    300,069                   300,069  
Foreign government debt securities
          250             250  
Corporate debt securities
          10,253             10,253  
Other
                       
                                 
Total securities available — for — sale
  $ 688,832     $ 4,971,648     $ 14,501     $ 5,674,981  
                                 
Trading account assets
                               
U.S. government agency
  $     $ 830,016     $     $ 830,016  
Corporate debt securities
          36,703             36,703  
                                 
Total trading account assets
  $     $ 866,719     $     $ 866,719  
                                 
Derivative instruments
                               
Trading derivatives
                               
Interest rate contracts
  $     $ 268,990     $ 3,312     $ 272,302  
Foreign exchange contracts
          13,389             13,389  
Equity contracts
          156,701             156,701  
                                 
Total derivative instruments
  $     $ 439,080     $ 3,312     $ 442,392  
                                 
Total assets
  $ 688,832     $ 5,410,728     $ 17,813     $ 6,984,092  
                                 
Liabilities
                               
Structured CDs (included in interest-bearing deposits)
  $     $ 1,307,774     $     $ 1,307,774  
Trading account liabilities (included in other liabilities)
                               
U.S. Treasury
    74,033                   74,033  
Derivative instruments (included in other liabilities)
                               
Trading derivatives
                               
Interest rate contracts
          293,827       14       293,841  
Foreign exchange contracts
          12,924             12,924  
Equity contracts
          127,212             127,212  
Commodity contracts
          637             637  
Hedging derivatives
                               
Interest rate contracts/cash flow hedges
          139,389             139,389  
                                 
Total derivative instruments
  $     $ 573,989     $ 14     $ 574,003  
                                 
Total liabilities
  $ 74,033     $ 1,307,774     $     $ 1,955,810  
                                 
 


75


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                                 
    December 31, 2009  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Level 3     Fair Value  
    (In thousands)  
 
Assets
                               
Securities available-for-sale
                               
U.S. Treasury
  $ 40,249     $     $     $ 40,249  
U.S. government agency
          2,884,429             2,884,429  
U.S. government sponsored mortgage-backed
          733,647             733,647  
State and municipal
          1,561,800       28,892       1,590,692  
Non-mortgage asset backed
          5       44,721       44,726  
Foreign government debt securities
          501,940             501,940  
Other
          103,148             103,148  
                                 
Total securities available-for-sale
  $ 40,249     $ 5,784,969     $ 73,613     $ 5,898,831  
Trading account assets
          1,113,460             1,113,460  
Derivative instruments
          253,010       1,407       254,417  
                                 
Total assets
  $ 40,249     $ 7,151,439     $ 75,020     $ 7,266,708  
                                 
Liabilities
                               
Structured CDs (included in interest-bearing deposits)
  $     $ 707,435     $     $ 707,435  
Trading account liabilities (included in other liabilities)
    144,657                   144,657  
Derivative instruments (included in other liabilities)
          387,414       103       387,517  
                                 
Total liabilities
  $ 144,657     $ 1,094,849     $ 103     $ 1,239,609  
                                 

76


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The following table presents changes in Level 3 assets and liabilities:
 
                                         
    Trading
    Securities
                Commitment
 
    Account
    Available-
    Derivative
    Derivative
    to Purchase
 
    Assets     for-sale     Assets     Liabilities     ARS  
    (In thousands)  
 
Fair value at January 1, 2009
  $     $ 55,060     $ 2,433     $ 852     $ 2,015  
Realized and unrealized gains and losses included in earnings(1)
          1,397       12,055       (749 )      
Unrealized gains and losses included in OCI
          20,706                    
Purchases, sales, issuances, settlements
          (3,550 )     (13,081 )           (2,015 )
                                         
Fair value at December 31, 2009
  $     $ 73,613     $ 1,407     $ 103     $  
                                         
Gains and losses included in earnings related to assets and liabilities held at December 31, 2009
  $     $ 1,796     $ 1,407     $ (103 )   $  
                                         
Fair value at January 1, 2010
  $     $ 73,613     $ 1,407     $ 103     $  
Realized and unrealized gains and losses included in earnings(1)
          1,909       16,312       (89 )      
Unrealized gains and losses included in OCI
          (12,236 )                  
Purchases, sales, issuances, settlements
          (48,785 )     (14,407 )            
                                         
Fair value at December 31, 2010
  $     $ 14,501     $ 3,312     $ 14     $  
                                         
Gains and losses included in earnings related to assets and liabilities held at December 31, 2010
  $     $ (4,319 )   $ 3,312     $ (14 )   $  
                                         
 
 
(1) Included in trading income for trading account assets, net securities gains (losses) for AFS securities, and other noninterest income for derivative assets and liabilities.
 
Transfers of assets and liabilities between Level 1 and Level 2 for the year ended December 31, 2010 were not material.
 
Certain assets and liabilities are measured at fair value on a nonrecurring basis, such as assets carried at lower of cost or market. During 2010 and 2009, the Bank recorded adjustments to fair value for nonmarketable securities, certain impaired loans and other real estate owned. The fair values of nonmarketable securities are generally estimated using financial performance results and forecasts and are classified as Level 3. Fair value adjustments are not recorded for these securities if there are not identified events or changes in circumstances that may have a significant adverse effect on their fair value. The fair values of certain impaired loans, including those acquired in business combinations, are based on appraised values of supporting collateral and management’s estimates of realizable value and are classified Level 3. The fair values of other real estate owned are based on appraised values and management’s estimates of realizable value and are classified Level 3. The fair value of contingent consideration from recent business combinations is estimated using cash flow analyses and market growth assumptions and is classified as Level 3.


77


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The fair value measurements recorded at December 31, 2010 and 2009 for assets and liabilities measured at fair value on a nonrecurring basis are presented in the following tables:
 
                                 
    December 31, 2010  
    Fair Value Measurements Using  
    Level 1     Level 2     Level 3     Losses  
    (In thousands)  
 
Assets
                               
Nonmarketable securities (included in other assets)
  $     $     $ 1,077     $ 239  
Collateral-dependent impaired loans
                211,815       61,894  
Other real estate owned
                18,942       15,329  
                                 
Total assets
  $     $     $ 231,834     $ 77,462  
                                 
 
                                 
    December 31, 2009  
    Fair Value Measurements Using  
    Level 1     Level 2     Level 3     Losses  
    (In thousands)  
 
Assets
                               
Nonmarketable securities (included in other assets)
  $     $     $ 18,322     $ 1,350  
Collateral-dependent impaired loans
                204,956       39,083  
Other real estate owned
                9,240       603  
                                 
Total assets
  $     $     $ 232,518     $ 41,036  
                                 
 
11.   Financial Instruments with Off-Balance-Sheet Risk
 
The Bank utilizes various financial instruments with off-balance-sheet risk in the normal course of business to meet its customers’ financing and risk management needs. The Bank’s major categories of financial instruments with off-balance-sheet risk include credit facilities, financial guarantees and various securities-related activities.
 
Credit facilities
 
Credit facilities with off-balance-sheet risk include commitments to extend credit and commercial letters of credit.
 
Commitments to extend credit are contractual agreements to lend to a customer as long as contract terms have been met. They generally require payment of a fee and have fixed expiration dates or other termination clauses. The Bank’s commitments serve both business and individual customer needs, and include commercial loan commitments, home equity lines, commercial real estate loan commitments, mortgage loan commitments and credit card lines. The maximum potential amount of undiscounted future payments the Bank could be required to make is represented by the total contractual amount of commitments, which was $12.9 billion and $17.1 billion at December 31, 2010 and 2009, respectively. Since only a portion of commitments will ultimately be drawn down, the Bank does not expect to provide funds for the total contractual amount. Risks associated with certain commitments are reduced by participations to third parties, which were $37.5 million at December 31, 2010 and $149.6 million at December 31, 2009.
 
Qualifying residential mortgage loan commitments are considered derivative instruments and are recorded at fair value on the Bank’s Consolidated Statements of Condition. See Note 12 to the Consolidated Financial Statements for additional information on derivative instruments.
 
Commercial letters of credit are commitments to make payments on behalf of customers when letter of credit terms have been met. Maximum risk of accounting loss is represented by total commercial letters of credit


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
outstanding. Letters of credit outstanding were $6.6 million at December 31, 2010 and $7.9 million at December 31, 2009.
 
Credit risks associated with all of these facilities are mitigated by reviewing customers’ creditworthiness on a case-by-case basis, obtaining collateral, limiting loans to individual borrowers, setting restrictions on long-duration maturities and establishing stringent covenant terms outlining performance expectations which, if not met, may cause the Bank to terminate the contract. Credit risks are further mitigated by monitoring and maintaining portfolios that are well-diversified.
 
Collateral is required to support certain of these credit facilities when they are drawn down and may include equity and debt securities, commodities, inventories, receivables, certificates of deposit, savings instruments, fixed assets, real estate, life insurance policies and memberships on national or regional stock and commodity exchanges. Requirements are based upon the risk inherent in the credit and are more stringent for firms and individuals with greater default risks. The Bank monitors collateral values and appropriately perfects its security interest.
 
Letters of credit and commitments to extend credit are reviewed periodically for probable loss. Accruals for probable credit losses on letters of credit and commitments to extend credit are recorded in other liabilities on the Bank’s Consolidated Statements of Condition. The liability is increased or decreased by changes in estimates through noninterest expense and reduced by net charge-offs. The liability balance at December 31, 2010 was $16.1 million and $6.0 million at December 31, 2009. See Note 4 to the Consolidated Financial Statements for additional information on the liability for off-balance-sheet credit losses.
 
The fair value of credit facilities (i.e. deferred income net of deferred expense) approximates their carrying value of $12.0 million at December 31, 2010 and $24.1 million at December 31, 2009.
 
Financial Guarantees
 
Financial guarantees with off-balance-sheet risk include standby letters of credit loans sold with recourse and written put options.
 
Standby letters of credit are unconditional commitments which guarantee the obligation of a customer to a third party should that customer default. They are issued to support financial and performance-related obligations. At December 31, 2010 and 2009, the Bank’s maximum risk of accounting loss for these items is represented by the total commitments outstanding of $2.3 billion and $2.8 billion, respectively. Risks associated with standby letters of credit are reduced by participations to third parties which totaled $0.6 billion and $0.9 billion at December 31, 2010 and 2009, respectively. In most cases, these commitments expire within three years without being drawn upon. The fair value of standby letters of credit (i.e. deferred income) approximates their carrying value of $1.5 million at December 31, 2010 and $1.8 million at December 31, 2009.
 
The Bank sells residential mortgage loans with limited recourse. The recourse provisions require the Bank to reimburse the buyer upon the occurrence of certain credit-related events that typically include delinquency or foreclosure within certain time periods and losses based on pre-determined rates. The maximum amount payable under the limited recourse provisions was $149.2 million at December 31, 2010 and $165.9 million at December 31, 2009. The carrying amount of the recourse liability was $1.1 million at both December 31, 2010 and $1.4 million at December 31, 2009.
 
Written put options are contracts that provide the buyer the right (but not the obligation) to sell a financial instrument at a specified price, either within a specified period of time or on a certain date. The Bank writes put options, providing the buyer the right to require the Bank to buy the specified assets per the contract terms. The maximum amount payable for the written put options was equal to their notional amount of $1.2 billion and $835.7 million at December 31, 2010 and 2009, respectively. The fair value of the derivative liability was $54.0 million at December 31, 2010 and $36.0 million at December 31, 2009.


79


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Securities activities
 
The Bank’s securities activities that have off-balance-sheet risk include municipal bond underwriting and when-issued securities.
 
Through its municipal bond underwriting activities, the Bank commits to buy and offer for resale newly issued bonds. The Bank is exposed to market risk because it may be unable to resell its inventory of bonds profitably as a result of unfavorable market conditions. In syndicate arrangements, the Bank is obligated to fulfill syndicate members’ commitments should they default. The syndicates of which the Bank was a member had no underwriting commitments at December 31, 2010 and December 31, 2009.
 
The Bank trades securities that have been authorized for issuance but have not actually been issued (“when-issued” securities). Since market values are subject to change, the Bank is exposed to market and credit risk because it may incur a loss to replace a position if a counterparty defaults and market values have changed unfavorably for the counterparty. Changes in the fair value of commitments to purchase and sell when-issued securities are recognized in the current period. There was no commitment to purchase or sell securities on a when-issued basis at December 31, 2010 or 2009.
 
Commitments to Invest in Equity Securities
 
The Bank’s commitments to invest in non-marketable equity securities have off-balance-sheet risk related to the uncalled capital commitments. The Bank’s commitment to invest in equity securities was $30.3 million at December 31, 2010 and $37.1 million at December 31, 2009.
 
12.   Derivative Financial Instruments
 
Derivative instruments are financial contracts that derive their value from underlying changes in interest rates, foreign exchange (“FX”) rates or other financial or commodity prices or indices. Derivative instruments are either regulated exchange-traded contracts or negotiated over-the-counter contracts. The Bank uses various derivative financial instruments, primarily interest rate and foreign exchange derivative contracts, as part of its trading activities or in the management of its risk strategy.
 
All derivative instruments are recognized at fair value in the Consolidated Statements of Condition. Fair value represents point-in-time estimates that may change in subsequent reporting periods due to market conditions or other factors. See Note 10 to the Consolidated Financial Statements for additional information on fair value measurement. All derivative instruments are designated either as hedging or trading.
 
The Bank enters into derivative contracts with BMO to facilitate a more efficient use of combined resources and to better serve customers. See Note 25 to the Consolidated Financial Statements for additional information on related party transactions.
 
Types of Derivatives
 
Swaps
 
Swaps are contractual agreements between two parties to exchange a series of cash flows. The various swap agreements that the Bank may enter into are as follows:
 
Interest rate swaps — counterparties generally exchange fixed and floating rate interest payments based on a notional value in a single currency.
 
Cross-currency swaps — fixed rate interest payments and principal amounts are exchanged in different currencies.


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Cross-currency interest rate swaps — fixed and floating rate interest payments and principal amounts are exchanged in different currencies.
 
Commodity swaps — counterparties generally exchange fixed and floating rate payments based on a notional value of a single commodity.
 
Equity swaps — counterparties exchange the return on an equity security or a group of equity securities for the return based on a fixed or floating interest rate or the return on another equity security or a group of equity securities.
 
Total return swaps — one counterparty agrees to pay or receive from the other cash amounts based on changes in the value of a reference asset or group of assets, including any returns such as interest earned on these assets, in exchange for amounts that are based on prevailing market funding rates.
 
The main risks associated with these instruments are related to exposure to movements in interest rates, foreign exchange rates, credit quality, securities values or commodities prices, as applicable, and the possible inability of counterparties to meet the terms of the contracts.
 
Forwards and Futures
 
Forwards and futures are contractual agreements to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a specific price and at a specific future date. Forwards are customized contracts transacted in the over-the-counter market. Futures are transacted in standardized amounts on regulated exchanges and are subject to daily cash margining.
 
The main risks associated with these instruments arise from the possible inability of over-the-counter counterparties to meet the terms of the contracts and from movements in commodities prices, securities values, interest rates and foreign exchange rates, as applicable.
 
Options
 
Options are contractual agreements that convey to the buyer the right but not the obligation to either buy or sell a specified amount of a currency, commodity, interest-rate-sensitive financial instrument or security at a fixed future date or within a fixed future period. As a writer of options, the Bank receives a premium from the purchaser for accepting market risk. As a purchaser of options, the Bank pays a premium for the right to exercise the option. Since the Bank has no obligation to exercise the option, its primary exposure to risk is the potential credit risk if the writer of an over-the-counter contract fails to meet the terms of the contract.
 
Caps, collars and floors are specialized types of written and purchased options. They are contractual agreements where the writer agrees to pay the purchaser, based on a specified notional amount, the difference between the market rate and the prescribed rate of the cap, collar or floor. The writer receives a premium for selling this instrument.
 
Derivative-Related Risks
 
Over-the-counter derivative instruments are subject to credit risk arising from the possibility that counterparties may default on their obligations. The credit risk associated with derivatives is normally a small fraction of the notional amount of the derivative instrument. Derivative contracts generally expose the Bank to potential credit loss if changes in market rates affect a counterparty’s position unfavorably and the counterparty defaults on payment. Credit risk is represented by the positive fair value of the derivative instrument. Replacement risk, the primary component of credit risk, is the risk of loss should a counterparty default following unfavorable market movements and represents the Bank’s cost of replacing contracts that have a positive fair value using current market rates. The Bank strives to limit credit risk by dealing with counterparties that are considered to be creditworthy, and by managing credit risk for derivatives using the same credit risk process that is applied to loans. Netting agreements provide for netting of contractual receivables and payables and apply to situations where the Bank is


81


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
engaged in more than one outstanding derivative transaction with the same counterparty and also has a legally enforceable master netting agreement with that counterparty. Netting agreements also provide for the application of cash collateral received or paid against derivative assets or liabilities. The Bank’s derivative contracts with BMO are transacted under the terms of a master netting agreement. At December 31, 2010 and 2009, cash collateral was not exchanged between the parties to the master netting agreement. Exchange-traded derivatives have no potential for credit exposure as they are settled net with each exchange.
 
Derivative instruments are subject to market risk. Market risk arises from the potential for loss resulting from adverse changes in the value of derivative instruments as a result of changes in certain market variables. These variables include interest rates, foreign exchange rates, equity and commodity prices and their implied volatilities, as well as credit spreads, credit migration and default. The Bank strives to limit market risk by employing comprehensive governance and management processes for all market risk-taking activities.
 
Uses of Derivatives
 
Trading Derivatives
 
Trading derivatives include derivatives entered into with customers to accommodate their risk management needs, derivatives transacted to generate trading income from the Bank’s trading positions, and derivatives used in the management of the Bank’s risk strategy that do not qualify as hedges for accounting purposes (“economic hedges”).
 
Trading derivatives are marked to fair value. Realized and unrealized gains and losses are recognized in trading noninterest income in the Bank’s Consolidated Statements of Operations. Unrealized gains on trading derivatives are recorded as assets and unrealized losses are recorded as liabilities in the Bank’s Consolidated Statements of Condition.
 
The Bank and BMO combined their U.S. foreign exchange (“FX”) activities. Under this arrangement, FX net profit is shared by the Bank and BMO in accordance with a specific formula set forth in the agreement. This agreement expires on September 30, 2011 but may be extended at that time. Either party may terminate the arrangement at its option. FX revenues are reported net of expenses. During 2010, 2009 and 2008, foreign exchange revenues were $4.9 million, $11.5 million and $6.9 million, respectively, under this agreement.
 
At December 31, 2010 and 2009, approximately 92 and 95 percent, respectively, of the Bank’s gross notional positions in foreign currency contracts are represented by seven currencies: Euro, Canadian dollar, British pound, Australian dollar, Swedish krona, Japanese yen and the Mexican peso.
 
The Bank enters into risk participation agreements whereby it assumes credit risk on behalf of unrelated counterparties that arises from interest rate and foreign currency swap transactions. In a risk participation agreement, one counterparty pays the other a fee in exchange for the second counterparty agreeing to make a payment if a credit event, that is contingent on a swap transaction, occurs. The amount payable under an agreement is based on the market value of the swap at the time of the credit event. The notional amount of the risk participation agreements was $38.0 million and $148.1 million at December 31, 2010 and 2009, respectively. The contract matures within one year at December 31, 2010. The fair value of the derivative liabilities was $37 thousand at December 31, 2010 and $0.2 million at December 31, 2009.
 
Certain customers enter into lending transactions and derivative transactions with the Bank. BMO bears the risk of loss associated with the derivative obligations of those customers in the event of default.
 
The Bank has issued certain financial instruments containing embedded derivatives. The embedded derivatives are separated from the host contracts and recorded at fair value when the economic characteristics of the derivatives are not clearly and closely related to those of the host contracts. Embedded derivatives in certain of the Bank’s equity linked certificates of deposit are accounted for separately from the host instruments.


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The following derivatives are used in the management of the Bank’s risk strategy but do not qualify as hedges for accounting purposes.
 
The Bank has qualifying mortgage loan commitments that are intended to be sold in the secondary market. These loan commitments are derivatives and are recorded at fair value. The Bank enters into forward sales of mortgage-backed securities to minimize its exposure to interest rate volatility. These forward sales of mortgage-backed securities are also derivatives and are accounted for at fair value. Changes in fair value are recognized in other noninterest income in the Bank’s Consolidated Statements of Operations.
 
The Bank uses total return swaps to minimize exposure to currency exchange rate and equity price fluctuations associated with certain obligations under the mid-term incentive plan, which is a stock-based compensation plan. The swap contracts are derivatives and are accounted for at fair value. Changes in fair value are recognized in compensation expense in the Bank’s Consolidated Statements of Operations. See Note 15 to the Consolidated Financial Statements for additional information on stock-based compensation plans.
 
The Bank issues certificates of deposit that are structured interest rate, equity-linked, foreign currency-linked, debt-linked and commodity-linked under the fair value option and enters into interest rate, equity and foreign exchange derivatives to manage exposure to changes in the fair value of structured certificates of deposit. Changes in fair value of the certificates of deposit and the derivatives are recognized in trading noninterest income in the Bank’s Consolidated Statements of Operations. See Note 7 to the Consolidated Financial Statements for additional information on structured certificates of deposit.
 
Hedging Derivatives
 
In accordance with its risk management strategy, the Bank enters into various derivative contracts to hedge its interest rate exposures.
 
The Bank uses interest rate contracts, primarily swaps, to reduce the level of financial risk inherent in mismatches between the interest rate sensitivities of certain assets and liabilities. The risk management strategy incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that may be caused by interest rate volatility. The Bank manages interest rate sensitivity by modifying the repricing or maturity characteristics of certain assets and liabilities so that net interest margin is not adversely affected, on a material basis, by movements in interest rates. As a result of interest rate fluctuations, fixed rate assets will appreciate or depreciate in market value. The effect of the unrealized appreciation or depreciation will generally be offset by the gains or losses on the derivative instruments.
 
Hedge Accounting
 
Cash Flow Hedges
 
Cash flow hedges modify exposure to variability in cash flows for variable rate, interest bearing instruments. The Bank’s cash flow hedges, which have a maximum term of 6.9 years at December 31, 2010, are hedges of floating rate loans, available-for-sale securities and long-term debt obligations.


83


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
To the extent that changes in the fair value of the derivative offset changes in the fair value of the hedged item, they are recorded in other comprehensive income. Any portion of the change in fair value of the derivative that does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge) is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.
 
For cash flow hedges that are discontinued before the end of the original hedge term, the unrealized gain or loss in accumulated other comprehensive income is amortized to interest income/expense in the Bank’s Consolidated Statements of Operations consistent with how the hedged item affects earnings. If the hedged item is sold or settled, the entire unrealized gain or loss is recognized in interest income/expense in the Bank’s Consolidated Statements of Operations. At December 31, 2010, the amount of other comprehensive income that is expected to be reclassified to interest income/expense in the Bank’s Consolidated Statements of Operations over the next 12 months is $3.8 million.
 
Fair Value Hedges
 
Fair value hedges modify exposure to changes in a fixed rate instrument’s fair value caused by changes in interest rates. The hedges convert fixed rate assets and liabilities to floating rate. The Bank’s fair value hedges include hedges of fixed rate available-for-sale securities and deposits.
 
For fair value hedges, the hedging derivative is recorded at fair value and the related hedge item, either fixed rate assets or liabilities, is adjusted for the changes in value of the risk being hedged. To the extent that the change in the fair value of the derivative does not offset changes in the fair value of the hedged item (the ineffectiveness of the hedge), the net amount is recorded directly in other noninterest income in the Bank’s Consolidated Statements of Operations.
 
For fair value hedges that are discontinued, the Bank stops adjusting the hedged item for changes in fair value that are attributable to the hedged risk. The fair value adjustment of the hedged item is amortized to the interest income/expense on the hedged item over its remaining term to maturity. If the hedged item is sold or settled, any remaining fair value adjustment is included in the determination of the gain or loss on sale or settlement.
 
The following table presents the impact of fair value hedges on the Bank’s financial results.
 
                 
    Pretax gain (loss)
 
    recorded
 
    in other noninterest
 
    income  
    2010     2009  
    (In thousands)  
 
Hedging derivatives:
               
Interest rate contracts
  $     $ (1,655 )
Hedged items:
               
Fixed rate AFS securities
          (2,701 )
Fixed rate deposits
          1,370  
 
The following table presents the impact of cash flow hedges on the Bank’s financial results.
 
                                                 
        Ineffective portion of
  Reclassification of gain
    Effective portion of
  gain (loss) recorded in
  (loss) from AOCI to
    pre-tax gain (loss)
  other noninterest
  interest income or
    recorded in OCI   income   interest expense
    2010   2009   2010   2009   2010   2009
    (In thousands)   (In thousands)   (In thousands)
 
Interest rate contracts
  $ 40     $ 66,722     $     $ (2 )   $ (6,096 )   $ (9,849 )


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The revenue from trading derivative instruments is presented below.
 
                     
    2010     2009    
Location of gain (loss) recognized in income
    (In thousands)      
 
Interest rate contracts
  $ 14,850     $ 1,710     Net money market, bond and derivative trading income
Interest rate contracts
    1,994       (277 )   Other non-interest income
Foreign exchange contracts
    4,866       11,465     Foreign exchange trading gains, net
Equity contracts
    25,019       10,165     Net money market, bond and derivative trading income
Equity contracts
    2,733       18,646     Salaries and other compensation expense
Commodity contracts
    305           Net money market, bond and derivative trading income
                     
Total
  $ 49,767     $ 41,709      
                     
 
The fair value of the Bank’s derivative instruments are as follows at December 31:
 
                                 
    Gross Assets     Gross Liabilities  
    2010     2009     2010     2009  
    (In thousands)     (In thousands)  
 
Trading derivatives(1):
                               
Interest rate contracts
  $ 272,302     $ 288,830     $ 293,841     $ 294,733  
Foreign exchange contracts
    13,389       12,435       12,924       12,176  
Equity contracts
    156,701       36,176       127,212       25,482  
Commodity contracts
                637        
Hedging derivatives(2):
                               
Interest rate contracts/cash flow hedges
          12,960       139,389       153,040  
                                 
Total fair value
  $ 442,392     $ 350,401     $ 574,003     $ 485,431  
                                 
 
 
(1) Trading derivatives are recorded in trading account assets and derivative instruments and in other liabilities.
 
(2) Hedging derivatives are recorded in other assets and other liabilities.
 
The notional amounts of the Bank’s derivative instruments are as follows at December 31:
 
                 
    2010     2009  
    (In thousands)  
 
Trading derivatives:
               
Interest rate contracts
  $ 18,000,087     $ 12,443,474  
Foreign exchange contracts
    620,865       1,366,632  
Equity contracts
    1,403,263       816,666  
Commodity contracts
    5,416        
Hedging derivatives:
               
Interest rate contracts/cash flow hedges
    2,221,000       3,381,000  
                 
Total
  $ 22,250,631     $ 18,007,772  
                 


85


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
13.   Concentrations of Credit Risk in Financial Instruments
 
The Bank had one major concentration of credit risk arising from financial instruments at December 31, 2010 and 2009. This concentration was the Midwest geographic area. This concentration exceeded 10 percent of the Bank’s total credit exposure, which is the total potential accounting loss should all customers and counterparties fail to perform according to contract terms and all collateral prove to be worthless.
 
Midwestern geographic area
 
A majority of the Bank’s customers and counterparties are located in the Midwestern region of the United States, defined here to include Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Ohio and Wisconsin. The Bank has credit exposure to these customers and counterparties through a broad array of banking and trade financing products including loans, loan commitments, standby and commercial letters of credit, investment securities and banker’s acceptances. The financial viability of customers and counterparties in the Midwest is, in part, dependent on the region’s economy. The Midwestern concentration was approximately $44.5 billion or 72 percent of the Bank’s total credit exposure at December 31, 2010 and $41.5 billion or 69 percent of the Bank’s total credit exposure at December 31, 2009.
 
The Bank manages this exposure by continually reviewing local market conditions and customers and counterparties, adjusting individual and industry exposure limits within the region and by obtaining or closely monitoring collateral values. See Note 11 to the Consolidated Financial Statements for information on collateral supporting credit facilities.
 
14.   Employee Benefit Plans
 
The Bank sponsors noncontributory defined benefit pension plans covering virtually all the Bank’s employees as of December 31, 2010. Most of the employees participating in retirement plans are included in one primary plan (“plan”). The plan is a multiple-employer plan covering the Bank’s employees as well as persons employed by certain affiliated entities.
 
Certain employees participating in the primary plan are also covered by a supplemental unfunded retirement plan. The purpose of the supplemental plan is to extend full retirement benefits to individuals without regard to statutory limitations for qualified funded plans.
 
Effective January 1, 2002, the plan’s benefit formula for new employees was changed to an account-based formula from a final average pay formula. The account-based benefit formula is based upon eligible pay, age and length of service. Prior to January 1, 2002, the plan’s benefit formula was a final average pay formula, based upon length of service and an employee’s highest qualifying compensation during five consecutive years of active employment less an amount determined by formula using an estimated Social Security benefit. For employees who were employed as of December 31, 2001 and leave the Bank on or after January 1, 2002, benefits are initially calculated two ways: under the account-based formula for service beginning January 1, 2002 and under the final average pay formula for all service. This latter group of employees will receive that retirement benefit which yields the highest return.
 
The policy for this plan is to have the participating entities, at a minimum, fund annually an amount necessary to satisfy the requirements under the Employee Retirement Income Security Act (“ERISA”), without regard to prior years’ contributions in excess of the minimum. For 2011 (plan year 2011), the estimated pension contribution is approximately $23 million. The total consolidated pension expense of the Bank, including the supplemental unfunded retirement plan, for 2010, 2009 and 2008 was $9.0 million, $16.8 million and $24.6 million, respectively. Those amounts include settlement gains for the supplemental unfunded retirement plan of $1.1 million recorded in 2010, settlement gains of $0.7 million recorded in 2009 and settlement losses of $0.3 million recorded in 2008. The qualified pension accumulated benefit obligation as of December 31, 2010, 2009 and 2008 was $455.9, $395.1 million and $350.2 million, respectively.


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
In addition to pension benefits, the Bank sponsors a postretirement medical plan that provides medical care benefits for the Bank’s retirees (and their dependents) who have attained age 55 and have at least 10 years of service. The Bank also provides medical care benefits for disabled employees and widows of former employees (and their dependents). The Bank provides these medical care benefits through a self-insured plan. Under the terms of the plan, the Bank contributes to the cost of coverage based on employees’ length of service. Cost sharing with plan participants is accomplished through deductibles, coinsurance and out-of-pocket limits. Funding for the plan largely comes from the general assets of the Bank supplemented by contributions to a trust fund created under Internal Revenue Code Section 401(h). Effective December 31, 2007 the plan was changed to reflect expanded coverage available through Medicare and supplemental plans for retirees age 65 and older. Post-65 benefits for new hires and employees under age 35 were eliminated and corporate contributions for post-65 benefits for certain other employees were reduced.
 
Under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, an employer is eligible for a federal subsidy if the prescription drug benefit available under its postretirement medical plan is “actuarially equivalent” to the Medicare Part D benefit. The Bank recorded a reduction to postretirement medical expense in the amount of $1.6 million in 2010, $1.9 million in 2009 and $2.0 million in 2008, as determined by the Bank’s actuarial consultants. Based on their analysis, the Bank’s postretirement benefit medical plan passes the test for actuarial equivalence and qualifies for the subsidy. In March 2010, new health care legislation (The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act) was enacted that changed the tax treatment of the subsidy associated with postretirement medical benefits. The legislation reduced the tax deductions for the cost of providing postretirement prescription drug coverage by the amount of subsidies received. With enactment of the legislation, the Bank was required to write off any deferred tax asset as a tax expense through the income statement, even if a portion of such asset had initially been established through OCI. As a result of this legislation, the Bank recorded additional tax expense of $5.5 million in 2010.
 
The Bank has a defined contribution plan that is available to virtually all employees. The 401(k) matching contribution is based on the amount of eligible employee contributions. The Bank’s total expense for the plan was $14.6 million, $13.9 and $14.1 million in 2010, 2009 and 2008, respectively.


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The following tables set forth the change in benefit obligation and plan assets for the pension and postretirement medical care benefit plans:
 
                                                 
    Pension Benefits     Postretirement Medical Benefits  
    2010**     2009**     2008**     2010**     2009**     2008**  
    (In thousands)  
 
Change in benefit obligation*
                                               
Benefit obligation at beginning of year
  $ 421,794     $ 415,035     $ 430,891     $ 68,731     $ 59,723     $ 60,988  
Service cost
    19,021       19,020       21,897       1,758       1,920       1,994  
Interest cost
    24,058       24,916       25,071       3,946       3,586       3,639  
Benefits paid
    (29,246 )     (32,797 )     (41,771 )     (3,323 )     (3,167 )     (2,624 )
Medicare drug legislation
                      (2,321 )     (1,188 )     841  
Actuarial loss (gain)
    49,915       (4,380 )     (21,590 )     4,604       7,857       (6,523 )
Change in measurement date
                537                   1,408  
                                                 
Benefit obligation at end of year
  $ 485,542     $ 421,794     $ 415,035     $ 73,395     $ 68,731     $ 59,723  
                                                 
Change in plan assets
                                               
Fair value of plan assets at beginning of year
  $ 416,832     $ 309,712     $ 380,294     $ 53,502     $ 43,051     $ 64,979  
Actual return on plan assets
    66,606       69,738       (123,769 )     5,621       10,451       (23,181 )
Employer contribution
    145,305       70,179       99,521                    
Benefits paid
    (29,246 )     (32,797 )     (41,771 )                  
Change in measurement date
                (4,563 )                 1,253  
                                                 
Fair value of plan assets at end of year ***
  $ 599,497     $ 416,832     $ 309,712     $ 59,123     $ 53,502     $ 43,051  
                                                 
Funded Status at end of year
  $ 113,955     $ (4,962 )   $ (105,322 )   $ (14,272 )   $ (15,229 )   $ (16,672 )
                                                 
Assets (liabilities) recognized in the Statements of Condition consist of:
                                               
Other assets
  $ 114,173     $ 24,906     $ 24,906     $ 4,587     $ 4,587     $ 4,587  
Accrued pension and post-retirement liabilities
    (218 )     (29,868 )     (130,228 )     (18,859 )     (19,816 )     (21,259 )
                                                 
Net liabilities recognized
  $ 113,955     $ (4,962 )   $ (105,322 )   $ (14,272 )   $ (15,229 )   $ (16,672 )
                                                 
Amounts recognized in Accumulated Other Comprehensive Income (Loss) consist of:
                                               
Net loss
  $ 122,910     $ 107,584     $ 153,771     $ 5,448     $ 4,506     $ 4,843  
Prior service cost
    2,896       1,791       2,255                    
Transition obligation
                      797       1,329       1,858  
                                                 
Amounts recognized in AOCI
  $ 125,806     $ 109,375     $ 156,026     $ 6,245     $ 5,835     $ 6,701  
                                                 


88


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                                                 
    Pension Benefits     Postretirement Medical Benefits  
    2010**     2009**     2008**     2010**     2009**     2008**  
    (In thousands)  
 
Components of net periodic benefit cost
                                               
Service cost
  $ 19,021     $ 19,020     $ 21,897     $ 1,758     $ 1,920     $ 1,994  
Interest cost
    24,058       24,916       25,071       3,946       3,586       3,639  
Expected return on plan assets
    (40,802 )     (31,477 )     (25,941 )     (4,280 )     (3,444 )     (5,013 )
Amortization of prior service cost
    679       464       464                    
Amortization of transition obligation
                      532       529       525  
Amortization of actuarial loss or (gain)
    7,001       3,546       1,530                   (958 )
                                                 
Net periodic benefit cost
  $ 9,957     $ 16,469     $ 23,021     $ 1,956     $ 2,591     $ 187  
                                                 
Other Changes in Plan Assets and Benefit Obligations recognized in Other Comprehensive Income
                                               
Net loss (gain)
  $ 22,327     $ (42,641 )   $ 128,120     $ 943     $ (337 )   $ 21,667  
Amortization of (loss) gain
    (7,001 )     (3,546 )     (1,912 )                 1,198  
Prior service cost
    1,784                                
Amortization of prior service cost
    (679 )     (464 )     (580 )                  
Amortization of transition obligation
                      (532 )     (529 )     (656 )
                                                 
Total recognized in OCI
  $ 16,431     $ (46,651 )   $ 125,628     $ 411     $ (866 )   $ 22,209  
                                                 
 
 
* Benefit obligation is projected for Pension Benefits and accumulated for Postretirement Medical Benefits.
 
** Plan assets and obligation measured as of December 31.
 
*** The actual allocation of plan assets at fair value is as follows:
 
                                                 
    Pension     Postretirement Medical  
    2010     2009     2008     2010     2009     2008  
 
Equity securities
    55 %     50 %     54 %     55 %     50 %     54 %
Fixed income securities
    43 %     49 %     32 %     43 %     49 %     32 %
Cash equivalents
    2 %     1 %     14 %     2 %     1 %     14 %
 
At December 31, 2010 approximately 26% of the plan assets consisted of investments in funds administered by Virtus Investment Partners, Inc. (“Virtus”). Virtus is a provider of investment management products and services to individuals and institutions. At December 31, 2009 Bankcorp owned convertible preferred shares in Virtus that represented 23% ownership in the company. During 2010, Bankcorp converted approximately one-fourth of the convertible preferred shares to common shares and still retains a 23% ownership in the company based on the combined shares.
 
Investment objectives include the achievement of a total account return that meets or exceeds the expected return on plan assets, the inflation rate, and peer balanced funds over a market cycle. The Bank’s assumption for the expected long-term (in excess of 20 years) rate of return on plan assets is based on the target allocation of plan assets by category and the estimated rates of return for each asset category. The assumption includes management’s review of the current rate environment, historical trend analysis and the mix of asset categories represented in the plan’s portfolio. The current portfolio target allocation is as follows:
 
         
Equity securities
    50 %
Fixed income securities
    50 %

89


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The weighted-average assumptions used to determine the benefit obligation and net benefit cost are as follows:
 
                                                 
    Pension Benefits     Postretirement Medical Benefits  
    2010     2009     2008     2010     2009     2008  
 
Weighted-average assumptions used to determine benefit obligation as of December 31
                                               
Discount rate
    5.40 %     5.90 %     6.20 %     5.40 %     5.90 %     6.20 %
Rate of compensation increase
    2.00 %     2.00 %     3.80 %     N/A       N/A       N/A  
Weighted-average assumptions used to determine net benefit cost for years ended December 31
                                               
Discount rate
    5.90 %     6.20 %     6.00 %     5.90 %     6.20 %     6.00 %
Expected return on plan assets
    8.00 %     8.00 %     8.00 %     8.00 %     8.00 %     8.00 %
Rate of compensation increase
    2.00 %     3.80 %     3.80 %     N/A       N/A       N/A  
 
For 2011, the Bank intends to change the expected return on plan assets to 7%.
 
The Bank’s pension and postretirement plan assets are measured at fair value on a recurring basis. See Note 10 to the Consolidated Financial Statements for information on the hierarchy of inputs and the primary valuation methodologies used to measure fair value.
 
Level 1 plan assets primarily include exchange-traded equity securities, exchange-traded mutual funds, exchange-traded derivatives, U.S. Treasury securities and money market funds. Mutual funds are valued at quoted market prices. Money market funds are stated at cost plus accrued interest. Level 2 plan assets include U.S. government agency securities and corporate debt securities. External vendors typically use pricing models to determine fair values for these securities. Standard market inputs include yield curves and indices and market-corroborated pricing. There are no plan assets classified Level 3 at December 31, 2010 or 2009.
 
While the Bank believes the valuation methodologies for its plan assets are appropriate and consistent with other market participants, the use of different assumptions or methodologies could have a material effect on their estimated fair values.
 
The fair value of the pension and postretirement benefit plan assets are presented in the following tables:
 
                         
    Pension Plan Assets at December 31, 2010  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Fair Value  
          (In thousands)        
 
Asset category
                       
Cash and money market funds
  $ 10,269     $     $ 10,269  
Equity securities
    191,798             191,798  
U.S. Treasury securities
    20,324             20,324  
U.S. government agency securities
            9,706       9,706  
Corporate debt securities
            168,843       168,843  
Mutual funds
    198,755             198,755  
Derivative instruments
    (198 )           (198 )
                         
Total plan assets at fair value
  $ 420,948     $ 178,549     $ 599,497  
                         
 


90


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                         
    Pension Plan Assets at December 31, 2009  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Fair Value  
          (In thousands)        
 
Asset category
                       
Cash and money market funds
  $ 4,913     $     $ 4,913  
Equity securities
    119,076             119,076  
U.S. Treasury securities
    2,207             2,207  
U.S. government agency securities
          8,153       8,153  
Corporate debt securities
          100,119       100,119  
Mutual funds
    182,752             182,752  
Derivative instruments
    (388 )           (388 )
                         
Total plan assets at fair value
  $ 308,560     $ 108,272     $ 416,832  
                         
 
                         
    Postretirement Medical Plan Assets at
 
    December 31, 2010  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Fair Value  
          (In thousands)        
 
Asset category
                       
Cash and money market funds
  $ 1,013     $     $ 1,013  
Equity securities
    18,915             18,915  
U.S. Treasury securities
    2,004             2,004  
U.S. government agency securities
          957       957  
Corporate debt securities
          16,651       16,651  
Mutual funds
    19,601             19,601  
Derivative instruments
    (19 )           (19 )
                         
Total plan assets at fair value
  $ 41,514     $ 17,608     $ 59,122  
                         
 
                         
    Postretirement Medical Plan Assets at
 
    December 31, 2009  
    Fair Value Measurements Using     Total at
 
    Level 1     Level 2     Fair Value  
          (In thousands)        
 
Asset category
                       
Cash and money market funds
  $ 630     $     $ 630  
Equity securities
    15,284             15,284  
U.S. Treasury securities
    283             283  
U.S. government agency securities
          1,047       1,047  
Corporate debt securities
          12,851       12,851  
Mutual funds
    23,457             23,457  
Derivative instruments
    (50 )           (50 )
                         
Total plan assets at fair value
  $ 39,604     $ 13,898     $ 53,502  
                         

91


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
For measurement purposes, an 8.0 percent annual rate of increase for pre 65 and an 7.9 percent annual rate of increase for post 65 in the per capita cost of covered health care benefits were assumed for 2010. The rate will be graded down to 4.5 percent for pre 65 and 4.5 percent for post 65 in 2029 and remain level thereafter.
 
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects.
 
                 
    1 Percentage
    1 Percentage
 
2010
  Point Increase     Point Decrease  
    (In thousands)  
 
Effect on total of service and interest cost components
  $ 648     $ (557 )
Effect on postretirement benefit obligation
  $ 8,925     $ (7,582 )


92


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
The following table sets forth the status of the supplemental unfunded retirement plan:
 
                         
    Supplemental Unfunded Retirement Benefits  
    2010     2009     2008  
          (In thousands)        
 
Change in benefit obligation
                       
Benefit obligation at beginning of year
  $ 4,945     $ 10,360     $ 12,781  
Service cost
    497       845       997  
Interest cost
    231       540       636  
Benefits paid
    (3,129 )     (3,491 )     (3,273 )
Actuarial loss (gain)
    5,131       (3,309 )     (724 )
Change in measurement date
                (57 )
                         
Benefit obligation at end of year
  $ 7,675     $ 4,945     $ 10,360  
                         
Change in plan assets
                       
Fair value of plan assets at beginning of year
  $     $     $  
Employer contribution
    3,129       3,491       3,738  
Benefits paid
    (3,129 )     (3,491 )     (3,273 )
Change in measurement date
                (465 )
                         
Fair value of plan assets at end of year
  $     $     $  
                         
Funded Status at end of year
  $ (7,675 )   $ (4,945 )   $ (10,360 )
                         
Liabilities recognized in the Statements of Condition consist of:
                       
Accrued pension and post-retirement liabilities
  $ (7,675 )   $ (4,945 )   $ (10,360 )
                         
Net liabilities recognized
  $ (7,675 )   $ (4,945 )   $ (10,360 )
                         
Amounts recognized in Accumulated Other Comprehensive Income (loss) consist of:
                       
Net loss or (gain)
  $ 4,036     $ (2,468 )   $ 157  
Prior service credit
    (940 )     (1,269 )     (1,599 )
                         
Amounts recognized in AOCI
  $ 3,096     $ (3,737 )   $ (1,442 )
                         
Components of net periodic benefit cost
                       
Service cost
  $ 497     $ 845     $ 997  
Interest cost
    231       540       636  
Amortization of prior service credit
    (330 )     (330 )     (330 )
Amortization of actuarial gain
    (305 )            
                         
Net periodic benefit cost
  $ 93     $ 1,055     $ 1,303  
                         
Other Changes in Plan Assets and Benefit Obligations recognized in Other Comprehensive Income
                       
Net loss (gain)
  $ 6,199     $ (2,625 )   $ (1,024 )
Amortization of gain
    305              
Amortization of prior service credit
    330       330       412  
                         
Total recognized in OCI
  $ 6,834     $ (2,295 )   $ (612 )
                         
 


93


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                         
    Supplemental Unfunded Retirement
 
    Benefits  
    2010     2009     2008  
 
Weighted-average assumptions used to determine benefit obligation as of December 31
                       
Discount rate
    4.70 %     5.20 %     5.50 %
Rate of compensation increase
    2.00 %     2.00 %     3.80 %
Weighted-average assumptions used to determine net benefit cost for years ended December 31
                       
Discount rate
    5.20 %     5.50 %     5.25 %
Rate of compensation increase
    2.00 %     3.80 %     3.80 %
 
The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year are $14.1 million and $0.7 million, respectively. The transition obligation for the postretirement medical plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year is $0.5 million. The prior service cost for the supplemental unfunded retirement benefit plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year is $0.3 million. No estimated net loss for the postretirement medical plan and the supplemental unfunded retirement benefit plan is expected to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next calendar year.
 
The benefits expected to be paid in each of the next five years and the aggregate for the five years thereafter are as follows:
 
                                 
          Postretirement Medical Benefits     Supplemental
 
    Pension
    Before Medicare
    Medicare
    Retirement
 
Year
  Benefits     Subsidy     Subsidy(1)     Benefits  
          (In thousands)        
 
2011
  $ 30,480     $ 4,118     $ 429     $ 957  
2012
    32,653       4,312       490       1,036  
2013
    31,879       4,562       546       805  
2014
    34,541       4,874       614       945  
2015
    34,015       5,148       689       912  
Thereafter
    184,245       30,967       4,815       4,660  
 
 
(1) Medicare subsidies expected to be received.
 
15.   Stock-Based Compensation Plans
 
The Bank has three types of stock-based compensation plans: a stock option program, a mid-term incentive plan and an employee share purchase plan. The Bank determines expense based on the fair value of stock-based compensation. Stock-based compensation expense is recognized based on the estimated number of shares for which service is expected to be rendered and over the period during which employees are required to provide service in exchange for the shares. Stock-based compensation granted to retirement-eligible employees is expensed fully at the time of grant.

94


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Stock Option Program
 
The HFC Stock Option Program was established under the BMO Stock Option Plan for certain designated executives and other employees of the Bank and affiliated companies in order to provide incentive to attain long-term strategic goals and to attract and retain services of key employees.
 
Options to acquire BMO stock are granted at an exercise price equal to the closing price of BMO’s common shares on the day prior to the grant date. Options vest 25% per year over a four-year period starting from their grant date. The vesting of a portion of the options granted is subject to achieving certain performance targets. All options expire 10 years from their grant date.
 
The expense recorded for this program is adjusted for estimated forfeitures. Cash flows resulting from realized tax deductions in excess of recognized compensation cost are financing cash flows.
 
The compensation expense related to this program totaled $1.6 million, $1.8 million and $2.0 million in 2010, 2009 and 2008, respectively. The excess tax benefits recognized for the years ended 2010, 2009 and 2008 were $0.6 million, $0.7 million and $0.7 million, respectively. At December 31, 2010, the total unrecognized compensation cost related to nonvested stock option awards was $1.9 million, and the weighted average period over which it is expected to be recognized is approximately 3.1 years.
 
The fair value of the stock options granted has been estimated using a trinomial option pricing model. The weighted average per share fair value of options granted during 2010, 2009 and 2008 were $10.46, $9.48 and $4.50, respectively. The total intrinsic value of stock options exercised during the years ended December 31, 2010, 2009 and 2008 was $12.5 million, $9.6 million and $3.7 million, respectively. Cash proceeds from options exercised under the plan totaled $33.0 million, $24.3 million and $15.0 million for the years ended December 31, 2010, 2009 and 2008, respectively. The tax benefits from stock options realized during 2010, 2009 and 2008 were $4.3 million, $2.9 million and $1.8 million, respectively.
 
The following table summarizes the stock option activity for 2010 and 2009 and provides details of stock options outstanding at December 31, 2010 and 2009:
 
                                 
    Year Ended December 31, 2010  
                      Wtd. Avg.
 
          Wtd. Avg.
    Aggregate Intrinsic
    Remaining
 
Options
  Shares     Exercise Price     Value     Contractual Life  
    (In millions)  
 
Outstanding at beginning of year
    2,150,591     $ 43.64     $ 23.5       4.63 years  
Granted
    189,375       58.09                  
Exercised
    (566,195 )     38.23                  
Transferred(1)
    282,371       45.92                  
                                 
Outstanding at December 31, 2010
    2,056,142       49.31     $ 20.2       5.10 years  
                                 
Options exercisable at December 31, 2010
    1,244,231     $ 46.00     $ 16.3       3.56 years  
 
 
(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.
 


95


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                                 
    Year Ended December 31, 2009  
                      Wtd. Avg.
 
          Wtd. Avg.
    Aggregate Intrinsic
    Remaining
 
Options
  Shares     Exercise Price     Value     Contractual Life  
    (In millions)  
 
Outstanding at beginning of year
    2,494,946     $ 35.34     $ 1.1       4.62 years  
Granted
    174,653       50.90                  
Exercised
    (541,535 )     29.16                  
Transferred(1)
    22,527       41.40                  
                                 
Outstanding at December 31, 2009
    2,150,591       43.64     $ 23.5       4.63 years  
                                 
Options exercisable at December 31, 2009
    1,452,407     $ 40.85     $ 19.4       3.05 years  
 
 
(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.
 
The following table summarizes the nonvested stock option activity for 2010:
 
                 
          Wtd. Avg.
 
          Grant Date
 
          Fair Value
 
Options
  Shares     per Share  
 
Nonvested at beginning of year
    698,184     $ 7.31  
Granted
    189,375       10.46  
Vested
    (143,212 )     4.25  
Transferred(1)
    67,564       7.39  
                 
Nonvested at December 31, 2010
    811,911     $ 8.06  
                 
 
 
(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.
 
The following table summarizes the nonvested stock option activity for 2009:
 
                 
          Wtd. Avg.
 
          Grant Date
 
          Fair Value
 
Options
  Shares     per Share  
 
Nonvested at beginning of year
    725,206     $ 6.87  
Granted
    174,653       9.48  
Vested
    (198,757 )     7.05  
Transferred(1)
    (2,918 )     7.45  
                 
Nonvested at December 31, 2009
    698,184     $ 7.31  
                 
 
 
(1) Transferred shares represent the net impact of employees moving between BMO and the Bank.
 
The following weighted-average assumptions were used to determine the fair value of options on the date of grant:
 
                 
    2010     2009  
 
Risk-free interest rate
    2.90 %     2.86 %
Expected life, in years
    6.5       6.5  
Expected volatility
    24.00 %     27.48 %
Expected dividend yield
    4.71 %     6.59 %

96


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Mid-Term Incentive Plan
 
The Bank maintains mid-term incentive plans in order to enhance the Bank’s ability to attract and retain high quality employees and to provide a strong incentive to employees to achieve BMO’s governing objective of maximizing value for its shareholders.
 
The mid-term incentive plans have a three year performance cycle. The right to receive distributions under the plans depends on the achievement of specific performance criteria that are set at the grant date such as the current market value of BMO’s common shares and BMO’s total shareholder return compared with that of its competitors. Distribution rights are subject to either cliff vesting at the end of the three year period or graded vesting of one-third per year over the three year period. Depending on the plan, participants receive either a single cash payment at the end of the three year period or three annual cash payments over the three year period.
 
The Bank was party to agreements made between BMO and third parties to assume a portion of the Bank’s obligations related to the 2007 and 2008 mid-term incentive plans. The Bank was not party to similar agreements for the 2009 or 2010 mid-term incentive plans. Amounts paid by the Bank under the agreements were capitalized and recognized as compensation expense over the performance cycles of the plans on a straight-line basis, including calendar years 2009 and 2010. Amounts related to units granted to employees who are eligible to retire are expensed at the time of grant. Any future obligations to participants required under these plans will be the responsibility of the third parties.
 
For the obligations relating to the plans for which BMO has not entered into agreements with third parties, the amount of compensation expense is amortized over the service period to reflect the current estimate of ultimate employer liability, which is a function of the current market value of BMO’s common shares and BMO’s total shareholder return compared with that of its competitors. Adjustments for changes in estimates of ultimate payments to participants are recognized in current and future periods. The Bank enters into certain total return swap contracts to minimize exposure to currency exchange rate and equity price fluctuations. The contracts are derivative instruments accounted for at fair value and do not qualify for hedge accounting.
 
The compensation expense related to the plans totaled $22.5 million, $23.2 million and $8.1 for the years ended December 31, 2010, 2009 and 2008, respectively. The related tax benefits recognized for the years ended December 31, 2010, 2009 and 2008 totaled $8.6 million, $8.8 million and $3.1 million, respectively. The total unrecognized compensation cost related to nonvested awards was $0.9 million at December 31, 2010. The weighted average period over which it is expected to be recognized is approximately 1.8 years.
 
Employee Share Purchase Plan
 
The BMO Employee Share Purchase Plan offers employees the opportunity to purchase BMO common shares at a discount of 15 percent from market value. Full-time and part-time employees of the Bank are eligible to participate in the plan. Employees can elect to contribute up to 15 percent of their salary toward the purchase of BMO common shares. The Bank contributes the difference between the employee cost and the market price. The shares in the plan are purchased on the open market and the plan reinvests all cash dividends in additional common shares. The Bank’s contribution is recorded as compensation expense over each three-month offering period. Compensation expense for the employee share purchase plan totaled $0.7 million, $0.8 million and $0.6 million in 2010, 2009 and 2008, respectively.
 
16.   Lease Expense and Obligations
 
Rental expense for all operating leases was $44.2 million in 2010, $42.8 million in 2009, and $41.5 million in 2008. These amounts include real estate taxes, maintenance and other rental-related operating costs of 6.9 million, $7.6 million, and $6.9 million, for 2010, 2009, and 2008, respectively, paid under net lease arrangements. Lease commitments are primarily for office space.


97


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
In March 2005, the Bank sold to a third party the land and building located at 111 West Monroe Street, Chicago, Illinois. Upon sale, the Bank entered into a leaseback agreement for approximately 50 percent of the building space with an average lease term of 16 years. The leaseback agreement meets the criteria to be recorded as an operating lease. The sale resulted in a gain which was deferred and is being amortized into income over the term of the leaseback. The remaining deferred gain resulting from the sale was $38.2 million, $41.4 million and $44.6 million at December 31, 2010, 2009 and 2008, respectively. $3.2 million, of deferred gain was amortized into income in 2010, 2009 and 2008.
 
In December 2001, the Bank closed on the sale of its operations center containing approximately 415,000 gross square feet located at 311 West Monroe Street, Chicago, Illinois, and leased back approximately 259,000 rentable square feet. The lease is recorded as an operating lease and the term ends on December 31, 2011. the Bank has rights of first offering to lease additional space and options to extend to December 31, 2026. The remaining deferred gain resulting from the sale, which is being amortized into income over the remaining life of the lease, was $1.7 million, $3.5 million and $5.2 million as of December 31, 2010, 2009 and 2008, respectively. $1.7 million of deferred gain was amortized into income in 2010, 2009 and 2008.
 
In addition, the Bank and other subsidiaries own or lease premises at other locations to conduct branch banking activities.
 
Minimum rental commitments as of December 31, 2010 for all non-cancelable operating leases are as follows:
 
         
Year
  Amount  
    (In thousands)  
 
2011
  $ 36,203  
2012
    31,900  
2013
    30,073  
2014
    29,399  
2015
    28,699  
Thereafter
    250,922  
         
Total minimum future rentals
  $ 407,196  
         
 
Occupancy expenses for 2010, 2009 and 2008 have been reduced by $3.4 million in each year for rental income from leased premises.


98


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
17.   Income Taxes
 
The 2010, 2009 and 2008 applicable income tax expense (benefit) were as follows:
 
                         
    Federal     State     Total  
    (In thousands)  
 
2010:
                       
Current
  $ 21,560     $ 2,806     $ 24,366  
Deferred
    (71,131 )     (3,798 )     (74,929 )
                         
Total
  $ (49,571 )   $ (992 )   $ (50,563 )
                         
2009:
                       
Current
  $ (153,525 )   $ 3,772     $ (149,753 )
Deferred
    38,888       (5,632 )     33,256  
                         
Total
  $ (114,637 )   $ (1,860 )   $ (116,497 )
                         
2008:
                       
Current
  $ (96,539 )   $ (1,185 )   $ (97,724 )
Deferred
    (14,021 )     15,526       1,505  
                         
Total
  $ (110,560 )   $ 14,341     $ (96,219 )
                         


99


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Net deferred tax assets are comprised of the following at December 31, 2010, 2009 and 2008:
 
                         
    December 31  
    2010     2009     2008  
    (In thousands)  
 
Deferred tax assets:
                       
Allowance for possible loan losses
  $ 284,718     $ 264,377     $ 233,062  
Deferred employee compensation
    26,837       25,179       21,979  
Deferred expense and prepaid income
    15,560       18,613       22,586  
Intangible assets and purchase accounting valuations
    13,772              
State tax loss carryforward
    34,176       29,479       11,971  
Tax credit carryforward
    46,459       1,947        
Other assets
    6,804       5,615       6,532  
                         
Gross deferred tax assets
  $ 428,326     $ 345,210     $ 296,130  
Valuation allowance
    (45,873 )     (37,241 )     (26,285 )
                         
Deferred tax assets, net of valuation allowance
  $ 382,453     $ 307,969     $ 269,845  
                         
Deferred tax liabilities:
                       
Depreciable assets
    (50,914 )     (47,457 )     (48,769 )
Intangible assets and purchase accounting valuations
          (9,993 )     (5,036 )
Pension and medical trust
    (86,141 )     (80,035 )     (10,113 )
Other liabilities
    (1,150 )     (1,373 )     (1,332 )
                         
Gross deferred tax liabilities
  $ (138,205 )   $ (138,858 )   $ (65,250 )
                         
Deferred tax assets
  $ 244,248     $ 169,111     $ 204,595  
Tax effect of fair value adjustments on available-for-sale securities, pension liabilities and hedging transactions recorded directly to stockholder’s equity
    82,055       58,323       111,480  
                         
Net deferred tax assets
  $ 326,303     $ 227,434     $ 316,075  
                         
 
A valuation allowance of $45.9 million, $37.2 million and $26.3 million exists at December 31, 2010, 2009 and 2008, respectively, to offset deferred tax assets related to the Bank’s state tax loss carry-forwards and certain state deferred tax assets. The valuation allowance increased by $8.6 million in 2010 and is due to the addition of state operating losses and valuation allowances established on certain current year state deferred tax assets. Management believes that the realization of the deferred tax assets, with the exception of certain state deferred tax assets and state tax loss carryforwards, is more likely than not based on available tax planning strategies and expectations of future taxable income.
 
State tax loss carry-forwards at December 31, 2010 of approximately $711.1 million will expire in varying amounts in 2013 through 2030.
 
Federal tax credit carry-forwards at December 31, 2010 of approximately $46.5 million consists of approximately $36.5 million of AMT tax credits which do not expire and $10.0 million of general business credits that will expire in varying amounts in 2024 through 2030.


100


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
A reconciliation of the U.S. federal statutory income tax rate to the actual income tax rate is provided below.
 
                         
    Years Ended December 31  
    2010     2009     2008  
 
Federal statutory rate:
    35.0 %     35.0 %     35.0 %
Increase (reduction) in income tax benefits due to:
                       
Bank-owned insurance
    31.9       6.8       9.1  
Valuation allowance change for state deferred taxes, net of federal effect
    (17.1 )     (4.8 )     (13.2 )
State income taxes, excluding valuation allowance, net of federal effect
    18.4       5.3       8.5  
Tax-exempt municipal income
    31.8       7.7       8.8  
Other, net
    0.2       0.8        
                         
Actual income tax rate
    100.2 %     50.8 %     48.2 %
                         
 
The balance of gross unrecognized tax benefits may decrease between zero and $1.8 million during the next twelve months depending upon the settlement of federal, state, and local audits.
 
With few exceptions, the Bank is no longer subject to U.S. federal, state or local income tax exams for years prior to 2006. The Bank joins in filing a consolidated Federal income tax return with its parent, Harris Financial Corp. The Internal Revenue Service is examining the 2006, 2007 and 2008 consolidated Federal income tax returns and it is anticipated to be completed by the end of 2011. As of December 31, 2010, no significant adjustments have been proposed for the Bank’s federal or state tax positions.
 
The Bank recognizes penalties and the accrual of interest related to unrecognized tax benefits in its income tax expense. During the years ended December 31, 2010, 2009 and 2008, the interest and penalties recognized by the Bank were not significant and did not affect the annual effective tax rate. The Bank had approximately $0.2 million, $0.2 million and $0.1 million accrued for the payment of interest and penalties at December 31, 2010, 2009 and 2008, respectively.
 
18.   Regulatory Capital
 
The Bank, as a federally-chartered bank, must adhere to the capital adequacy guidelines of the Federal Reserve Board (the “Board”) and the Office of the Comptroller of the Currency (“OCC”). The guidelines specify minimum ratios for Tier 1 capital to risk-weighted assets of 4 percent and total regulatory capital to risk-weighted assets of 8 percent.
 
Risk-based capital guidelines define total capital to consist primarily of Tier 1 (core) and Tier 2 (supplementary) capital. In general, Tier 1 capital is comprised of stockholder’s equity, including certain types of preferred stock, less goodwill and certain other intangibles. Core capital must comprise at least 50 percent of total capital. Tier 2 capital basically includes subordinated debt (less a discount factor during the five years prior to maturity), other types of preferred stock and the allowance for loan losses. The portion of the allowance for loan losses includable in Tier 2 capital is limited to 1.25 percent of risk-weighted assets.
 
The Board and OCC also requires an additional measure of capital adequacy, the Tier 1 leverage ratio, which is evaluated in conjunction with risk-based capital ratios. The Tier 1 leverage ratio is computed by dividing period-end Tier 1 capital by adjusted quarterly average assets. The Board and OCC established a minimum ratio of 3 percent applicable only to the strongest banking organizations having, among other things, excellent asset quality, high liquidity, good earnings and no undue interest rate risk exposure. Other institutions are expected to maintain a minimum ratio of 4 percent.
 
The Federal Deposit Insurance Corporation Improvement Act of 1991 contains prompt corrective action provisions that established five capital categories for all FDIC-insured institutions ranging from “well capitalized”


101


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
to “critically undercapitalized.” Classification within a category is based primarily on the three capital adequacy measures.
 
Noncompliance with minimum capital requirements may result in regulatory corrective actions that could have a material effect on the Bank’s financial statements.
 
As of December 31, 2010 and 2009, the most recent notification from the FDIC categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. Management is not aware of any conditions or events since December 31, 2010 that have changed the capital category of the Bank.
 
At December 31, 2010 and 2009, the Bank had $250 million of minority interest in preferred stock of a subsidiary. The preferred stock is noncumulative, exchangeable Series A preferred stock with dividends payable at the rate of 7.375% per annum. During 2010 and 2009, $18.4 million of dividends were declared and paid on the preferred stock. The preferred stock qualifies as Tier 1 capital for the Bank under U.S. banking regulatory guidelines.
 
The following table summarizes the Bank’s risk-based capital ratios and Tier 1 leverage ratio for the past two years as well as the minimum amounts and ratios as per capital adequacy guidelines and FDIC prompt corrective action provisions.
 
                                                 
                To Be Well Capitalized
 
          For Capital
    Under Prompt Corrective
 
    Actual     Adequacy Purposes     Action Provisions  
    Capital
    Capital
    Capital
    Capital
    Capital
    Capital
 
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
    (In thousands)  
 
As of December 31, 2010
                                               
Total Capital to Risk-Weighted Assets
  $ 4,945,364       17.87 %   ³ $ 2,213,929       ³ 8.00 %   ³ $ 2,767,411       ³ 10.00 %
Tier 1 Capital to Risk-Weighted Assets
  $ 4,422,319       15.98 %     ³ 1,106,963       ³4.00 %   ³ $ 1,660,445       ³ 6.00 %
Tier 1 Capital to Quarterly Average Assets
  $ 4,422,319       9.64 %   ³ $ 1,834,987       ³4.00 %   ³ $ 2,293,734       ³ 5.00 %
As of December 31, 2009
                                               
Total Capital to Risk-Weighted Assets
  $ 4,160,567       13.55 %   ³ $ 2,456,423       ³ 8.00 %   ³ $ 3,070,529       ³ 10.00 %
Tier 1 Capital to Risk-Weighted Assets
  $ 3,520,984       11.46 %   ³ $ 1,228,965       ³ 4.00 %   ³$ 1,843,447       ³ 6.00 %
Tier 1 Capital to Quarterly Average Assets
  $ 3,520,984       8.82 %   ³ $ 1,596,818       ³ 4.00 %   ³ $ 1,996,023       ³ 5.00 %
 
19.   Investments in Subsidiaries and Statutory Restrictions
 
Harris N.A.’s investment in the combined net assets of its wholly-owned subsidiaries was $983 million and $1.2 billion at December 31, 2010 and 2009, respectively.
 
Provisions of Federal banking laws place restrictions upon the amount of dividends that can be paid to Bankcorp by its bank subsidiaries. The National Bank Act requires all national banks to obtain prior approval from the OCC if dividends declared by the national bank (including subsidiaries of the national bank, except for dividends paid by such subsidiary to the national bank), in any calendar year, will exceed its net income for that year, combined with its retained net income (as defined in the applicable regulations) for the preceding two years. These provisions apply to a national bank and its subsidiaries on a consolidated basis, notwithstanding the earnings of any subsidiary on a stand-alone basis. Beginning in 2009, HNA no longer had sufficient capacity to declare and pay dividends without prior regulatory approval of the OCC. As a result, Harris Preferred Capital Corporation, as an


102


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
indirect subsidiary of HNA, became subject to the provisions relating to dividend approval and HNA must receive prior approval from the OCC before Harris Preferred Capital Corporation declares dividends on the Preferred Shares. Prior approval from the OCC was received for the dividend declarations in 2010 and the most recent dividend declaration in March 2011. Harris Preferred Capital Corporation anticipates the need to request similar approvals from the OCC in 2011. At this time, Harris Preferred Capital Corporation has no reason to expect that such approvals will not be received. There is no assurance that HNA and Harris Preferred Capital Corporation will not be subject to the requirement to receive prior regulatory approvals for Preferred Shares dividend payments in the future or that, if required, such approvals will be obtained. Based on these and certain other prescribed regulatory limitations, HNA could not have declared dividends without regulatory approval at December 31, 2010. Actual dividends paid could be subject to further restrictions related to regulatory capital adequacy guidelines. There were no cash dividends paid to Bankcorp by HNA in 2010 or in 2009.
 
The Bank is required by the Federal Reserve Act to maintain reserves against certain of their deposits. Reserves are held either in the form of vault cash or balances maintained with the Federal Reserve Bank. Required reserves are essentially a function of daily average deposit balances and statutory reserve ratios prescribed by type of deposit. During 2010 and 2009, daily average reserve balances of $312.1 million and $522.5 million, respectively, were required for HNA. At year-end 2010 and 2009, balances on deposit at the Federal Reserve Bank totaled $14.1 billion and $8.4 billion, respectively. Interest income recognized in the year ended December 31, 2010 and 2009 was $25.8 million and $15.8 million, respectively. The Federal Reserve Bank started paying interest in October 2008.
 
20.   Contingent Liabilities and Litigation
 
HNA and certain of its subsidiaries are party to legal proceedings in the ordinary course of their businesses. While there is inherent difficulty in predicting the outcome of these proceedings, management does not expect the outcome of any of these proceedings, individually or in the aggregate, to have a material adverse effect on the Bank’s consolidated financial position or results of operations.
 
21.   Accumulated Other Comprehensive Loss
 
The following table summarizes the components of accumulated other comprehensive loss shown in stockholder’s equity, net of tax:
 
                                 
    Unrealized
          Unrealized
    Accumulated
 
    Gain on
    Pension and
    Loss on
    Other
 
    Securities
    Postretirement
    Cash Flow Hedge
    Comprehensive
 
    Available-For-Sale     Adjustments     Activity     Loss  
          (In thousands)        
 
Balance at December 31, 2010
  $ 41,132     $ (85,007 )   $ (92,659 )   $ (136,534 )
                                 
Balance at December 31, 2009
  $ 60,522     $ (74,904 )   $ (83,402 )   $ (97,784 )
                                 
Balance at December 31, 2008
  $ 54,463     $ (111,391 )   $ (149,111 )   $ (206,039 )
                                 


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
22.   Foreign Activities (by Domicile of Customer)
 
Income and expenses identifiable with foreign and domestic operations are summarized in the table below:
 
                         
    Foreign     Domestic     Consolidated  
    (In thousands)  
 
2010
                       
Total operating income
  $ 13,710     $ 1,743,414     $ 1,757,124  
Total expenses
    12,497       1,776,642       1,789,139  
                         
Income (loss) before taxes
  $ 1,213     $ (33,228 )   $ (32,015 )
Applicable income tax expense (benefit)
    482       (51,045 )     (50,563 )
                         
Net income
  $ 731     $ 17,817     $ 18,548  
                         
Identifiable assets at year-end
  $ 1,388,067     $ 48,638,293     $ 50,026,360  
                         
2009
                       
Total operating income
  $ 26,788     $ 1,807,397     $ 1,834,185  
Total expenses
    32,196       2,012,801       2,044,997  
                         
Loss before taxes
  $ (5,408 )   $ (205,404 )   $ (210,812 )
Applicable income tax benefit
    (2,149 )     (114,348 )     (116,497 )
                         
Net loss
  $ (3,259 )   $ (91,056 )   $ (94,315 )
                         
Identifiable assets at year-end
  $ 1,434,674     $ 42,536,953     $ 43,971,627  
                         
2008
                       
Total operating income
  $ 36,075     $ 2,264,959     $ 2,301,034  
Total expenses
    93,673       2,388,384       2,482,057  
                         
Loss before taxes
  $ (57,598 )   $ (123,425 )   $ (181,023 )
Applicable income tax benefit
    (22,892 )     (73,327 )     (96,219 )
                         
Net loss
  $ (34,706 )   $ (50,098 )   $ (84,804 )
                         
Identifiable assets at year-end
  $ 1,757,762     $ 65,548,293     $ 67,306,055  
                         
 
Determination of rates for foreign funds generated or used is based on the actual external costs of specific interest-bearing sources or uses of funds for the periods. Internal allocations for certain unidentifiable income and expenses were distributed to foreign operations based on the percentage of identifiable foreign income to total income. As of December 31, 2010, 2009 and 2008, identifiable foreign assets accounted for 2.8 percent and 3.3 percent, and 2.6 percent respectively, of total consolidated assets. Assets and liabilities denominated in foreign currencies have been translated into United States dollars at respective year-end rates of exchange. Monthly translation gains or losses are computed at rates prevailing at month-end. There were no material translation gains or losses during the three years presented.
 
23.   Business Combinations
 
On December 17, 2010, BMO announced it had reached a definitive agreement to purchase Marshall & Ilsley Corporation (“M&I”) in a common stock for common stock transaction. The purchase price will depend on the number of M&I common shares outstanding at the closing date and is estimated at $4.1 billion. BMO intends that M&I will ultimately merge with and into HFC immediately upon acquisition. In addition, BMO has agreed to have HFC purchase M&I’s Troubled Asset Relief Program (“TARP”) preferred shares and warrants from the


104


 

 
HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
U.S. Treasury. At the time of acquisition, it is anticipated that the commercial banking operations of M&I will be merged with those of the Bank. Subject to regulatory approval and M&I shareholders’ vote, the acquisition is expected to close prior to July 31, 2011. At December 31, 2010, M&I’s assets and deposits totaled $50.8 billion and $38.3 billion, respectively. This acquisition would substantially increase the Bank’s assets, geographic presence, scope of operations and customer base.
 
On April 23, 2010, the Bank acquired certain assets and liabilities of Rockford, Illinois-based, AMCORE from the FDIC for $221.5 million. The Bank assumed approximately $2.5 billion in assets, including approximately $2.1 billion in loans, and $2.2 billion in deposits. The Bank recorded a core deposit intangible of $21.1 million to be amortized over 10 years on an accelerated basis and a customer relationship intangible of $1.3 million to be amortized over 13 years on an accelerated basis. The acquisition includes a loss share agreement with the FDIC which provides for reimbursement from the FDIC for 80% of losses incurred on covered assets, including loans and other real estate owned, subsequent to acquisition date. An indemnification asset estimated at a fair value of $427.5 million was recorded at acquisition based on the present value of expected cash flows to be received from the FDIC for loss reimbursements covered by the agreement. The Bank recorded goodwill of $84.6 million which is expected to be deductible for tax purposes. As part of the acquisition, the Bank obtained the option to purchase certain AMCORE branches after the close of the transaction. The Bank increased the purchase price by $19.9 million as a result of exercising the option to purchase certain of these branches. Acquisition costs of $6.2 million were recorded to noninterest expense for the year ended December 31, 2010. The acquisition provides the Bank with an opportunity to expand its branch network into communities in northern Illinois and southern Wisconsin. The results of AMCORE’s operations have been included in the Bank’s consolidated financial statements since April 23, 2010.
 
On December 31, 2009, BMO and the Bank completed the acquisition of the net cardholder receivables and other assets and obligations of the Diners Club North American franchise from an unrelated bank for initial cash consideration of $678 million, subject to a post-closing adjustment based on all parties’ final agreement of the net asset value transferred. Based on a post-closing adjustment of $48.4 million, the final purchase price was reduced to $629.6 million during 2010. The acquisition of the net cardholder receivables of Diners Club gives the Bank the right to issue Diners Club cards to corporate and professional clients in the United States and will accelerate the Bank’s initiative to expand in the travel-and-entertainment card sector. As part of this acquisition, the Bank recorded a purchased credit card relationship intangible asset estimated at $46.3 million which will be amortized on an accelerated basis over 15 years. The Bank recorded goodwill of $11.5 million which is expected to be deductible for tax purposes. The gross contractual amount of receivables was $743.2 million. Acquisition-related costs of $0.6 million for the year ended December 31, 2009 were recorded to noninterest expense. The results of the operations of Diners Club have been included in the Bank’s consolidated financial statements since January 1, 2010.
 
On February 13, 2009, the Bank completed the acquisition of selected assets of Pierce, Givens & Associates, LLC (“Pierce Givens”) for cash consideration of $3.4 million. The Bank recorded a customer relationship intangible asset estimated at $3.0 million with an expected life of 5 years. No goodwill was recorded in the transaction. Acquisition-related costs of $0.4 million for the year-ended December 31, 2009 were recorded to noninterest expense. The acquisition provides the Bank with the opportunity to expand its tax planning and compliance capabilities in the ultra high-net-worth market. The results of Pierce Givens’ operations have been included in the Bank’s consolidated financial statements since February 14, 2009.
 
On February 29, 2008, Bankcorp completed the acquisition of Merchants and Manufacturers Bancorporation, Inc. (“Merchants and Manufacturers”), for a purchase price of $136.7 million. Of this amount, $112.0 million was recorded as goodwill and $11.0 million was recorded as a core deposit premium intangible with an expected life of ten years. Bankcorp recorded additional goodwill of $3.4 million for related acquisition costs. Goodwill and other intangibles related to this acquisition are not deductible for tax purposes. The results of Merchants and Manufacturers’ operations have been included in Bankcorp’s consolidated financial statements since March 1, 2008. The


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Notes to Consolidated Financial Statements — (Continued)
 
acquisition of Merchants and Manufacturers provides Bankcorp with the opportunity to expand banking services in the Wisconsin market.
 
On February 29, 2008, BMO completed the acquisition of Ozaukee Bank (“Ozaukee”), for a purchase price of $183.3 million consisting of 3,283,190 BMO common shares with a market value of $55.84 per share. BMO immediately contributed Ozaukee to HFC in exchange for HFC common shares. HFC immediately contributed Ozaukee to Bankcorp in exchange for Bankcorp common shares. Of the purchase price amount, $125.0 million was recorded as goodwill and $11.7 million was recorded as a core deposit premium intangible with an expected life of ten years. Bankcorp recorded additional goodwill of $1.8 million for related acquisition costs. Goodwill and other intangibles related to this acquisition are not deductible for tax purposes. The results of Ozaukee’s operations have been included in Bankcorp’s consolidated financial statements since March 1, 2008. The acquisition of Ozaukee provides Bankcorp with the opportunity to expand banking services in the Wisconsin market.
 
On September 6, 2008, Bankcorp merged Merchants and Manufacturers with and into the Bank and merged Ozaukee with and into the Bank. Each transaction was recorded at its respective carrying value on that date and had no impact on the consolidated results of the Bank.
 
The following table summarizes the adjusted estimated fair value of the assets acquired and liabilities assumed of AMCORE, Pierce Givens, Diners Club, Merchants and Manufacturers and Ozaukee at the dates of acquisition:
 
                                         
    2010     2009     2008  
          Pierce
          Merchants and
       
    AMCORE     Givens     Diners Club     Manufacturers     Ozaukee  
    (In thousands)  
 
Cash and cash equivalents
  $ 413,568     $     $     $ 36,223     $ 52,125  
Securities
    9,931                   135,116       116,404  
Loans, net
    1,525,626             647,942       1,031,275       532,507  
Premises and equipment
    20,857             4,394       35,162       14,297  
Bank owned life insurance
                      9,221       9,579  
Goodwill
    84,572             11,492       112,049       125,022  
FDIC Indemnification asset
    427,521                          
Identifiable intangible assets
    22,353       3,000       46,311       10,985       11,736  
Other real estate owned
    23,011                          
Other assets
    38,058       423       1,710       46,063       9,723  
                                         
Total assets
  $ 2,565,497     $ 3,423     $ 711,849     $ 1,416,094     $ 871,393  
                                         
Deposits
  $ 2,172,542     $     $ 9,511     $ 1,047,570     $ 595,461  
Borrowings
    137,409                   154,399       82,453  
Accrued expenses
                      19,746       5,541  
Note payable
                      53,611        
Other liabilities
    14,163             72,750       4,071       4,594  
                                         
Total liabilities
  $ 2,324,114     $     $ 82,261     $ 1,279,397     $ 688,049  
                                         
Purchase price
  $ 241,383     $ 3,423     $ 629,588     $ 136,697     $ 183,344  
                                         
 
24.   Related Party Transactions
 
During 2010, 2009 and 2008, the Bank engaged in various transactions with BMO and its subsidiaries. These transactions included the payment and receipt of service fees and occupancy expenses; purchasing and selling


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
Federal funds; repurchase and reverse repurchase agreements; short and long-term borrowings; interest rate and foreign exchange rate contracts. The purpose of these transactions was to facilitate a more efficient use of combined resources and to better serve customers. Fees for these services were determined in accordance with applicable banking regulations. During 2010, 2009 and 2008, the Bank received from BMO approximately $34.8 million, $27.4 million, and $24.5 million respectively, primarily for data processing, other operations support and corporate support provided by the Bank. Excluding interest expense payments disclosed below, the Bank made payments for services to BMO of approximately $88.3 million, $85.2 million, and $89.8 million, in 2010, 2009, and 2008, respectively. During 2010, 2009 and 2008, the Bank received from HFC approximately $53.2 million $51.4 million, and $39.8 million, respectively, primarily for data processing, other operations support and corporate support provided by the Bank. Excluding interest expense payments disclosed below, the Bank made payments for services to HFC of approximately $8.9 million, $6.9 million, and $10.5 million in 2010, 2009 and 2008, respectively. During 2010, 2009 and 2008, the Bank received from Bankcorp approximately $16.6 million, $15.1 million, and $15.9 million, respectively, primarily for data processing, other operations support and corporate support provided by the Bank. Excluding interest expense payments disclosed below, the Bank made payments for services to Bankcorp of approximately $0.3 million, $0.1 million, and $0.1 million, in 2010, 2009 and 2008, respectively.
 
During 2010, the Bank sold $272 million of nonperforming loans to psps. During 2009, the Bank sold $503 million of nonperforming loans to psps. psps was formed in December 2008 to hold and manage nonperforming loans. Loans were sold at fair value. For nonperforming loans sold, credit losses were recorded at the Bank prior to closing, as required, to reflect any credit deterioration. Credit-related write-downs were reflected in the provision for credit losses and/or as write-downs against the allowance for loan losses. For these loans, the carrying value after any required write-downs was considered by management to represent estimated fair value. No gain or loss was recognized in the Consolidated Statements of Operations on sale of loans from the Bank to psps.
 
In December 2008, the Bank and BMO Harris Financing Inc. (“BHFI”) sold performing and nonperforming loans to BMO Chicago Branch and to psps. psps purchased approximately $362 million in nonaccrual loans from the Bank. Approximately $110 million of nonperforming loans were sold from the Bank to BMO Chicago Branch. Loans were sold at fair value. For performing and nonperforming loans sold, credit losses were recorded at the Bank, as required, to reflect any credit deterioration. Credit-related write-downs were reflected in the provision for credit losses and/or as write-downs against the allowance for loan losses. For these loans, the carrying value after any required write-downs was considered by management to represent estimated fair value. In addition, each performing loan sold was assessed to determine whether its fair value had declined below carrying value due to interest/credit spread changes from the time of origination. Pricing to reflect current interest/credit spreads was based on secondary market quotes. A $9.5 million pretax loss on sale of loans from the Bank to BMO Chicago Branch was recorded to loan sale losses in the Consolidated Statements of Operations.
 
At December 31, 2010, derivative contracts with BMO represent $350.8 million and $422.6 million of unrealized gains and unrealized losses, respectively. At December 31, 2009, derivative contracts with BMO represented $350.4 million and $485.4 million of unrealized gains and unrealized losses, respectively. At December 31, 2008, derivative contracts with BMO represented $325.4 million and $512.4 million of unrealized gains and unrealized losses, respectively.
 
In June 2007 the Bank amended the leaseback agreement for the building located at 111 West Monroe Street, Chicago, Illinois. The Bank received from BMO Chicago Branch a payment of $6.1 million as compensation for the extension of the original lease termination dates and a payment of $5.8 million as compensation for the vacancy anticipated on the original lease. The payments were deferred and are amortized on a straight-line basis over the remaining term of the lease. Deferred revenue recognized of $0.7 million was recognized in 2010, 2009 and 2008.
 
The Bank and BMO combined their U.S. foreign exchange (“FX”) activities. Under this arrangement, the Bank and BMO share FX net profit in accordance with a specific formula set forth in the agreement. This agreement expires on September 30, 2011 but may be extended at that time. Either party may terminate the arrangement at its


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
option. FX revenues are reported net of expenses. During 2010, 2009 and 2008 foreign exchange revenues were $4.9 million, $11.5 million, and $6.9 million, respectively, under this agreement.
 
The Bank has loans outstanding to certain executive officers and directors. These loans totaled $1.3 million and $1.2 million at December 31, 2010 and 2009, respectively.
 
During 2010 and 2009 the Bank held demand deposits on behalf of BMO and its subsidiaries. At December 31, 2010 and 2009, the Bank had $239.1 million $353.1 million of such deposits, respectively. The Bank also held a foreign demand deposit with a BMO affiliate of $2.7 billion as of December 31, 2010 and none at December 31, 2009.
 
The Bank enters into purchases of securities, primarily U.S. Treasury and Federal agency securities under agreements to resell identical securities with HFC and its subsidiaries. The amounts advanced under these agreements represent short-term loans and are reflected as assets in the Consolidated Statements of Condition. Securities purchased under agreement to resell between the Bank and HFC and its subsidiaries totaled $1.2 billion and $144.9 million at December 31, 2010 and 2009, respectively.
 
The following tables summarize the Bank’s related party transactions for long-term notes (senior and subordinated) and certificates of deposit:
 
                                             
    Interest Expense
    Loan Balance
           
    Year Ended December 31     December 31            
    2010     2009     2010     2009     Rate   Reprice  
    (In thousands)            
 
Long-term notes — senior/unsecured
                                           
Floating rate senior note to BMO subsidiary due June 15, 2010
        $ 2,526                          
Floating rate senior note to BMO subsidiary due June 13, 2011
    3,594       12,096       746,500       746,500     14bps + 90 day LIBOR     Quarterly  
Floating rate senior note to BMO branch due August 14, 2012
    5,301       8,722       1,100,000       1,100,000     14bps + 90 day LIBOR     Quarterly  
Floating rate senior note to BMO subsidiary due September 29, 2011
    9,990       7,092       550,000       550,000     14bps + 90 day LIBOR     Quarterly  
                                             
Total long-term notes — senior/unsecured
  $ 18,885     $ 30,436     $ 2,396,500     $ 2,396,500              
                                             
Long-term notes — subordinated
                                           
Floating rate subordinated note to Bankcorp due December 23, 2012
  $ 48     $ 424     $     $ 28,500     50bps + 90 day LIBOR     Quarterly  
Floating rate subordinated note to Bankcorp due May 30, 2013
    57       498             34,000     50bps + 90 day LIBOR     Quarterly  
Floating rate subordinated note to Bankcorp due November 26, 2013
    41       347             24,000     50bps + 90 day LIBOR     Quarterly  
Floating rate subordinated note to Bankcorp due February 26, 2014
    12       91             6,250     50bps + 90 day LIBOR     Quarterly  
Floating rate subordinated note to Bankcorp due May 31, 2014
    702       1,310       100,000       100,000     35bps + 90 day LIBOR     Quarterly  
Floating rate subordinated note to Bankcorp due May 31, 2016
    728       1,335       100,000       100,000     38bps + 90 day LIBOR     Quarterly  
                                             
Total long-term notes — subordinated
  $ 1,588     $ 4,005     $ 200,000     $ 292,750              
                                             
Total long-term notes
  $ 20,473     $ 34,441     $ 2,596,500     $ 2,689,250              
                                             
 


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
                                             
    Interest Expense
    Certificate of Deposit
           
    Year Ended December 31     Balance December 31            
    2010     2009     2010     2009            
    (In thousands)            
 
Certificates of deposit
                                           
Certificate of deposit to BMO subsidiary due on March 31, 2009
  $     $ 4,534     $     $     4.30%     Fixed  
Certificate of deposit to BMO subsidiary due on May 29, 2009
          632                 35bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on June 30, 2009
          484                 35bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on July 31, 2009
          696                 38bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on August 28, 2009
          1,281                 38bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on September 28, 2009
          7,016                 6bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on February 7, 2011
    3       17       1,300       1,300     0.18%     Fixed  
Certificate of deposit to BMO subsidiary due on October 10, 2010
          2             125     0.25%     Fixed  
Certificate of deposit to BMO subsidiary due on January 26, 2011(1)
                250           0.14%     Fixed  
Certificate of deposit to BMO subsidiary due on January 4, 2011
    4       2       3,194       3,121     0.12%     Fixed  
Certificate of deposit to BMO subsidiary due on July 29, 2011
    12,201       11,804       950,000       950,000     93bps + 90 day LIBOR     Quarterly  
Certificate of deposit to BMO subsidiary due on September 29, 2011
          9,468                 145bps + 90 day LIBOR     Quarterly  
                                             
Total certificates of deposit
  $ 12,208     $ 35,936     $ 954,744     $ 954,546              
                                             
 
 
(1) Includes interest expense less than $1 thousand.
 
25.   Restructuring Charge
 
During 2007, the Bank recorded a restructuring charge of $18.8 million in the Consolidated Statements of Operations. The objectives of the restructuring were to enhance customer service by directing spending and resources to front-line sales and service improvements, creating more efficient processes and systems and continuing to accelerate the pace of growth.
 
The charge related to the elimination of positions in primarily non-customer-facing areas of the Bank across all support functions and business groups, lease cancellation payments for those locations where the Bank has legally extinguished its lease obligations as well as costs associated with the carrying value of abandoned assets in excess of their fair market value.
 
During the years ended December 31, 2009 and 2008, the Bank changed its estimate for restructuring, resulting in a $0.7 million reduction and a $2.7 million reduction, respectively, in the original accrual due primarily to lower severance payments than originally estimated.
 
         
    Severance-Related
 
    Charges  
 
Balance at December 31, 2008
  $ 862  
Restructuring reversals during the year
    (702 )
(Paid), reversed during the year
    (160 )
         
Balance at December 31, 2009
  $  
         

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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
26.   Visa Indemnification Charge
 
HNA was a member of Visa U.S.A. Inc. (“Visa U.S.A.”) and in 2007 received shares of restricted stock in Visa, Inc. (“Visa”) as a result of its participation in the global restructuring of Visa U.S.A., Visa Canada Association, and Visa International Service Association in preparation for an initial public offering by Visa. HNA and other Visa U.S.A. member banks are obligated to share in potential losses resulting from certain indemnified litigation involving Visa that has been settled.
 
A member bank such as HNA is also required to recognize the contingent obligation to indemnify Visa under Visa’s bylaws (as those bylaws were modified at the time of the Visa restructuring on October 3, 2007) for potential losses arising from the other indemnified litigation that has not yet settled at its estimated fair value. HNA is not a direct party to this litigation and does not have access to any specific, non-public information concerning the matters that are the subject of the indemnification obligations. While the estimation of any potential losses is highly judgmental, as of December 31, 2007, HNA recorded a liability and corresponding charge of $34 million (pretax) for the remaining litigation.
 
The initial public offering (IPO) occurred on March 25, 2008 followed by a mandatory partial redemption of Harris’ restricted stock in Visa that took place in two parts: exchange for cash and funding of the covered litigation escrow account. During the first quarter of 2008, HNA received $37.8 million in cash in conjunction with the mandatory partial redemption which was recognized as an equity security gain in the Consolidated Statements of Operations since there was no basis in the stock. In addition, Visa funded the U.S. litigation escrow account with IPO proceeds. Harris’ share of the U.S. litigation escrow account funding was $17 million which was recognized as a reversal to the litigation reserve and as a decrease to noninterest expense.
 
On October 27, 2008, Visa announced the settlement of the litigation involving Discover Financial Services. As a result, HNA recorded an additional reserve for this matter of $7 million (pretax) during the third quarter of 2008 as an increase to noninterest expense.
 
In October 2010, June 2010, July 2009 and December 2008, HNA recorded decreases to noninterest expense of $4.7 million, $2.8 million, $3.0 million and $6.3 million, respectively, as a reduction in the Visa litigation reserve to reflect Visa’s use of a portion of the Bank’s restricted Visa stock to fund the escrow account available to settle certain litigation matters. Visa’s funding of amounts required beyond the current escrow, if any, will be obtained via additional mandatory redemptions of restricted shares. As of December 31, 2010 and 2009, the recorded reserve relating to the Visa litigation matter included in the Consolidated Statements of Condition was $7.2 million and $14.8 million, respectively.
 
27.   Other Assets
 
Other securities are recorded in Other Assets on the Bank’s Consolidated Statements of Condition and primarily include Federal Reserve stock, FHLB stock and Community Reinvestment Act (“CRA”) investments. Other securities totaled $334.0 million at December 31, 2010 and $269.2 million at December 31, 2009.
 
Federal Reserve stock totaled $104.8 million and $70.4 million at year end 2010 and 2009, respectively, and FHLB stock totaled $172.5 million and $155.0 million at year end 2010 and 2009. The Bank is required to own these securities as a member of both the Federal Reserve System and the FHLB, and in amounts as required by these financial institutions. These securities are “restricted” in that they can only be sold back to the respective institutions or another member institution at par. Therefore, their fair value is considered to be equal to amortized cost unless there is an identified event that may have a significant adverse effect on their fair value. No other-than-temporary impairment was recorded for Federal Reserve stock or FHLB stock during 2010 or 2009.
 
The FHLB of Chicago announced in October 2007 that it was under a consensual cease and desist order with its regulator, which among other things, restricts various future activities of the FHLB of Chicago. Such restrictions may limit or prevent the FHLB of Chicago from paying dividends or redeeming stock without prior approval. The FHLB of Chicago paid a dividend in the first quarter of 2011. Based on evaluations of this investment as of December 31, 2010 and 2009, the Bank believes the cost of the investment will be recovered.


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HARRIS N.A. AND SUBSIDIARIES
 
Notes to Consolidated Financial Statements — (Continued)
 
At December 31, 2010, no FHLB stock was pledged as collateral for FHLB advances.
 
Investments in companies where the Bank does not have significant influence are recorded at cost. Investments in companies where the Bank exerts significant influence are initially recorded at cost and adjusted for the Bank’s proportionate share of the net income or loss of the companies.
 
Securities received in satisfaction of debt are recorded at fair value. Fair value is determined using exchange traded prices where available. Otherwise, fair value is determined using other methods such as third party valuations or analysis of discounted cash flows. Securities that are not designated trading or available-for-sale are recorded in other assets.
 
CRA investments and other nonmarketable securities are subject to ongoing impairment reviews. See Note 2 to the Consolidated Financial Statements for additional information on the impairment review applied to all investments, including nonmarketable securities. During 2010, the Bank recorded other-than-temporary impairment of $0.2 million on four CRA investments. During 2009, the Bank recorded other-than-temporary impairment of $1.3 million on 27 CRA investments. During 2008, the Bank recorded other-than-temporary impairment of $4.6 million on six CRA investments. Losses related to declines in the estimated fair value of the investments were recorded in the Consolidated Statements of Operations to other-than-temporary impairment in 2010, 2009 and 2008.
 
The acquisition of AMCORE from the FDIC includes a loss share agreement with the FDIC. The loss share agreement provides for reimbursement from the FDIC for 80% of losses incurred on covered assets, including loans and OREO, subsequent to acquisition date. At acquisition, acquired loans and OREO of $1.5 billion and $23.0 million, respectively, were subject to the loss share agreement. An indemnification asset estimated at a fair value of $427.5 million was recorded at acquisition based on the present value of expected cash flows to be received from the FDIC for loss reimbursements covered by the agreement. The indemnification asset is included in Other Assets. Subsequent to acquisition date but prior to December 31, 2010, the FDIC indemnification asset was increased by approximately $8.1 million due to an increase in the expected cash flows to be received from the FDIC from those initially expected and was reduced by $75.2 million for losses reimbursed by the FDIC. The balance at December 31, 2010 was $359.9 million.
 
Other real estate owned (“OREO”) received in satisfaction of debt is included in Other Assets and recorded at the lower of the recorded investment in the loan or the fair value of the real estate received, less estimated selling costs. Any write-down to the fair value of OREO at the time of acquisition is charged to the allowance for loan losses. Losses to OREO arising from subsequent write-downs to fair value are charged to noninterest expense and recognized as a valuation allowance against the OREO.
 
At December 31, 2010, OREO totaled $37.7 million which was net of the valuation allowance of $3.6 million, of which $21.7 million was covered by the FDIC loss share agreement. At December 31, 2009, OREO totaled $10.9 million which was net of the valuation allowance of $0.6 million.
 
Property held for sale is recorded in other assets at the lower of cost or fair value less estimated selling costs. The carrying value of property held for sale was $4.6 million and $4.9 million at December 31, 2010 and 2009, respectively. All changes in the valuation allowance were recorded directly to noninterest expense during the years ended December 31, 2010 and 2009.
 
28.   Subsequent Events
 
The consolidated financial statements have been prepared by management from the books and records of the Bank and audited by independent certified public accountants. The statements reflect all adjustments and disclosures which, in the opinion of management, are necessary for a fair presentation of the results for the periods presented. Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements through March 31, 2011, the date the consolidated financial statements were issued.


111