BNCCORP Inc.
Annual Report 2008

Plain-text annual report

BNCCORP, Inc. BNCCORP, Inc. Corporate Profile BNCCORP, Inc. (Pink Sheets: BNCC) operates community banking and wealth management businesses from 20 locations in Arizona, Minnesota and North Dakota. In 2008, we expanded mortgage banking operations to originate residential mortgage loans from five locations in Arizona, Iowa, Kansas and Missouri. To Our Stockholders, Customers, Employees and Friends: The economic environment during the past year was one of the most challenging in decades, especially for the financial institution sector. I am pleased to report that despite nearly unprecedented market disruption, BNCCORP delivered solid results for 2008. We recorded growth in net income, in sharp contrast to the severe losses experienced by much of the nation’s banking industry. More important, we strengthened our capital base as an added measure of security against the fiscal pressures that are expected to persist well into 2009, if not beyond. While no institution is immune to the global economic downturn, we believe BNC is well- positioned to navigate turbulent times and concurrently serve our customers, community and stockholders. FINANCIAL PERFORMANCE In 2008, BNC delivered one of its strongest performances, benefitting from our efforts in prior years to refocus on the Company’s core businesses. Net income rose to $2.22 million, or $0.67 per diluted share, from $1.98 million, or $0.57 per diluted share, for 2007. The key factors contributing to our earnings from continuing operations were an increase in net interest income due to the growth in our balance sheet, higher non-interest income from mortgage banking revenues, and reduced non-interest expenses. These improvements were partly offset by a $4 million increase in the provision for loan losses resulting from the difficult credit environment. Our total assets amounted to $861.5 million at the end of 2008, growing $161.9 million from the prior year. Loans held for investment contributed $45.2 million of this increase, as we continued to serve the needs of businesses and individuals in our marketplace through prudent and responsible lending. At the same time, the investment portfolio increased by $86.9 million year-over-year, as a result of leverage strategies designed to increase our net interest income. Total deposits reached $675.3 million at December 31, 2008, growing by $133.5 million, a $63.7 million increase in core deposits contributed significantly to deposit growth. THE BENEFITS OF STRATEGIC TRANSFORMATION To a major extent, our performance in 2008 was the direct outcome of our earlier efforts to restructure and reposition BNC’s business. In the 2007 Annual Report, we described our strategic initiatives to sell our former insurance agency subsidiary and to use the sale proceeds to significantly increase our capital base, reduce or refinance higher-cost debt, and reinvest in higher-yielding assets. Due to this transformation, BNC now has a far stronger balance sheet, greater capacity to deliver revenue and earnings from recurring sources, and virtually no exposure to the cyclicality and seasonality of the insurance segment. Candidly, we did not fully anticipate the global economic turmoil at the time we planned this strategic transformation. None-the-less, we were confident the transformation would make the Company’s core businesses more sustainable – and our capital base stronger. These actions have positioned BNC well for the severe conditions the global economy faces today and opportunities we believe will emerge tomorrow. CAPITAL – AND CONFIDENCE BNC’s solid capital foundation provides an important measure of assurance to customers and investors in a difficult economy, while supporting our capacity to make loans, serve our market and grow our business. The Company and its BNC National Bank subsidiary maintained strong capital ratios throughout the year and continued to exceed regulatory standards for “well-capitalized” institutions at December 31, 2008. GREGORY K. CLEVELAND President and Chief Executive Officer “…we believe BNC is well- positioned to navigate turbulent times and concurrently serve our customers, community and stockholders.” BNCCORP, Inc. Annual Report 2008 1 In January 2009, we further strengthened our capital base by becoming one of the select institutions permitted to participate in the U.S. Treasury’s Capital Purchase Program. Under the program, which is available only to strong, sound community banks, the U.S. Treasury purchased shares of non-voting senior preferred stock in BNCCORP, Inc. and exercised warrants for an additional class of preferred shares. The proceeds from our participation in the program added approximately $20.1 million to our capital. We recognize that there is uncertainty as to future conditions or restrictions that may be imposed by governmental agencies on banks that have participated in this program. However, in view of our responsibility to guard against the even greater uncertainties of the current economic climate, and the opportunity to build a more robust capital foundation, we believed it was in the best interests of our Company, our depositors and our shareholders to take part in the Treasury program. ASSET QUALITY In view of the weakness in economic conditions, credit risk has increased industry-wide during 2008 and is expected to remain an issue in periods beyond. Accordingly, our classified loans, non-accrual loans and other real estate owned – as well as related provisions for credit and other real estate losses – were higher in 2008 than in recent years. All of these metrics are likely to be elevated for the foreseeable future. Due to the extremely illiquid markets for virtually every asset class, and the possibility of further declines in asset valuations, it is very likely that asset quality will continue to come under pressure. We believe this is one of the primary risks inherent in the financial system for the foreseeable future. Given these conditions, we continue to carefully monitor our asset quality while at the same time remaining committed to serving the needs of credit-worthy borrowers in our marketplace. CHALLENGE – AND OPPORTUNITY While it is easy to see challenges in the present economic environment, we also believe there will be opportunities for BNC. Our mortgage banking operations, for example, may benefit from lower interest rates. We are also seeing a return to more realistic pricing of lending products, as the marketplace now has a clearer understanding of the impact of risk on asset pricing. In the deposit area, we would expect a “flight to quality” as customers shift to better-capitalized institutions. Overall, we see the potential to gain market share from competitors that may be unable or unwilling to meet customers’ needs under current business conditions. Our view of these potential opportunities does not change the fact that the global business climate is expected to remain unforgiving in the coming year. It is not possible to predict the length or depth of the economic downturn. As a result, expectations for financial performance should remain modest for the near term. What we do know is that BNC is approaching this period from a position of strength. We have abundant capital to support our business and to enhance our ability to serve customers. We are maintaining a close watch over our asset quality and have a disciplined focus on managing expenses. Fortunately, our business is geographically diverse, with banking operations in Arizona, Minnesota and North Dakota. Weak economies is some of our markets can be offset by stability in other regions. And, we have a talented, dedicated and experienced team that is driven to deliver solid results under adverse circumstances. In summary, we are confident that the Company is positioned to withstand the harsh economic headwinds and to benefit from opportunities that may arise. On behalf of the Board of Directors of BNC and our entire team, we want to thank our customers, shareholders and community for their support, and assure you that we remain committed to the continued strong, sound operation of BNC for the long term. Sincerely, GREGORY K. CLEVELAND President and Chief Executive Officer 2 BNCCORP, Inc. Annual Report 2008 BNCCORP, INC. INDEX TO YEAR END FINANCIAL REPORT December 31, 2008 TABLE OF CONTENTS Selected Financial Data .................................................................................................................. Business .......................................................................................................................................... 4 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations .................................................................................................................................... 8 Quantitative and Qualitative Disclosures about Market Risk ....................................................... 27 BNCCORP, Inc. Annual Report 2008 3 Selected Financial Data The selected consolidated financial data presented below under the captions “Income Statement Data” and “Balance Sheet Data” as of and for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 is derived from the historical audited consolidated financial statements of the Company. The financial data below should be read in conjunction with and is qualified by the Consolidated Financial Statements and the notes thereto. $ $ $ Income Statement Data from Continuing Operations: Total interest income Total interest expense Net interest income Provision for credit losses Non-interest income Non-interest expense Income tax expense (benefit) Income (loss) from continuing operations Balance Sheet Data: (at end of period) Total assets Investments securities available for sale Federal Funds Sold Federal Reserve Bank and Federal Home Loan Bank stock Loans held for sale Participating interests in mortgage loans Loans and leases held for investment, net of unearned income Allowance for credit losses Total deposits Short-term borrowings Federal Home Loan Bank advances Long-term borrowings Guaranteed preferred beneficial interests in Company’s subordinated debentures Common stockholders’ equity Book value per common share outstanding Tangible book value Earnings Performance / Share Data from Continuing Operations: Return (loss) on average total assets Return (loss) on average common stockholders’ equity Efficiency ratio Net interest margin Net interest spread Basic earnings (loss) per common share Diluted earnings (loss) per common share Average common shares outstanding Average common and common equivalent shares Shares outstanding at year end Balance Sheet and Other Key Ratios from Continuing $ $ $ $ Operations: 2008 For the Years Ended December 31, 2005 2006 2007 (dollars in thousands, except share and per share data) 2004 46,026 $ 19,215 26,811 7,750 10,395 26,501 737 2,218 $ 44,241 $ 21,994 22,247 3,750 3,853 28,147 (2,728) (3,069) $ 42,408 $ 23,606 18,802 210 5,138 23,075 (363) 1,018 $ 37,264 $ 19,718 17,546 250 5,823 21,859 238 1,022 $ 30,141 14,146 15,995 175 5,235 19,924 (177) 1,308 861,498 $ 209,857 - 5,989 13,403 28,584 542,753 (8,751) 675,321 16,844 84,500 - 699,591 $ 122,899 - 4,918 - 24,357 497,556 (6,599) 541,874 5,365 61,400 - 692,276 $ 182,974 24,000 5,003 1,669 56,125 333,934 (3,370) 529,252 9,709 62,200 1,167 740,016 $ 227,185 - 5,791 266 101,336 310,368 (3,188) 548,790 21,416 82,200 3,850 673,710 235,916 - 7,541 25,682 34,515 293,814 (3,335) 455,343 33,697 97,200 10,079 23,025 53,947 16.35 $ 16.23 $ 23,075 59,730 17.11 $ 16.99 $ 22,711 55,602 15.44 $ 7.15 $ 22,648 51,612 14.97 $ 6.63 $ 22,509 42,596 14.77 4.42 0.28% 3.85% 71.22% 3.64% 3.46% 0.67 $ 0.67 $ 3,291,697 3,319,225 3,299,163 (0.47)% (5.25)% 107.85% 3.81% 3.31% (0.89) $ (0.89) $ 3,456,993 3,515,852 3,491,337 0.14% 1.92% 96.39% 3.04% 2.73% 0.29 $ 0.29 $ 3,473,670 3,514,709 3,600,467 0.14% 2.14% 93.54% 2.79% 2.58% 0.33 $ 0.33 $ 2,988,440 3,048,139 3,447,945 0.21% 2.86% 93.85% 2.85% 2.71% 0.39 0.38 2,813,531 2,896,241 2,884,876 0.09% 0.17% (0.579)% 1.02% 607% 6.79% Nonperforming assets to total assets Nonperforming loans to loans and leases held for investment Net loan charge-offs to average loans and leases held for investment Allowance for credit losses to total loans Allowance for credit losses to total nonperforming loans Average common stockholders’ equity to average total assets 3.84% 4.22% (0.534)% 1.50% 38% 7.25% 0.77% 1.09% (0.129)% 1.26% 122% 9.16% 0.02% 0.03% (0.008)% 0.86% 3,304% 7.87% 0.02% 0.03% (0.130)% 0.77% 2,229% 6.75% 4 BNCCORP, Inc. Annual Report 2008 1 Quarterly Financial Data 2008 Interest income Interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Non-interest income Non-interest expense Income (loss) from continuing operations before income taxes Income tax expense (benefit) Income (loss) from continuing operations Discontinued operations: Income from discontinued insurance segment Income tax expense Income from discontinued operations Net income (loss) Basic earnings per common share: Income (loss) from continuing operations First Quarter Second Quarter Third Quarter Fourth Quarter $ 11,385 5,113 6,272 800 $ 11,496 4,731 6,765 2,000 $ 11,694 4,884 6,810 1,800 $ 11,451 4,487 6,964 3,150 YTD $ 46,026 19,215 26,811 7,750 5,472 2,300 5,739 4,765 3,358 7,078 5,010 2,409 6,875 3,814 2,328 6,809 19,061 10,395 26,501 2,033 671 1,362 1,045 345 700 544 39 505 (667) (318) (349) 2,955 737 2,218 - - $ 1,362 - - - $ 700 - - - - - - $ 505 $ (349) $ 2,218 $ 0.40 $ 0.22 $ 0.16 $ (0.11) $ 0.67 Income from discontinued insurance segment, net of income taxes Basic earnings (loss) per common share $ 0.00 0.40 $ 0.00 0.22 $ 0.00 0.16 $ 0.00 (0.11) $ 0.00 0.67 Diluted earnings per common share: Income (loss) from continuing operations $ 0.39 $ 0.21 $ 0.15 $ (0.11) $ 0.67 Income from discontinued insurance segment, net of income taxes Diluted earnings (loss) per common share $ 0.00 0.39 $ 0.00 0.21 $ 0.00 0.15 $ 0.00 (0.11) $ 0.00 0.67 Average common shares: Basic Diluted 3,407,821 3,449,481 3,248,101 3,294,559 3,243,388 3,233,740 3,261,945 3,237,177 3,291,697 3,319,225 BNCCORP, Inc. Annual Report 2008 5 2 Interest income Interest expense Net interest income Provision for credit losses 2007 First Quarter $ 10,875 6,076 4,799 250 Second Quarter $ 11,133 5,773 5,360 700 Third Quarter Fourth Quarter $ 10,988 5,047 5,941 2,800 $ 11,245 5,098 6,147 - YTD $ 44,241 21,994 22,247 3,750 Net interest income after provision for credit losses 4,549 4,660 3,141 6,147 18,497 Non-interest income (loss) Non-interest expense 1,697 5,986 (284) 7,739 310 6,859 2,130 7,563 3,853 28,147 Income (loss) from continuing operations before income taxes Income tax expense (benefit) Income (loss) from continuing operations Discontinued operations: Income from discontinued insurance segment, (including a gain on sale of $6,083 for the second, third and fourth quarters) Income tax expense (benefit) Income (loss) from discontinued operations Net income (loss) Basic earnings per common share: Income (loss) from continuing operations Income (loss) from discontinued insurance segment, net of income taxes Basic earnings (loss) per common share $ Diluted earnings per common share: Income (loss) from continuing operations Income (loss) from discontinued insurance segment, net of income taxes Diluted earnings (loss) per common share $ 260 (1) 261 (3,363) (1,386) (1,977) (3,408) (1,345) (2,063) 714 4 710 (5,797) (2,728) (3,069) 2,070 774 1,296 $ 1,557 6,084 2,280 (12) 62 (26) (49) 8,116 3,067 3,804 $ 1,827 (74) $ (2,137) 23 $ 733 5,049 $ 1,980 $ 0.06 $ (0.56) $ (0.60) $ 0.21 $ (0.89) 0.40 0.46 $ 1.08 0.52 $ (0.02) (0.62) $ - 0.21 $ 1.46 0.57 $ 0.07 $ (0.56) $ (0.60) $ 0.20 $ (0.89) 0.39 0.46 $ 1.08 0.52 $ (0.02) (0.62) $ 0.01 0.21 $ 1.46 0.57 Average common shares: Basic Diluted 3,500,810 3,555,984 3,501,544 3,573,181 3,414,670 3,475,599 3,439,571 3,487,268 3,456,993 3,515,852 6 BNCCORP, Inc. Annual Report 2008 3 Business General BNCCORP, Inc. (BNCCORP or the Company) is a bank holding company registered under the Bank Holding Company Act of 1956 headquartered in Bismarck, North Dakota. It is the parent company of BNC National Bank (the Bank). The Company operates community banking and wealth management businesses from 20 locations in Arizona, Minnesota and North Dakota. In 2008, we expanded mortgage banking operations to originate residential mortgage loans from five locations in Arizona, Iowa, Kansas and Missouri. During 2007 we sold substantially all of the assets of BNC Insurance, Inc, our insurance agency. The proceeds from the sale were primarily used to fortify the balance sheet and capital of the Bank. Operating Strategy In our banking and wealth management operations we provide relationship-based services to small and mid-sized businesses, business owners, professionals and consumers in our primary market areas of Arizona, Minnesota and North Dakota. Key elements of our operating strategy are: • • • • • Provide individualized, high-level customer service; Offer diversified products and services; Emphasize deposit growth; Expand opportunistically; and Manage credit risk. In 2008 we continued to execute this strategy by expanding our mortgage banking operations. We believe this expansion was opportunistic because the cost of entry in this industry was low and these operations enhanced our line of products. We are optimistic it can be expanded into markets where we have banking and wealth management operations to further synergize our business. Current Operating Environment The global economy is experiencing a recessionary decline in asset values. Governments throughout the world are attempting to support economies because private capital is either unable or unwilling to counteract the decline in asset values. It is not unreasonable to presume we are in a depression. Recessionary devaluation can impact many asset classes. Cash positions can be devalued by inflation and devaluation of the dollar. Investments can be devalued by illiquidity and declines in the assets supporting the investments. Real estate loans can be devalued by declines in their collateral. Commercial business loans can be devalued when businesses suffer in a recessionary environment. Maturities of debt can be accelerated when the assets collateralizing debt devalue. Devaluation of our assets, or assets collateralizing our loans, could adversely impact earnings and regulatory capital. Our business is significantly influenced by asset values. Maintaining sufficient capital and liquidity is essential to survival of all businesses, including BNCCORP. BNCCORP, Inc. Annual Report 2008 7 4 Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview The following table summarizes net income (loss) and basic and diluted earnings (loss) per share for the year ended December 31 (dollars are in thousands): Net income (loss) attributable to continuing operations Net income attributable to discontinued operations Net income attributable to common shareholders Net income per share Basic earnings (loss) per share from continuing operations Basic earnings per share from discontinued operations Basic earnings per share Diluted earnings (loss) per share from continuing operations Diluted earnings per share from discontinued operations Diluted earnings per share 2008 2007 $ $ $ $ $ $ $ $ 2,218 - 2,218 0.67 - 0.67 0.67 - 0.67 $ $ (3,069) 5,049 1,980 $ $ $ $ $ $ (0.89) 1.46 0.57 (0.89) 1.46 0.57 Highlights. The following information highlights key developments in 2008: • Assets increased by $161.9 million, or 23.1%, from $699.6 million to $861.5 million; • Investment securities increased by $86.9 million as a result of leverage strategies implemented to increase net interest income; • Loans held for investment increased $45.2 million primarily due to organic growth; • Nonperforming assets increased significantly, including other real estate owned which increased by $10.2 million due to foreclosures; • Total deposits increased by $133.5 million to $675.3 million; • Core deposits increased $63.7 million to $575.6 million; • Wholesale deposits increased by $69.7 million as proceeds were used to fund purchases of investment securities; • Net interest income increased approximately 21% to $26.811 million; • Provisions for credit losses increased by $4 million to $7.750 million; • Non-interest income increased significantly to $10.4 million; and • Non-interest expenses decreased by 5.85 % to $26.501 million. Results from Continuing Operations Net income from continuing operations in 2008 was $2.218 million, or $0.67 per diluted share, compared to a net loss of $(3.069) million, or $(0.89) per diluted share in 2007. Net Interest Income in Continuing Operations The following table sets forth information relating to our average balance sheet data and reflects the yield on average assets and cost of average liabilities. Such yields and costs are derived by dividing income and expense by the average balance of assets and liabilities. All average balances have been derived from monthly averages, which are indicative of daily averages (dollars are in thousands): 8 BNCCORP, Inc. Annual Report 2008 5  Analysis of Changes in Net Interest Income For the Year ended December 31, For the Year ended December 31, For the Year ended December 31, 2008 Average balance Interest earned Average yield or or owed cost Average balance 2007 Interest earned or owed Average yield or Average 2006 Interest earned cost balance or owed Average yield or cost (dollars in thousands) (dollars in thousands) (dollars in thousands) Assets Federal funds sold/interest-bearing due from $ Taxable investments Tax-exempt investments 95 $ 1 172,383 9,864 16,994 839 1.05% $ 5.72% 4.94% 14,616 $ 754 6,001 124,242 926 18,815 5.16% $ 4.83% 4.92% 42,121 $ 2,069 8,044 174,995 1,644 36,249 Loans held for sale Participating interests in mortgage loans Loans and leases held for investment 3,586 220 24,688 1,408 525,311 33,694 6.13% 5.70% 6.41% 417 27,469 402,616 - 2,137 34,423 0.00% 7.78% 8.55% 1,088 33,180 334,058 - 2,344 28,307 4.91% 4.60% 4.54% 0.00% 7.06% 8.47% Allowance for credit losses (7,105) - (4,335) - (3,326) - Total interest-earning assets Non-interest-earning assets: Assets from discontinued operations Cash and due from banks Other 735,952 46,026 6.25% 583,840 44,241 7.58% 618,365 42,408 6.86% - 10,481 47,835 13,344 12,468 41,653 31,129 15,360 40,004 Total assets $ 794,268 $ 651,305 $ 704,858 Liabilities and Stockholders’ Equity Deposits: Interest checking and money market accounts Savings Certificates of deposit: Under $100,000 $100,000 and over Total interest-bearing deposits Borrowings: Short-term borrowings FHLB advances Long-term borrowings Subordinated debentures $ 244,279 4,074 9,859 33 1.67% $ 0.33% 249,246 8,399 8,007 66 3.21% $ 0.79% 246,476 8,398 7,440 66 3.02% 0.79% 232,367 8,981 3.87% 149,010 7,141 4.79% 150,194 6,440 58,378 2,011 3.44% 44,824 2,319 5.17% 54,155 2,499 544,883 15,099 2.77% 451,479 17,533 3.88% 459,223 16,445 7,049 144 87,159 2,291 519 25 2.04% 2.63% 4.82% 8,706 32,991 131 398 1,915 11 4.57% 5.80% 8.40% 14,480 73,060 2,659 685 4,020 201 4.29% 4.61% 3.58% 4.73% 5.50% 7.56% 22,734 1,656 7.29% 22,641 2,137 9.44% 22,458 2,255 10.04% Total interest-bearing liabilities 662,344 19,215 2.90% 515,948 21,994 4.26% 571,880 23,606 4.13% Non-interest-bearing demand accounts Total deposits and interest-bearing liabilities Liabilities from discontinued operations Other non-interest-bearing liabilities Total liabilities Stockholders’ equity Total liabilities and stockholders’ 66,388 728,732 - 7,928 736,660 57,608 68,277 584,225 2,584 6,089 592,898 58,407 68,743 640,623 6,062 5,161 651,846 53,012 equity $ 794,268 $ 651,305 $ 704,858 Net interest income $ 26,811 $ 22,247 $ 18,802 Net interest spread Net interest margin Ratio of average interest-earning assets to average interest-bearing liabilities 3.35% 3.64% 3.32% 3.81% 2.73% 3.04% 111.11% 113.16% 108.13% BNCCORP, Inc. Annual Report 2008 9 6 The following table illustrates the dollar amount of changes in our interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the changes related to volume and rates (changes attributable to the combined impact of volume and rate have been allocated proportionately): For the Years Ended December 31, For the Years Ended December 31, 2008 Compared to 2007 2007 Compared to 2006 Change Due to Change Due to Volume Rate Total Volume (in thousands) Rate (in thousands) Total $ (418) 2,616 (91) 97 $ (335) 1,247 4 123 $ (753) 3,863 (87) 220 $ (1,425) (2,477) (873) - $ 110 434 155 - $ (1,315) (2,043) (718) - (200) 9,051 (529) (9,780) (728) (729) (503) 5,859 296 257 (207) 6,116 Interest Earned on Interest- Earning Assets Federal funds sold/interest- bearing due from Taxable investments Tax-exempt investments Loans held for sale Participating interests in mortgage loans Loans held for investment Total increase (decrease) in interest income 11,055 (9,270) 1,785 581 1,252 1,833 Interest Expense on Interest- Bearing Liabilities Interest checking and money market accounts Savings Certificates of Deposit: Under $100,000 $100,000 and over Short-term borrowings FHLB advances Long-term borrowings Subordinated debentures Total increase (decrease) in (157) 14 (3,776) (47) (3,933) (33) 84 - 483 - 567 - 2,814 2,948 (65) 565 16 9 (974) (3,256) (189) (189) (2) (490) 1,840 (308) (254) 376 14 (481) (50) (606) (265) (2,339) (215) 19 751 426 (22) 234 25 (137) 701 (180) (287) (2,105) (190) (118) interest expense 6,144 (8,923) (2,779) (3,372) 1,760 (1,612) Increase (decrease) in net interest income $ 4,911 $ (347) $ 4,564 $ 3,953 $ (508) $ 3,445 Net interest income was $26.811 million in 2008 compared to $22.247 million in 2007, an increase of $4.564 million or 21%. The net interest margin decreased to 3.64% for the year ended December 31, 2008, from 3.81% in 2007. The margin decreased in 2008 due to the impact of non-accrual loans and other nonperforming assets. Interest income increased in 2008 primarily due to higher balances of investment securities and higher rates earned thereon. These increases are the result of a leverage strategy implemented to increase net interest income. Loan balances increased primarily due to organic growth. This increase partially offset the decline in interest income due to decreasing interest rates and nonaccrual loans. 10 BNCCORP, Inc. Annual Report 2008 7 Interest expense decreased in 2008 primarily because interest rates decreased significantly in 2008. Increases in the balances of deposits and borrowings partially offset the decline in rates. Net interest income was $22.247 million in 2007 compared to $18.802 million in 2006, an increase of $3.445 million or 18.3%. The net interest margin increased to 3.81% for the year ended December 31, 2007, from 3.04% in 2006. The margin increased in 2007 as a result of transactions that restructured our balance sheet. Interest income increased in 2007 primarily due to higher balances of loans and leases held for investment. These balances were higher due to purchases of loans aggregating $70.0 million and organic loan growth. A significant portion of loan purchases related to loan participations we had previously sold, which we were able to repurchase when our lending limit increased after the sale of BNC Insurance. The increase in interest income resulting from the increase in loans and leases held for investment was partially offset by a decrease in investment securities and Federal Funds sold. Interest rates on all of our interest earning assets were higher in 2007 than in 2006. Interest expense decreased in 2007 primarily because of lower balances of FHLB advances which we prepaid in the middle of the year. Interest rates paid on deposits increased in 2007 compared to 2006. Non-interest Income in Continuing Operations The following table presents the major categories of our non-interest income (dollars are in thousands): Non-interest Income For the Years Ended December 31, Increase ( Decrease) 2008 – 2007 2008 2007 $ % Bank charges and service fees Wealth management revenues Mortgage banking revenues Gain on sales of commercial real estate loans Net gain on sale of premises and equipment Net gain (loss) on sales of securities Other Total non-interest income $ $ 2,337 2,826 2,101 1,116 775 247 993 10,395 $ 2,010 2,041 158 1,731 - (3,277) 1,190 $ 3,853 $ 327 785 1,943 (615) 775 3,524 (197) $ 6,542 16 % (a) 38 % (b) 1,230 % (c) (36) % (d) 100 % (e) (108) % (f) (17) % 170 % (a) Reducing waived service charges was an area of focus in 2008. We also received a significant fee charged to a client for not utilizing its line of credit. (b) We earn custodial fees for accumulating and maintaining documents related to insurance products sold by others. These transaction based services were significant in early 2008 and tapered dramatically by the end of the year. (c) We expanded our mortgage banking operations in mid 2008. (d) Gains on sales of commercial real estate loans can fluctuate significantly from period to period. Early in the year we had a significant amount of sales, by the end of the year these transactions had virtually ceased. In the second quarter of 2008, we sold a building previously occupied by our insurance segment. (e) (f) Gains and losses on sales of securities vary depending on the nature and volume of transactions. In 2007, we sold a relatively large volume of securities at a loss in order to improve net interest income in future periods. BNCCORP, Inc. Annual Report 2008 11 8 Non-interest Expense in Continuing Operations The following table presents the major categories of our non-interest expense (dollars are in thousands): Non-interest Expense For the Years Ended December 31, 2008 2007 Increase (Decrease) 2008 – 2007 $ % Salaries and employee benefits Data processing fees Occupancy Depreciation and amortization Marketing and promotion Professional services FDIC and other assessments Office supplies, telephone and postage ORE expenses Debt extinguishment costs Other Total non-interest expense Efficiency ratio $ 14,673 2,202 2,140 1,375 1,127 1,177 400 533 515 - 2,359 $ 26,501 71.22% $ 14,868 2,524 2,074 1,697 703 840 228 499 - 2,724 1,990 $ 28,147 107.85% $ $ (195) (322) 66 (322) 424 337 172 34 515 (2,724) 369 (1,646) (36.63)% (1) % (a) (13) % 3 % (19) % (b) 60 % (c) 40 % (d) 75 % (e) 7 % 100 % (f) (100) % (g) 19 % (6) % (a) In 2008, compensation increased due to expanded mortgage banking operations and merit increases. Despite these increases, compensation was lower in 2008 than 2007 because we incurred a compensation charge of $1.160 million when one of the founders of the Company retired in 2007 and he was awarded retirement compensation. (b) Depreciation and amortization declined because of properties that have been divested after the sale of our insurance segment. (c) Marketing costs increased due to new locations, mortgage banking and promotions for depository products. (d) Professional services increased because of legal fees associated with problem credits and services required by mortgage banking operations. (e) FDIC assessments increased when the benefits of reduced assessments expired in the third quarter of 2008. We expect FDIC assessments to increase in future periods. (f) ORE expenses increased concurrently with foreclosure activities. (g) Debt extinguishment costs were incurred in 2007 when FHLB advances were prepaid and subordinated debentures were refinanced. These costs were incurred in order to improve net interest margin in future periods. Income Tax Expense in Continuing Operations We recorded an income tax expense of $737 thousand and an income tax benefit of $(2.728) million for the years ended December 2008 and 2007, respectively. In 2008 the effective tax rate was 24.9%. In 2007, the benefit primarily related to losses on sales of securities, debt extinguishment costs incurred, the provision for credit losses and interest earned on tax exempt securities. Results from Discontinued Operations Net income from discontinued operations in 2007 was $5.049 million, or $1.46 per diluted share. The 2007 discontinued operations included a pre-tax gain on sale of our former insurance segment aggregating $6.083 million. See Note 2 of the Consolidated Financial Statements for a discussion of our rationale for the sale of this segment. Net Income in 2008 compared to 2007 Net income, which combines the results of continuing operations and discontinued operations, was $2.218 million, or $0.67 per diluted share, in 2008 compared to net income of $1.980 million, or $0.57 per diluted share, in 2007. 12 BNCCORP, Inc. Annual Report 2008 9 Financial Condition Assets The following table presents our assets by category as of December 31, 2008 and 2007 (dollars are in thousands): As of December 31, Increase (Decrease) 2008 – 2007 2008 2007 $ % Cash and cash equivalents $ 10,569 $ 14,856 $ (4,287) Investment securities available for sale 209,857 122,899 86,958 Federal Reserve Bank and Federal Home Loan Bank of Des Moines stock Loans held for sale Participating interests in mortgage loans Loans and leases held for investment, net Other real estate owned Premises and equipment, net Interest receivable Other assets Premises and equipment held for sale, net 5,989 13,403 28,584 534,002 10,189 20,810 3,263 24,832 - 4,918 - 24,357 490,957 - 19,448 3,290 15,294 3,572 1,071 13,403 4,227 43,045 10,189 1,362 (27) 9,538 (3,572) Total assets $ 861,498 $ 699,591 $ 161,907 (29) % (a) 71 % (b) (c) 22 % 100 % (d) 17 % (e) 9 % (f) 100 % (g) 7 % (1) % 62 % (h) (100) % (i) 23 % (a) Cash balances can vary significantly on a daily basis. (b) Investments increased as a result of our strategy to leverage the balance sheet in order to increase net interest income. (c) Increases in these stocks are required when we increase utilization of FHLB advances. (d) Loans held for sale increased after we expanded mortgage banking operations in the second quarter of 2008. (e) Participating interests in mortgage loans are collateralized by loans held for sale by mortgage banking counterparties. These balances will vary depending on the volume of loans originated by the counterparties. (f) Loans and leases held for investment increased due to organic growth. (g) OREO increased due to several foreclosures in 2008. (h) Other assets increased due to deferred tax assets, derivatives and cash surrender value of insurance products. (i) Assets held for sale at the end of 2007 were sold in 2008. Investment Securities Available for Sale The following table presents the composition of the available-for-sale investment portfolio by major category (in thousands): BNCCORP, Inc. Annual Report 2008 13 10 Investment Portfolio Composition 2008 December 31, 2007 2006 Amortized cost Estimated fair market value Amortized cost Estimated fair market value Amortized cost Estimated fair market Value $ 1,505 $ 1,543 $ 1,799 $ 1,784 $ 2,165 $ 2,122 2,891 2,917 3,329 3,333 8,149 8,139 23,037 23,170 2,394 2,413 9,533 9,370 37,896 39,024 62,384 63,306 148,119 144,477 138,851 13,482 129,185 14,018 32,830 17,885 33,079 18,984 - - 17,727 18,866 U.S. government agency mortgage-backed securities guaranteed by GNMA U.S. government agency mortgage-backed securities issued by FNMA Collateralized mortgage obligations guaranteed by GNMA Collateralized mortgage obligations issued by FNMA or FHLMC Other collateralized mortgage obligations State and municipal bonds Total investments $ 217,662 $ 209,857 $ 120,621 $ 122,899 $ 185,693 $ 182,974 See Note 1 of our Consolidated Financial Statements for management’s conclusion on other than temporary impairment. The following table presents maturities for all securities available for sale (other than equity securities) and yields for all securities in our investment portfolio at December 31, 2008 (dollars are in thousands): Investment Portfolio - Maturity and Yields After 5 but within 10 years within 5 years Amount Yield (1) Amount Yield (1) Amount Yield (1) Within 1 year After 1 but After 10 years Amount Yield (1) Total Amount Yield (1) U.S. government agency mortgage-backed securities guaranteed by GNMA (2) (3) U.S. government agency mortgage-backed securities issued by FNMA (2) (3) Collateralized mortgage obligations guaranteed by GNMA (2) (3) Collateralized mortgage obligations issued by FNMA or FHLMC (2) (3) Other collateralized mortgage obligations (2) (3) State and municipal bonds (2) Total book value of investment $ - 0.00% $ 21 4.34% $ 1,484 5.25% $ - 0.00% $ 1,505 5.24% - 0.00% - 0.00% - - 0.00% 0.00% - - 0.00% 2,892 6.52% 2,891 6.52% 0.00% 23,037 4.99% 23,037 4.99% - 0.00% 3,212 4.74% 7,305 4.89% 27,378 5.08% 37,896 5.01% - 0.00% - 0.00% 26,365 2,480 8.40% 3,052 7.56% 3,647 5.95% 7.63% 112,486 4,303 5.79% 7.16% 138,851 13,482 5.82% 7.61% securities $ 2,480 8.40% $ 6,285 6.11% $ 38,801 5.88% $ 170,096 5.61% $ 217,662 5.71% Unrealized holding loss on securities available for sale Total investment in securities available for sale (7,805) $ 209,857 5.92% (1) Yields include adjustments for tax-exempt income. (2) Based on amortized cost rather than fair value. (3) Maturities of mortgage-backed securities and collateralized obligations are based on contractual maturities. Actual maturities may vary because obligors may have the right to call or prepay obligations with or without call or prepayment penalties. 14 BNCCORP, Inc. Annual Report 2008 11 As of December 31, 2008, we had $209.9 million of available-for-sale securities in the investment portfolio compared to $122.9 and $183.0 million at December 31, 2007 and 2006, respectively. In 2008, investment securities increased because we leveraged our balance sheet in order to increase net interest income. We have unrealized losses because credit spreads have widened for many types of investments. See Notes 1 and 4 of our Consolidated Financial Statements for a discussion of impairment assessments. During 2007, investment securities declined because we sold approximately $59.5 million of securities to finance repayment of $62.0 million of FHLB advances. Unrealized gains in the investment portfolio have increased primarily because interest rates have declined. During 2007, $3.277 million of net losses on sales of securities were realized. We elected to incur these losses in order to improve net interest income in future periods. At December 31, 2008, we held ten securities, other than U.S. Government Agency CMOs that exceeded 10% of stockholders’ equity. The total carrying value of these ten securities was $73.2 million. A significant portion of our investment securities portfolio was pledged as collateral. (See Note 4 of our Consolidated Financial Statements for the amount of investments that serve as collateral.) Federal Reserve Bank and Federal Home Loan Bank of Des Moines Stock Our equity securities consisted of $1.3 million of Federal Reserve Bank (“FRB”) stock as of December 31, 2008 and 2007, and $4.7 and $3.6 million of FHLB of Des Moines stock as of December 31, 2008 and 2007, respectively. Loan Portfolio The following table presents the composition of our loan portfolio (dollars are in thousands): 2008 2007 December 31, 2006 2005 2004 Amount % Amount % Amount % Amount % Amount % Commercial and industrial $ 138,671 24.6 $ 125,555 24.4 $ 100,127 25.9 $ 88,467 21.6 $ 75,460 23.2 Real estate mortgage 265,360 47.2 181,000 35.1 Real estate construction 108,713 19.3 167,345 32.5 124,551 89,619 32.2 23.2 122,785 30.1 129,321 39.8 80,296 19.7 68,967 21.2 Agricultural 22,023 3.9 17,074 3.3 14,286 3.7 12,706 3.1 13,919 4.3 Consumer/other Participating interests in mortgage loans Lease financing Total principal amount of loans Unearned income and net unamortized deferred fees and costs Loans, net of unearned income and unamortized fees and costs Less allowance for credit losses Net loans 7,506 1.3 5,878 1.1 4,237 1.1 4,718 1.2 5,480 1.7 28,584 5.1 24,357 4.7 56,125 14.5 101,336 24.8 34,515 10.6 1,287 0.2 1,815 0.4 1,800 0.5 2,131 0.5 1,540 0.5 572,144 101.6 523,024 101.5 390,745 101.0 412,439 101.0 329,202 101.3 (807) (0.1) (1,111) (0.2) (686) (0.2) (735) (0.2) (873) (0.3) 571,337 101.5 521,913 101.3 390,059 100.9 411,704 100.8 328,329 101.0 (8,751) (1.5) (6,599) (1.3) (3,370) (0.9) (3,188) (0.8) (3,335) (1.0) $ 562,586 100.0 $ 515,314 100.0 $ 386,689 100.0 $ 408,516 100.0 $ 324,994 100.0 BNCCORP, Inc. Annual Report 2008 15 12 Change in Loan Portfolio Composition As of December 31, 2008 2007 Increase (Decrease) 2008 – 2007 $ % Commercial and industrial Real estate mortgage Real estate construction Agricultural Consumer/other Participating interests in mortgage loans Lease financing Total principal amount of loans Unearned income and net unamortized deferred $ 138,671 265,360 108,713 22,023 7,506 28,584 1,287 572,144 $ 125,555 181,000 167,345 17,074 5,878 24,357 1,815 523,024 $ 13,116 84,360 (58,632) 4,949 1,628 4,227 (528) 49,120 fees and costs (807) (1,111) 304 Loans, net of unearned income and unamortized deferred fees and costs Less allowance for credit losses Net loans 571,337 (8,751) $ 562,586 521,913 (6,599) $ 515,314 49,424 (2,152) $ 47,272 10 % (a) 47 % (b) (35) % (b) 29 % (c) 28 % 17 % (d) (29) % 9 % (27) % 9 % 33 % 9 % (a) The increase is partially due to higher outstanding balances with existing customers. We are also obtaining better opportunities for new loans because some of our competitors have been weakened due to the challenging economy. (b) Real estate loans have increased and construction loans have decreased because projects under construction have been completed and reclassified between categories. (c) The increase in agricultural loans is due to additional lending activities in North Dakota. (d) Participating interests in mortgage loans are collateralized mortgage loans held for sale by mortgage banking counterparties. These loans will vary significantly depending on the volume of originations by the counterparties. Loan Participations Pursuant to our lending policy, loans may not exceed 85% of the Bank’s legal lending limit (except to the extent collateralized by U.S. Treasury securities or Bank deposits and, accordingly, excluded from the Bank’s legal lending limit) unless the Chief Credit Officer and the Executive Credit Committee grant prior approval. To accommodate customers whose financing needs exceed lending limits and internal loan restrictions relating primarily to industry concentration, the Bank sells loan participations to outside participants without recourse. The Bank generally retains the right to service the loans as well as the right to receive a portion of the interest income on the loans. Loan participations sold on a nonrecourse basis to outside financial institutions were as follows as of the dates indicated: Loan Participations Sold December 31, (in thousands) 2008 2007 2006 2005 2004 $ 315,469 201,776 188,994 183,795 131,317 16 BNCCORP, Inc. Annual Report 2008 13 Concentrations of Credit See Note 6 of our Consolidated Financial Statements for concentration of credit information. Loan Maturities The following table sets forth the remaining maturities of loans in each major category of our portfolio as of December 31, 2008 (in thousands): Maturities of Loans (1) Commercial and industrial Real estate mortgage Real estate construction Agricultural Consumer/other Participating interests in mortgage loans Lease financing Total principal amount of loans Over 1 year through 5 years One year or less Fixed rate $ 81,218 71,320 60,598 12,395 3,170 $ 19,878 63,381 2,341 6,664 2,796 Floating rate $ 10,104 64,534 37,296 390 670 Over 5 years Fixed rate Floating rate $ 12,121 $ 15,350 30,157 35,968 105 8,373 1,546 1,028 203 667 Total $ 138,671 265,360 108,713 22,023 7,506 28,584 381 257,666 $ 906 - $ 95,966 - - $ 112,994 - - - 44,132 $ 61,386 $ 28,584 1,287 $ 572,144 (1) Maturities are based on contractual maturities. Floating rate loans include loans that would reprice prior to maturity if base rates change. Actual maturities may differ from the contractual maturities shown above as a result of renewals and prepayments. Loan renewals are evaluated in the same manner as new credit applications. Provision for Credit Losses We provide for credit losses to maintain our allowance for credit losses at a level considered adequate for estimated probable losses in the loan and lease portfolio as of each balance sheet date. The provision for credit losses for the year ended December 31, 2008 was $7.750 million as compared to $3.750 million in 2007. The provision for loan losses increased in 2008 due to loan growth, an increase in nonperforming loans and deteriorating economic conditions. Allowance for Credit Losses Credit risk is the risk of loss from a customer default. We have in place a process to identify and manage our credit risk. The process includes initial credit review and approval, periodic monitoring to measure compliance with credit agreements and internal credit policies, internal credit review, monitoring changes in the risk ratings of loans and leases, identification of problem loans and leases and special procedures for collection of problem loans and leases. The risk of loss is difficult to estimate and is subject to fluctuations in values, general economic conditions and other factors. The determination of the allowance for credit losses is a critical accounting policy, which involves estimates and our judgment on a number of factors such as net charge-offs, delinquencies in the loan and lease portfolio and general and economic conditions. BNCCORP, Inc. Annual Report 2008 17 14 The following table summarizes activity in the allowance for credit losses and certain ratios: Analysis of Allowance for Credit Losses (dollars are in thousands) For the Years ended December 31, Balance of allowance for credit losses, beginning of period Charge-offs: Commercial and industrial Real estate mortgage Real estate construction Agricultural Consumer/other Lease financing Total charge-offs Recoveries: Commercial and industrial Real estate mortgage Real estate construction Agricultural Consumer/other Lease financing Total recoveries Net charge-offs Provision for credit losses charged to operations 2008 2007 2006 2005 2004 $ 6,599 $ 3,370 $ 3,188 $ 3,335 $ 4,763 738 426 4,529 - 253 - 5,946 84 - 196 - 68 - 348 (5,598) 1,504 500 - - 123 - 2,127 1,500 - - - 106 - 1,606 (521) 19 - - - 32 - 51 3 - - - 20 - 23 (28) 534 24 - - 31 - 589 95 10 16 - 69 2 192 (397) 1,578 - - 97 208 -- 1,883 141 33 - - 97 9 280 (1,603) 7,750 3,750 210 250 175 Balance of allowance for credit losses, end of period $ 8,751 $ 6,599 $ 3,370 $ 3,188 $ 3,335 Ratio of net charge-offs to average total loans Ratio of net charge-offs to average loans and (0.507)% (0.121)% (0.008)% (0.102)% (0.548)% leases held for investment (0.534)% (0.129)% (0.008)% (0.130)% (0.579)% Average gross loans and leases held for investment Ratio of allowance for credit losses to loans and leases held for investment Ratio of allowance for credit losses to total nonperforming loans $ 525,311 $ 402,615 $ 334,058 $ 305,073 $ 276,652 1.61% 1.33% 1.01% 1.03% 38% 122% 3,304% 2,229% 1.14% 607% The allowance for credit losses increased significantly in recent periods because of growth in the loan and lease portfolio, an increase in nonperforming assets and deteriorating economic conditions. The carrying value of non performing assets is supported by recent appraisals. We consider the allowance for credit losses adequate to cover losses inherent in the loan and lease portfolio. However, no assurance can be given that we will not sustain loan and lease losses that are sizable in relation to the amount reserved, or that subsequent evaluations of the loan and lease portfolio will not require significant increases in the allowance for credit losses. A protracted economic slowdown and/or a decline in commercial, industrial or real estate segments may have an adverse impact on the adequacy of the allowance for credit losses by increasing credit risk and the risk of potential loss. See Notes 1 and 7 of our Consolidated Financial Statements and “Critical Accounting Policies” for further information concerning accounting policies associated with the allowance for credit losses. 18 BNCCORP, Inc. Annual Report 2008 15 The table below presents, for the periods indicated an allocation of the allowance for credit losses among the various loan categories and sets forth the percentage of loans in each category to gross loans. The allocation of the allowance for credit losses as shown in the table should neither be interpreted as an indication of future charge- offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. Allocation of the Allowance for Loan Losses (dollars are in thousands) 2008 2007 Loans in category as a percentage of total gross loans Amount of allowance Amount of allowance Loans in category as a percentage of total gross loans December 31, 2006 Loans in category as a percentage of total gross loans Amount of allowance 2005 2004 Loans in category as a percentage Amount of total of gross loans allowance Loans in category as a percentage of total gross loans Amount of allowance Commercial and industrial Real estate mortgage (a) Real estate construction (a) Agricultural Consumer/other Participating interests in mortgage loans Lease financing $ 1,268 24% $ 1,410 24% $ 1,602 26% $ 1,632 21% $ 1,583 2,829 47% 1,956 35% 838 32% 846 30% 1,116 4,293 180 85 86 10 19% 2,740 32% 534 23% 467 19% 379 4% 1% 5% - 276 112 85 20 3% 1% 171 70 4% 1% 158 73 3% 1% 186 62 5% 140 14% - 25% - - 15 - 12 1% 9 Total $ 8,751 100% $ 6,599 100% $ 3,370 100% $ 3,188 100% $ 3,335 23% 39% 21% 4% 2% 11% 0% 100% (a) In recent periods the portion of our allowance allocated to real estate loans increased because real estate is devaluing. Allowance for Credit Losses; Impact on Earnings. The allowance for credit losses is an estimate that reflects uncertain matters. Additionally, a different estimate that could have been used in the current period could have had a material impact on reported financial condition or results of operations. We are not aware of known trends, commitments, events or other uncertainties reasonably likely to occur that would materially affect our methodology or the assumptions used, although changes in qualitative and quantitative factors could occur at any time and such changes could be of a material nature. We have calculated the allowance for credit losses to provide for estimated probable losses in the loan and lease portfolio as of December 31, 2008. From period to period, economic situations change, financial conditions of borrowers may deteriorate or improve and other factors we consider in arriving at our estimates may change. However, our basic methodology for determining an appropriate allowance for credit losses has remained relatively stable. The amount of the provision for credit losses charged to operations is directly related to our estimates of the appropriate level of the allowance for credit losses. Charge-offs and recoveries during the applicable periods also impact the level of the allowance for credit losses resulting in a provision for credit losses that could be higher or lower in order to bring the allowance for credit losses in line with our estimates. BNCCORP, Inc. Annual Report 2008 19 16 Nonperforming Loans and Assets The following table sets forth, as of the dates indicated, the amounts of nonperforming loans and other assets, the allowance for credit losses and certain related ratios (dollars are in thousands): Nonperforming Assets 2008 2007 December 31, 2006 (dollars in thousands) 2005 2004 Nonperforming loans: Loans 90 days or more delinquent and still accruing interest Nonaccrual loans Total nonperforming loans Other real estate Total nonperforming assets Allowance for credit losses Ratio of total nonperforming loans to total loans Ratio of total nonperforming loans to loans and leases held for investment Ratio of total nonperforming assets to total assets Ratio of allowance for credit losses to nonperforming loans $ 6 22,909 22,915 10,189 33,104 8,751 3.92% $ $ $ $ $ 4.22% 3.84% - 5,399 5,399 - 5,399 6,599 1.03% 1.09% 0.77% $ 2 100 102 - 102 3,370 0.03% $ $ $ - 143 143 - 143 3,188 0.03% $ $ $ 25 524 549 - 549 3,335 0.16% $ $ 0.03% 0.02% 0.05% 0.02% 0.19% 0.09% 38% 122% 3,304% 2,229% 607% Past Due, Non-accrual and Restructured Loans The following table indicates the effect on income if interest on non-accrual and restructured loans outstanding at year end had been recognized at original contractual rates during the year ended December 31 (in thousands): Interest income that would have been recorded $ 1,661 1,247 Interest income recorded Effect on interest income $ 414 2008 Loans 90 days or more delinquent and still accruing interest include loans over 90 days past due which we believe, based on our specific analysis of the loans, do not present doubt about the collection of interest and principal in accordance with the loan contract. Loans in this category must be well secured and in the process of collection. Our lending and management personnel monitor these loans closely. Non-accrual loans include loans on which the accrual of interest has been discontinued. Accrual of interest is discontinued when we believe that the borrower’s financial condition is such that the collection of interest is doubtful. A delinquent loan is generally placed on non-accrual status when it becomes 90 days or more past due unless the loan is well secured and in the process of collection. When a loan is placed on non-accrual status, accrued but uncollected interest income applicable to the current reporting period is reversed against interest income of the current period. Accrued but uncollected interest income applicable to previous reporting periods is charged against the allowance for credit losses. No additional interest is accrued on the loan balance until the collection of both principal and interest becomes reasonably certain. 20 BNCCORP, Inc. Annual Report 2008 17 Restructured loans are those for which concessions, including a reduction of the interest rate or the deferral of interest or principal, have been granted due to the borrower’s weakened financial condition. Interest on restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur. If collection of principal and interest on restructured loans is in doubt, interest income is recognized on a cash basis. A loan that has performed in accordance with its restructured terms for one year is no longer reported as a restructured loan. The table below summarizes the amounts of restructured loans. All of the restructured loans were also non- accrual loans. Restructured Loans As of December 31, (in thousands) 2008 2007 2006 2005 2004 $ 2,379 2,585 54 91 - Other real estate owned and repossessed assets represent properties and other assets acquired through, or in lieu of, loan foreclosure. They are initially recorded at fair value at the date of acquisition establishing a new cost basis. Write-downs to fair value at the time of acquisition are charged to the allowance for credit losses. After foreclosure, we perform valuations periodically and the real estate is recorded fair value less cost to sell. Reductions to other real estate owned and repossessed assets are considered valuation allowances. Expenses incurred to record valuation allowances subsequent to foreclosure are charged to non-interest expense. Impaired loans See Note 6 of our Consolidated Financial Statements for impaired loans information. Potential Problem Loans Asset values are declining throughout most of the country. So long as this devaluation continues, virtually all real estate loans are potential problem assets. Notwithstanding the prior paragraph, we attempt to quantify potential problem loans with more immediate credit risk. We estimate such loans totaled $13.2 million and $4.5 million at December 31, 2008 and 2007, respectively. A significant portion of these potential problem loans are not in default but may have characteristics such as recent adverse operating cash flows or general risk characteristics that the loan officer feels might jeopardize the future timely collection of principal and interest payments. The ultimate resolution of these credits is subject to changes in economic conditions and other factors. These loans are closely monitored to ensure that our position as creditor is protected to the fullest extent possible. BNCCORP, Inc. Annual Report 2008 21 18 Liabilities and Stockholders’ Equity The following table presents our liabilities and stockholders’ equity of December 31, 2008 and 2007 (dollars are in thousands): Liabilities and Stockholders’ Equity Deposits: Non-interest-bearing Interest-bearing- Savings, interest checking and money market Time deposits $100,000 and over Other time deposits Short-term borrowings FHLB advances Long-term borrowings Guaranteed preferred beneficial interests in Company's subordinated debentures Accrued interest payable Accrued expenses Other liabilities Total liabilities Stockholders' equity Total liabilities and As of December 31, 2008 2007 Increase (Decrease) 2008 – 2007 $ % $ 68,996 $ 72,234 $ (3,238) (4) % (a) 266,851 42,342 297,132 16,844 84,500 - 23,025 1,679 3,325 2,857 807,551 53,947 245,722 44,038 179,880 5,365 61,400 - 23,075 2,843 3,387 1,917 639,861 59,730 21,129 (1,696) 117,252 11,479 23,100 - (50) (1,164) (62) 940 167,690 (5,783) (b) 9 % (4) % 65 % (c) 214 % (d) 38 % (e) - % - % (41) % (2) % 49 % 26 % (10) % stockholders’ equity $ 861,498 $ 699,591 $ 161,907 23 % (a) These accounts fluctuate daily due to the cash management activities of our customers. (b) Our customers have migrated to insured deposits as other investment vehicles have incurred losses. (c) We used certificate of deposits to fund our investment securities as part of our leverage strategy. (d) Short-term borrowings increased because a client has provided funds via customer repurchase agreements. (e) FHLB advances were used to fund purchases of investments. 22 BNCCORP, Inc. Annual Report 2008 19 Deposits The following table sets forth, for the periods indicated, the distribution of our average deposit account balances and average cost of funds rates on each category of deposits (dollars are in thousands): Average Deposits and Deposits Costs For the Years Ended December 31, 2008 Percent of deposits Wgtd. avg. rate Average balance 2007 Percent of deposits Average balance 2006 Wgtd. avg. rate Average balance Percent Wgtd. avg. rate of deposits $ 244,279 9,859 39.96% 1.61% 1.67% $ 0.33% 249,246 8,399 47.95% 1.62% 3.21% 0.79% $ 246,476 8,398 46.68% 3.02% 1.59% 0.79% 232,367 58,378 38.01% 9.55% 3.87% 3.44% 149,010 44,824 290,745 47.56% 3.78% 193,834 28.67% 8.62% 37.29% 4.79% 5.17% 150,194 54,155 28.45% 4.29% 10.26% 4.61% 4.88% 204,349 38.70% 4.37% 544,883 89.14% 2.77% 451,479 86.86% 3.88% 459,223 86.98% 3.58% 66,388 10.86% - 68,277 13.14% - 68,743 13.02% - Interest checking and MMDAs Savings deposits Time deposits (CDs): CDs under $100,000 CDs $100,000 and over Total time deposits Total interest-bearing deposits Non-interest-bearing demand deposits Total deposits $ 611,271 100.00% 2.47% $ 519,756 100.00% 3.37% $ 527,966 100.00% 3.11% Time deposits, in denominations of $100,000 and more, totaled $42.3 million at December 31, 2008 as compared to $44.0 million at December 31, 2007. The following table sets forth the amount and maturities of time deposits of $100,000 and more as of December 31, 2008 (in thousands): Time Deposits of $100,000 and Over Maturing in: 3 months or less Over 3 months through 6 months Over 6 months through 12 months Over 12 months Total $ $ 11,662 7,458 16,884 6,338 42,342 Borrowed Funds The following table provides a summary of our short-term borrowings and related cost information as of, or for the years ended, December 31 (dollars are in thousands): Short-Term Borrowings Short-term borrowings outstanding at period end Weighted average interest rate at period end Maximum month-end balance during the period Average borrowings outstanding for the period Weighted average interest rate for the period 2008 2007 2006 $ $ $ 16,844 0.88% 16,844 7,049 2.04% $ $ $ $ $ $ 5,365 3.64% 15,518 8,706 4.57% 9,709 4.81% 21,059 14,480 4.73% Note 12 of our Consolidated Financial Statements summarizes the general terms of our short-term borrowings outstanding at December 31, 2008 and 2007. BNCCORP, Inc. Annual Report 2008 23 20 FHLB advances totaled $84.5 million and $61.4 million at December 31, 2008 and 2007, respectively, while long-term borrowings totaled $0 million, for the same periods. Notes 13 and 14 of our Consolidated Financial Statements summarize the general terms of our FHLB advances and long-term borrowings at December 31, 2008 and 2007. Guaranteed Preferred Beneficial Interests in Company’s Subordinated Debentures See Note 15 of our Consolidated Financial Statements for a description of the subordinated debentures. Capital Resources and Expenditures We actively monitor compliance with regulatory capital requirements, including risk-based and leverage capital measures. Under the risk-based capital method of capital measurement, the ratio computed is dependent on the amount and composition of assets recorded on the balance sheet, and the amount and composition of off-balance- sheet items and the level of capital. Note 18 of our Consolidated Financial Statements includes a summary of the risk-based and leverage capital ratios of BNCCORP and the Bank as of December 31, 2008 and 2007. Although there is currently no regulation requiring a minimum ratio of tangible common equity to tangible assets, the banking industry has historically used this ratio. Our ratios of tangible capital to tangible assets at December 31, 2008 are as follows: Actual Amount Ratio For Capital Adequacy Amount Ratio To be Well Capitalized Ratio Amount 2008 Tangible Common Equity (to total assets): Consolidated BNC National Bank $ 53,538 75,573 6.21 % 8.77 N/A N/A N/A N/A N/A N/A N/A N/A On January 16, 2009, BNC announced that it has received net proceeds of approximately $20.1 million through the sale of shares of non-voting senior preferred stock to the U.S. Department of the Treasury under the Capital Purchase Program. The Treasury Department also received a warrant exercisable for shares of an additional class of BNCCORP, Inc. preferred stock which has an aggregate liquidation preference of approximately $1.0 million. The Treasury Department exercised this warrant at the closing of the transaction. The proceeds of the sale will further increase the Company’s capital ratios and strengthen its capital position. If the Capital Purchase Program transaction had been consummated as of December 31, 2008, the pro forma capital of the Company would have been as follows: Actual Amount Ratio For Capital Adequacy Ratio Amount To be Well Capitalized Amount Ratio 2008 Pro forma Capital (to total assets): Total Capital (to risk-weighted assets) Consolidated $ 109,041 15.88 % Tier 1 Capital (to risk-weighted assets) Consolidated Tier 1 Capital (to average assets) 103,375 15.05 Consolidated 103,375 12.16 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 24 BNCCORP, Inc. Annual Report 2008 21 Off-Balance-Sheet Arrangements In the normal course of business, we are a party to various financial instruments with off-balance-sheet risk. These instruments include commitments to extend credit, commercial letters of credit, performance and financial standby letters of credit and interest rate swaps, caps and floors. Such instruments help us to meet the needs of our customers, manage our interest rate risk and effectuate various transactions. These instruments and commitments, which we enter into for purposes other than trading, carry varying degrees of credit, interest rate or liquidity risk in excess of the amount reflected in the consolidated balance sheets. See Notes 21 and 22 to the Consolidated Financial Statements for a detailed description of each of these instruments. Contractual Obligations, Contingent Liabilities and Commitments As disclosed in the Notes to the Consolidated Financial Statements, we have certain contractual obligations, contingent liabilities and commitments. At December 31, 2008, the aggregate contractual obligations (excluding bank deposits), contingent liabilities and commitments were as follows (in thousands): Contractual Obligations: year 1 to 3 years 3 to 5 years After 5 years Total Payments due by period Less than 1 Total borrowings Commitments to sell loans Annual rental commitments under non-cancelable operating leases Total $ 79,344 13,832 $ - - $ 15,000 - $ 30,025 $ 124,369 13,832 - 1,256 $ 94,432 2,004 $ 2,004 742 $ 15,742 1,560 $ 31,585 $ 5,562 143,763 Other Commitments: Less than 1 year 1 to 3 years 3 to 5 years After 5 years Total Amount of Commitment - Expiration by Period Commitments to lend Standby and commercial letters of credit Total $ 105,258 $ 35,362 $ 2,770 $ 397 $ 143,787 3,968 $ 109,226 2,514 $ 37,876 27 $ 2,797 6,509 - $ 397 $ 150,296 We are a party to transactions involving financial instruments that create risks that may or may not be reflected on a traditional balance sheet. These financial instruments can be subdivided into two categories: Cash financial instruments, generally characterized as on-balance-sheet items; include investments, loans, mortgage-backed securities, deposits and debt obligations. Credit-related financial instruments, generally characterized as off-balance-sheet items, include such instruments as commitments to extend credit, commercial letters of credit and performance and financial standby letters of credit. Liquidity Risk Management Liquidity risk is the possibility of being unable to meet all present and future financial obligations in a timely manner. The objectives of liquidity management policies are to maintain adequate liquid assets, liability diversification among instruments, maturities and customers and a presence in both the wholesale purchased funds market and the retail deposit market. BNCCORP, Inc. Annual Report 2008 25 22 The Consolidated Statements of Cash Flows in the Consolidated Financial Statements present data on cash and cash equivalents provided by and used in operating, investing and financing activities. In addition to liquidity from core deposit growth, together with repayments and maturities of loans and investments, we utilize brokered deposits, sell securities under agreements to repurchase and borrow overnight Federal funds. The Bank is a member of the FHLB of Des Moines, which affords it the opportunity to borrow funds in terms ranging from overnight to 10 years and beyond. Advances from the FHLB are collateralized by the Bank’s mortgage loans and various investment securities. We have also obtained funding through the issuance of subordinated notes, subordinated debentures and long-term borrowings. Our liquidity is measured by our ability to raise cash when we need it at a reasonable cost and with a minimum of losses. Given the uncertain nature of our customers’ demands as well as our desire to take advantage of earnings enhancement opportunities, we must have adequate sources of on- and off-balance-sheet funds that can be accessed as needed. We measure our liquidity position on a monthly basis. Key factors that determine our liquidity are the reliability or stability of our deposit base, the pledged/non-pledged status of our investments and potential loan demand. Our liquidity management system divides the balance sheet into liquid assets and short-term liabilities that are assumed to be vulnerable to non-replacement under abnormally stringent conditions. The excess of liquid assets over short-term liabilities is measured over a 30-day planning horizon. Assumptions for short-term liabilities vulnerable to non-replacement under abnormally stringent conditions are based on a historical analysis of the month-to-month percentage changes in deposits. In addition, we subject these assumptions to stress tests to measure the degree of volatility our liquidity position could manage over the 30-day horizon. The excess of liquid assets over short-term liabilities and other key factors such as expected loan demand as well as access to other sources of liquidity such as lines with the FHLB, Federal funds and those other supplemental sources listed above are tied together to provide a measure of our liquidity. We have a targeted range of liquidity metrics and manage our operations such that these targets can be achieved. We believe that our prudent management policies and guidelines will ensure adequate levels of liquidity to fund anticipated needs of on- and off-balance-sheet items. In addition, a contingency funding policy statement identifies actions to be taken in response to an adverse liquidity event. As of December 31, 2008, the Bank had established Federal funds purchase programs with other lending institutions, totaling $9 million. At December 31, 2008, the Bank had purchased Federal funds of $7 million under these programs leaving $2 million available. The Federal funds purchase programs, if advanced upon, mature daily with interest rates that float at the Federal funds rate. Forward-Looking Statements Statements included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” which are not historical in nature are intended to be, and are hereby identified as “forward-looking statements” for purposes of the safe harbor provided by Section 27A of the Securities Act and Section 21E of the Exchange Act. We caution readers that these forward-looking statements, including without limitation, those relating to our future business prospects, revenues, working capital, liquidity, capital needs, interest costs, income and expenses, are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated in the forward-looking statements due to several important factors. These factors include, but are not limited to: risks of loans and investments, including dependence on local and regional economic conditions; competition for our customers from other providers of financial services; possible adverse effects of changes in interest rates including the effects of such changes on derivative contracts and associated accounting consequences; risks associated with our acquisition and growth strategies; and other risks which are difficult to predict and many of which are beyond our control. 26 BNCCORP, Inc. Annual Report 2008 23 Recently Issued and Adopted Accounting Pronouncements Note 1 of our Consolidated Financial Statements includes a summary of recently issued and adopted accounting pronouncements and their related or anticipated impact on the Company. Critical Accounting Policies Note 1 of our Consolidated Financial Statements includes a summary of our critical accounting policies and their related impact on the Company. Quantitative and Qualitative Disclosures About Market Risk Market risk arises from changes in interest rates, exchange rates, and commodity prices and equity prices and represents the possibility that changes in future market rates or prices will have a negative impact on our earnings or value. Our principal market risk is interest rate risk. Interest rate risk arises from changes in interest rates. Interest rate risk can result from: (1) Repricing risk – timing differences in the maturity/repricing of assets, liabilities, and off-balance-sheet contracts; (2) Options risk – the effect of embedded options, such as loan prepayments, interest rate caps/floors, and deposit withdrawals; (3) Basis risk – risk resulting from unexpected changes in the spread between two or more different rates of similar maturity, and the resulting impact on the behavior of lending and funding rates; and (4) Yield curve risk – risk resulting from unexpected changes in the spread between two or more rates of different maturities from the same type of instrument. We have risk management policies to monitor and limit exposure to interest rate risk. To date we have not conducted trading activities as a means of managing interest rate risk. Our asset/liability management process is utilized to manage our interest rate risk. The measurement of interest rate risk associated with financial instruments is meaningful only when all related and offsetting on-and off-balance-sheet transactions are aggregated, and the resulting net positions are identified. Our interest rate risk exposure is actively managed with the objective of managing the level and potential volatility of net interest income in addition to the long-term growth of equity, bearing in mind that we will always be in the business of taking on rate risk and that rate risk immunization is not entirely possible. Also, it is recognized that as exposure to interest rate risk is reduced, so too may the overall level of net interest income and equity. In general, the assets and liabilities generated through ordinary business activities do not naturally create offsetting positions with respect to repricing or maturity characteristics. Access to the derivatives market can be an important element in maintaining our interest rate risk position within policy guidelines. Using derivative instruments, principally interest rate floors, caps, and interest rate swaps, the interest rate sensitivity of specific transactions, as well as pools of assets or liabilities, can be adjusted to maintain the desired interest rate risk profile. See “-Loan Portfolio-Interest Rate Caps and Floors” “-Borrowings-Interest Rate Caps and Floors” and Notes 1 and 17 to the Consolidated Financial Statements for a summary of our accounting policies pertaining to such instruments. Our primary tool for measuring and managing interest rate risk is net interest income simulation. This exercise includes our assumptions regarding the changes in interest rates and the impact on our current balance sheet. Interest rate caps and floors are included to the extent that they are exercised in the 12-month simulation period. Additionally, changes in prepayment behavior of the residential mortgage, CMOs, and mortgage-backed securities portfolios in each rate environment are captured using industry estimates of prepayment speeds for various coupon segments of the portfolio. For purposes of this simulation, projected month-end balances of the various balance sheet accounts are held constant at their December 31, 2008 levels. Cash flows from a given account are reinvested back into the same account so as to keep the month-end balance constant at its December 31, 2008 level. The static balance sheet assumption is made so as to project the interest rate risk to net interest income embedded in the existing balance sheet. With knowledge of the balance sheet’s existing net interest income profile, more informed strategies and tactics may be developed as it relates to the structure/mix of growth. BNCCORP, Inc. Annual Report 2008 27 24 We monitor the results of net interest income simulation on a quarterly basis at regularly scheduled ALCO meetings. Each quarter net interest income is generally simulated for the upcoming 12-month horizon in seven interest scenarios. The scenarios generally modeled are parallel interest ramps of +/- 100bp, 200bp, and 300bp along with a rates unchanged scenario. Given the low absolute level of interest rates as of December 31, 2008, the downward scenarios for interest rate movements is limited to -100bp. The parallel movement of interest rates means all projected market interest rates move up or down by the same amount. A ramp in interest rates means that the projected change in market interest rates occurs over the 12-month horizon on a pro-rata basis. For example, in the +100bp scenario, the projected prime rate is projected to increase from 3.25% to 4.25% 12 months later. The prime rate in this example will increase 1/12th of the overall decrease of 100 basis points each month. The net interest income simulation result for the 12-month horizon that covers the calendar year of 2008 is shown below: Net Interest Income Simulation Movement in interest rates $ Projected 12-month net interest income Dollar change from unchanged scenario $ Percentage change from unchanged scenario Policy guidelines (decline limited to) -100bp 27,984 371 $ Unchanged 27,613 - +100bp 27,129 (484) $ $ +200bp $ 26,809 $ $ $ (804) 1.34% (5.00)% - - (1.75)% (5.00)% (2.91)% (10.00)% +300bp 26,483 (1,130) (4.09)% (15.00)% Because one of the objectives of asset/liability management is to manage net interest income over a one-year planning horizon, policy guidelines are stated in terms of maximum potential percentage reduction in net interest income resulting from changes in interest rates over the 12-month period. It is no less important, however, to give attention to the absolute dollar level of projected net interest income over the 12-month period. Our general policy is to limit the percentage decrease in projected net interest income to 5, 10, and 15 percent from the rates unchanged scenario for the +/- 100bp, 200bp, and 300bp interest rate ramp scenarios, respectively. When a given scenario falls outside of these limits, the ALCO reviews the circumstances surrounding the exception and, considering the level of net interest income generated in the scenario and other related factors, may approve the exception to the general policy or recommend actions aimed at bringing the respective scenario within the general limits noted above. Since there are limitations inherent in any methodology used to estimate the exposure to changes in market interest rates, these analyses are not intended to be a forecast of the actual effect of changes in market interest rates such as those indicated above on the Company. Further, these analyses are based on our assets and liabilities as of December 31, 2008 (without forward adjustments for planned growth and anticipated business activities) and do not contemplate any actions we might undertake in response to changes in market interest rates. Static gap analysis is another tool that may be used for interest rate risk measurement. The net differences between the amount of assets, liabilities, equity and off-balance-sheet instruments repricing within a cumulative calendar period is typically referred to as the “rate sensitivity position” or “gap position.” The following table sets forth our rate sensitivity position as of December 31, 2008. Assets and liabilities are classified by the earliest possible repricing date or maturity, whichever occurs first. 28 BNCCORP, Inc. Annual Report 2008 25 Interest Sensitivity Gap Analysis 0–3 months Estimated maturity or repricing at December 31, 2008 1–5 years (dollars are in thousands) 4–12 months Over 5 years Total Interest-earning assets: Interest-bearing deposits with banks Investment securities FRB and FHLB stock Fed Funds Sold Loans held for sale, fixed rate Loans held for sale, floating rate Loans held for investment, fixed rate Loans held for investment, floating rate $ - 19,637 5,989 - - - 26,571 314,086 $ - 47,025 - - - 41,987 56,674 3,027 $ - $ - 52,530 - - - - 20,439 2,141 90,665 - - - - 93,271 26,544 $ - 209,857 5,989 - - 41,987 196,955 345,798 Total interest-earning assets $ 366,283 $ 148,713 $ 210,480 $ 75,110 $ 800,586 Interest-bearing liabilities: Interest checking and money market accounts Savings Time deposits under $100,000 Time deposits $100,000 and over Short-term borrowings FHLB advances Long-term borrowings Subordinated debentures Total interest-bearing liabilities Interest rate gap $ 256,091 10,760 95,417 11,662 16,844 62,500 - - $ - - 103,273 24,343 - - - - $ - $ - - 5,456 - - 7,000 - 23,025 - 92,985 6,338 - 15,000 - - $ 256,091 10,760 297,131 42,343 16,844 84,500 - 23,025 $ 453,274 $ (86,991) $ $ 127,616 $ 114,323 $ 35,481 $ 730,694 21,097 96,157 $ 39,629 $ 69,892 Cumulative interest rate gap at December 31, 2008 $ (86,991) $ (65,894) $ 30,263 69,892 Cumulative interest rate gap to total assets (10.10)% (7.65)% 3.51% 8.11% The table assumes that all savings and interest-bearing demand deposits reprice in the earliest period presented, however, we believe a significant portion of these accounts constitute a core component and are generally not rate sensitive. Our position is supported by the fact that aggressive reductions in interest rates paid on these deposits historically have not caused notable reductions in balances in net interest income because the repricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures. As a result, assets and liabilities indicated as repricing within the same period may in fact reprice at different times and at different rate levels. Static gap analysis does not fully capture the impact of embedded options, lagged interest rate changes, administered interest rate products, or certain off-balance-sheet sensitivities to interest rate movements. Therefore, this tool generally cannot be used in isolation to determine the level of interest rate risk exposure in banking institutions. Since there are limitations inherent in any methodology used to estimate the exposure to changes in market interest rates, these analyses are not intended to be a forecast of the actual effect of changes in market interest rates such as those indicated above on the Company. Further, these analyses are based on our assets and liabilities as of December 31, 2008 and do not contemplate any actions we might undertake in response to changes in market interest rates. BNCCORP, Inc. Annual Report 2008 29 26 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Independent Auditors’ Report Consolidated Balance Sheets as of December 31, 2008 and 2007 Consolidated Statements of Income for the years ended December 31, 2008 and 2007 Consolidated Statements of Comprehensive Income for the years ended December 31, 2008 and 2007 Consolidated Statements of Cash Flows for the years ended December 31, 2008 and 2007 Page 31 32 33 35 36 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2008 and 2007 38 Notes to Consolidated Financial Statements 39 30 BNCCORP, Inc. Annual Report 2008 27 Independent Auditors’ Report The Board of Directors and Stockholders BNCCORP, Inc.: We have audited the accompanying consolidated balance sheets of BNCCORP, Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the years then ended. 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 BNCCORP, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. Omaha, Nebraska March 23, 2009 BNCCORP, Inc. Annual Report 2008 31 KPMG LLP Suite 1501 Two Central Park Plaza Omaha, NE 68102 Suite 1600 233 South 13th Street Lincoln, NE 68508-2041 KPMG LLP, a U.S. limited liability partnership, is the U.S.member firm of KPMG International, a Swiss cooperative.Financial Statements FINANCIAL INFORMATION BNCCORP, INC. AND SUBSIDIARIES Consolidated Balance Sheets As of December 31 (In thousands, except share data) ASSETS 2008 2007 CASH AND CASH EQUIVALENTS INVESTMENT SECURITIES AVAILABLE FOR SALE FEDERAL RESERVE BANK AND FEDERAL HOME LOAN BANK STOCK LOANS HELD FOR SALE PARTICIPATING INTERESTS IN MORTGAGE LOANS LOANS AND LEASES HELD FOR INVESTMENT ALLOWANCE FOR CREDIT LOSSES Net loans and leases OTHER REAL ESTATE OWNED PREMISES AND EQUIPMENT, net INTEREST RECEIVABLE OTHER ASSETS PREMISES AND EQUIPMENT HELD FOR SALE, net Total assets $ 10,569 209,857 5,989 13,403 28,584 542,753 (8,751) 562,586 10,189 20,810 3,263 24,832 - 861,498 $ $ 14,856 122,899 4,918 - 24,357 497,556 (6,599) 515,314 - 19,448 3,290 15,294 3,572 699,591 $ LIABILITIES AND STOCKHOLDERS’ EQUITY DEPOSITS: Noninterest-bearing Interest-bearing – Savings, interest checking and money market Time deposits $100,000 and over Other time deposits Total deposits SHORT-TERM BORROWINGS FEDERAL HOME LOAN BANK ADVANCES LONG-TERM BORROWINGS GUARANTEED PREFERRED BENEFICIAL INTERESTS IN COMPANY’S SUBORDINATED DEBENTURES ACCRUED INTEREST PAYABLE ACCRUED EXPENSES OTHER LIABILITIES Total liabilities STOCKHOLDERS’ EQUITY: $ 68,996 $ 72,234 266,851 42,342 297,132 675,321 16,844 84,500 - 23,025 1,679 3,325 2,857 807,551 245,722 44,038 179,880 541,874 5,365 61,400 - 23,075 2,843 3,387 1,917 639,861 Preferred stock, $.01 par value – 2,000,000 shares authorized; no shares issued or outstanding - - Common stock, $.01 par value – 10,000,000 shares authorized; 3,299,163 and 3,491,337 shares issued and outstanding Capital surplus – common stock Retained earnings Treasury stock, at cost (357,738 and 150,116 shares) Accumulated other comprehensive income (loss), net Total stockholders’ equity Total liabilities and stockholders’ equity 33 26,628 36,104 (5,020) (3,798) 53,947 861,498 $ 35 26,355 34,105 (2,424) 1,659 59,730 699,591 $ See accompanying notes to consolidated financial statements. 29 32 BNCCORP, Inc. Annual Report 2008 BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Income For the Years Ended December 31 (In thousands, except per share data) INTEREST INCOME: Interest and fees on loans Interest and dividends on investments Taxable Tax-exempt Dividends Total interest income INTEREST EXPENSE: Deposits Short-term borrowings Federal Home Loan Bank advances Long-term borrowings Subordinated debentures Total interest expense Net interest income PROVISION FOR CREDIT LOSSES 2008 2007 $ 35,322 $ 36,560 9,599 839 266 46,026 15,099 144 2,291 25 1,656 19,215 26,811 7,750 6,541 926 214 44,241 17,533 398 1,915 11 2,137 21,994 22,247 3,750 NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 19,061 18,497 NON-INTEREST INCOME: Bank charges and service fees Wealth management revenues Mortgage banking revenues Gains on sales of commercial real estate loans Gain on sales of premises and equipment Net gain (loss) on sales of securities Other Total non-interest income NON-INTEREST EXPENSE: Salaries and employee benefits Data processing fees Occupancy Depreciation and amortization Marketing and promotion Professional services FDIC and other assessments Office supplies, telephone and postage ORE expenses Debt extinguishment costs Other Total non-interest expense Income (loss) from continuing operations before income taxes Income tax expense (benefit) Income (loss) from continuing operations 2,337 2,826 2,101 1,116 775 247 993 10,395 14,673 2,202 2,140 1,375 1,127 1,177 400 533 515 - 2,359 26,501 2,955 737 2,218 $ See accompanying notes to consolidated financial statements. $ 2,010 2,041 158 1,731 - (3,277) 1,190 3,853 14,868 2,524 2,074 1,697 703 840 228 499 - 2,724 1,990 28,147 (5,797) (2,728) (3,069) BNCCORP, Inc. Annual Report 2008 33 30 BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Income, continued For the Years Ended December 31 (In thousands, except per share data) Discontinued Operations: Income from discontinued insurance segment Income tax expense Income from discontinued operations NET INCOME BASIC EARNINGS PER COMMON SHARE: Income (loss) from continuing operations Income from discontinued insurance segment, net of income taxes Basic earnings per common share DILUTED EARNINGS PER COMMON SHARE Income (loss) from continuing operations Income from discontinued insurance segment, net of income taxes Diluted earnings per common share 2008 2007 - - - 2,218 $ $ 8,116 3,067 5,049 1,980 0.67 $ (0.89) - 0.67 $ 1.46 0.57 0.67 $ (0.89) - 0.67 $ 1.46 0.57 $ $ $ $ $ $ See accompanying notes to consolidated financial statements. 34 BNCCORP, Inc. Annual Report 2008 31  BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income For the Years Ended December 31 (In thousands) NET INCOME 2008 2007 $ 2,218 $ 1,980 Unrealized gain on cash flow hedge, net $ 1,332 $ 690 Unrealized gain (loss) on securities available for sale Reclassification adjustment for (gains) losses included in net income Other comprehensive income (loss), before tax Income tax (expense) benefit related to items of other comprehensive income Other comprehensive income (loss) (9,836) (247) (8,751) 3,294 (5,457) 1,720 3,277 5,687 (2,117) 3,570 3,570 (5,457) TOTAL COMPREHENSIVE INCOME (LOSS) $ (3,239) $ 5,550 See accompanying notes to consolidated financial statements. BNCCORP, Inc. Annual Report 2008 35 32 BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the Years Ended December 31 (In thousands) OPERATING ACTIVITIES: Net income Adjustments to reconcile net income to net cash provided by (used in) operating activities - Provision for credit losses Depreciation and amortization Net amortization of premiums (discounts) on investment securities and subordinated debentures Fair value adjustment for loans held for sale Share-based compensation Change in other assets, net Loss on sale of ORE (Gain) loss on sales of bank premises and equipment, net Net realized (gain) loss on sales of investment securities Deferred income taxes Unamortized premium related to early extinguishment of subordinated debt Change in other liabilities, net Originations of loans to be participated Proceeds from participations of loans Funding of originations of loans held for sale Proceeds from sale of loans held for sale Change in operating accounts of discontinued operations Gain on sale of discontinued operations Net cash (used in) provided by operating activities INVESTING ACTIVITIES: Changes in federal funds sold, net Purchases of investment securities Proceeds from sales of investment securities Proceeds from maturities of investment securities Purchases of Federal Reserve and Federal Home Loan Bank Stock Sales of Federal Reserve and Federal Home Loan Bank Stock Net (increase) decrease in participating interests in mortgage loans Net increase in loans, excluding participating interests in mortgage loans Proceeds from sales of ORE Additions to bank premises and equipment Proceeds from sales of bank premises and equipment Proceeds from sale of insurance operations, net Net cash used in investing activities 2008 2007 $ 2,218 $ 1,980 7,750 1,375 (1,164) (268) 273 (3,877) 38 (775) (247) (1,158) - (138) (201,489) 201,489 (102,040) 88,905 - - (9,108) - (141,821) 14,209 31,981 (8,618) 7,547 (4,227) (61,511) 222 (2,990) 4,600 - (160,608) 3,750 1,752 163 - 298 (419) - 11 3,277 (1,325) 289 1,733 (205,929) 205,929 (11,364) 13,033 (2,540) (6,083) 4,555 24,000 (71,196) 106,450 26,379 (2,817) 2,902 31,768 (164,143) - (1,889) 836 35,204 (12,506) See accompanying notes to consolidated financial statements. 36 BNCCORP, Inc. Annual Report 2008 33 BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows, continued For the Years Ended December 31 (In thousands) FINANCING ACTIVITIES: Net increase in deposits Net increase (decrease) in short-term borrowings Repayments of Federal Home Loan Bank advances Proceeds from Federal Home Loan Bank advances Repayments of long-term borrowings Proceeds from long-term borrowings Purchases of treasury stock Net cash provided by financing activities NET DECREASE IN CASH AND CASH EQUIVALENTS CASH AND CASH EQUIVALENTS, beginning of year CASH AND CASH EQUIVALENTS, end of year SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid Income taxes paid 2008 2007 133,448 11,479 (3,413,530) 3,436,630 - - (2,598) 165,429 (4,287) 14,856 10,569 $ 12,622 (4,344) (320,200) 319,400 (16,167) 15,000 (1,720) 4,591 (3,360) 18,216 14,856 15,892 2,231 $ $ 21,981 3,367 $ $ $ SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Additions to other real estate in settlement of loans $ 10,717 $ - See accompanying notes to consolidated financial statements. BNCCORP, Inc. Annual Report 2008 37 34 BNCCORP, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders’ Equity For the Years Ended December 31, 2008 and 2007 (In thousands, except share data) Preferred Stock Common Stock Shares Amount Shares Amount Capital Surplus Common Stock Retained Earnings Treasury Stock Accumulated Other Comprehensive Income (Loss) Total BALANCE, December 31, 2006 - $ - 3,600,467 $ 36 $ 25,950 $ 32,125 $ (598) $ (1,911) $ 55,602 Net income - - - - - 1,980 - - 1,980 Other comprehensive income - - - - - - - 3,570 3,570 Impact of share-based compensation Purchase of common shares - - - - (14,348) - 405 - (107) - 298 (94,782) (1) - - (1,719) - (1,720) BALANCE, December 31, 2007 - $ - 3,491,337 $ 35 $ 26,355 $ 34,105 $ (2,424) $ 1,659 $ 59,730 Net income - - - - Other comprehensive (loss) - - - - - - 2,218 - - 2,218 - - (5,457) (5,457) Cumulative effect of change in accounting principle related to split dollar life insurance policies Impact of share-based compensation Purchase of common shares - - - - - (219) - - (219) - - - - 8,152 - 273 - - - 273 (200,326) (2) - - (2,596) - (2,598) BALANCE, December 31, 2008 - $ - 3,299,163 $ 33 $ 26,628 $ 36,104 $ (5,020) $ (3,798) $ 53,947 See accompanying notes to consolidated financial statements. 38 BNCCORP, Inc. Annual Report 2008 35 BNCCORP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements NOTE 1. Description of Business and Significant Accounting Policies Description of Business BNCCORP, Inc. (“BNCCORP”) is a registered bank holding company incorporated under the laws of Delaware. It is the parent company of BNC National Bank (together with its wholly owned subsidiaries, BNC Insurance Services, Inc., and BNC Asset Management, Inc., collectively the “Bank”). The Company operates community banking, and wealth management businesses in Arizona, Minnesota and North Dakota from 20 locations. BNC also conducts mortgage banking from five locations in Iowa, Kansas, Missouri and Arizona. The consolidated financial statements included herein are for BNCCORP and its subsidiaries. The accounting and reporting policies of BNCCORP and its subsidiaries (collectively, the “Company”) conform to U.S. generally accepted accounting principles and general practices within the financial services industry. The more significant accounting policies are summarized below. Principles of Consolidation The accompanying consolidated financial statements include the accounts of BNCCORP and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles 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. Ultimate results could differ from those estimates. CRITICAL ACCOUNTING POLICIES Critical accounting policies are dependent on estimates that are particularly susceptible to significant change and include the determination of the allowance for credit losses, income taxes, other than temporary impairment and fair value. The following have been identified as “critical accounting policies”. Allowance for Credit Losses The Bank maintains an estimate of its allowance for credit losses at a level considered adequate to provide for probable losses related to specifically identified loans as well as the remaining loan and lease portfolio that have been incurred as of each balance sheet date. The loan and lease portfolio and other credit exposures are reviewed regularly to evaluate the adequacy of the allowance for credit losses. The Bank evaluates the allowance necessary for specific nonperforming loans and also estimates losses in other credit exposures. The resultant three allowance components are as follows: Specific Reserves. The amount of specific reserves is determined through a loan-by-loan analysis of problem loans over a minimum size. Included in problem loans are those non-accrual or renegotiated loans that meet the criteria as being “impaired” under the definition in Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan”. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Any allowance on impaired loans is generally based on one of three methods, as SFAS No. 114 requires that impaired loans be measured at either the present value of expected cash flows at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral of the loan. Problem loans also include those credits that have been internally classified as credits requiring management’s attention due to underlying problems in the borrower’s business or collateral concerns. BNCCORP, Inc. Annual Report 2008 39 36 Reserves for Homogeneous Loan Pools. The Bank makes a significant number of loans and leases that, due to their underlying similar characteristics, are assessed for loss as “homogeneous” pools. Included in the homogeneous pools are consumer loans and commercial loans under a certain size which have been excluded from the specific reserve allocation as previously discussed. The Bank segments the homogeneous pools by type of loan or lease and, using historical loss information, estimates a loss reserve for each pool. Qualitative Reserve. The Bank’s senior lending management also allocates reserves for special circumstances which are unique to the measurement period. These include, among other things, prevailing trends and economic conditions in certain geographic, industry or lending segments of the portfolio; management’s assessment of credit risk inherent in the loan portfolio, delinquency data; historical loss experience and peer-group loss history. Continuous credit monitoring and analysis of loss components are the principal processes relied upon by management to determine changes in estimated credit losses are reflected in the Bank’s allowance for credit losses on a timely basis. Management also considers experience of peer institutions and regulatory guidance in addition to the Bank’s own experience. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for credit losses. Such agencies may require additions to the allowance based on their judgment about information available to them at the time of their examination. Loans, leases and other extensions of credit deemed uncollectible are charged to the allowance. Subsequent recoveries, if any, are credited to the allowance. Management’s estimate of the allowance for credit losses is highly dependent upon variables affecting valuation, including, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. These variables are reviewed periodically. Actual losses may vary from the current estimated allowance for credit losses. The provision for credit losses is the amount necessary to adjust the allowance to the level determined appropriate through application of the above processes. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for credit losses that we believe is appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors that occur in a particular period. Qualitative factors include the general economic environment in our markets and the state of certain industries in our market areas. Size and complexity of individual credits, loan structure, the extent and nature of waivers of loan policies and pace of portfolio growth are other qualitative factors that are considered in our methodology. Our methodology is, and has been, consistently applied. However, we will enhance our methodology as circumstances dictate to keep pace with the complexity of the loan and lease portfolio. We believe that our systematic methodology is appropriate given our size and level of complexity. Income Taxes The Company files consolidated federal and unitary state income tax returns. Deferred income taxes are accounted for using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Such differences can relate to differences in accounting for credit losses, depreciation, unrealized gains and losses on investment securities, deferred compensation and leases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. 40 BNCCORP, Inc. Annual Report 2008 37 The determination of current and deferred income taxes is based on complex analyses of many factors including interpretation of federal and state income tax laws, the difference between tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts due or owed such as the timing of reversals of temporary differences and current financial accounting standards. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income taxes. The Company adopted Financial Accounting Standards Board (FASB) Financial Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes”, on January 1, 2007. FIN 48 is an interpretation of SFAS No. 109, “Accounting for Income Taxes”, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit based on the technical merits of the position. The adoption of FIN 48 did not have a material impact on the Company’s results of operations or financial position. See Footnote 24 to these consolidated financial statements, for additional information. Other Than Temporary Impairment Declines in the fair value of individual available-for-sale or held-to-maturity securities below their cost, which are deemed other than temporary, could result in a charge to earnings and the corresponding establishment of a new cost basis for the security. Such write-downs would be included in non-interest income as realized losses. The Company assesses available information regarding the collectability of securities such as past events, current conditions and reasonable and supportable forecasts. Consideration is also given to a variety of factors including, but not limited to, the following: • Recent and expected performance of the securities; • Financial condition of issuers or guarantors; • Recent cash flows; • Seniority of invested tranches and subordinated credit support; • Vintage of origination; • Location of collateral; • Ratings of securities; • Value of underlying collateral; • Delinquency and foreclosure data; • Historical losses and estimated severity of future losses; • Credit surveillance data which summarize retrospective performance; and • Anticipated future cash flows and prospective performance assessments. Determining whether an other than temporary impairment has occurred requires management’s judgment of factors that may indicate an impairment loss has incurred. There were no securities that management concluded were other than temporarily impaired in either 2008 or 2007. Note 4 to these consolidated financial statements includes a summary of investment securities in a loss position at December 31, 2008 and a discussion concerning such securities. Fair Value Several accounting standards require recording assets and liabilities based on their fair values. Determining the fair value of assets and liabilities can be highly subjective. BNCCORP, Inc. Annual Report 2008 41 38 SFAS No. 157 “Fair Value Measurements” defines fair value and establishes a framework for measuring fair value of assets and liabilities using a hierarchy system consisting of three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access. Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. Management assigns a level to assets and liabilities accounted for at fair value and uses the methodologies prescribed by SFAS 157 to determine fair value. OTHER SIGNIFICANT ACCOUNTING POLICIES Investment Securities Investment securities that the Bank intends to hold for indefinite periods of time as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital or similar factors are classified as available for sale. Available for sale securities are carried at market value. Net unrealized gains and losses, net of deferred income taxes, on investment and mortgage-backed securities available for sale are reported as a separate component of stockholders’ equity until realized (see “Comprehensive Income”). All securities, other than the securities of the Federal Reserve Bank (“FRB”) and the Federal Home Loan Bank (“FHLB”), were classified as available for sale as of December 31, 2008 and 2007. Investment securities that the Bank intends to hold until maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts using a level yield method over the period to maturity. There were no such securities as of December 31, 2008 or 2007. Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. Dividend and interest income is recognized when earned. Realized gains and losses on the sale of investment securities are determined using the specific-identification method and recognized in non-interest income on the trade date. Federal Reserve Bank and Federal Home Loan Bank of Des Moines Stock Investments in FRB and FHLB stock are carried at cost, which approximates fair value. Loans Held For Sale At December 31, 2007 loans held for sale were accounted for at the lower of cost or market. In 2008, loans held for sale were accounted for at fair value pursuant to the fair value option permitted by SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities”. We elected the fair value option for loans held for sale because they are economically hedged with forward sales commitments. We expect that changes in the fair value of loans held for sale and forward sales commitments will be offsetting. Adopting SFAS No. 159 had no impact on retained earnings. For mortgage loans held for sale carried at fair value under SFAS 159, gains and losses from the initial measurement and subsequent changes in fair value are included in mortgage banking revenue. 39 42 BNCCORP, Inc. Annual Report 2008 Participating Interests in Mortgage Loans The Bank purchases participating interests in mortgage loans owned by mortgage banking counter-parties. The participating interests are generally outstanding for a short duration as funds are advanced to finance loans closed by the counterparties and are repaid when the counterparties sell the loans. The participating interests are stated at the aggregate amount of the loans financed by the counterparties. An allowance for losses is estimated on the participating interests and is included in the allowance for credit losses. Loans and Leases Loans and leases held for investment are stated at their outstanding principal amount net of unearned income, net of unamortized deferred fees and costs and an allowance for credit losses. Interest income is recognized on an accrual basis using the interest method prescribed in the loan agreement except when collectability is in doubt. Loans and leases, including loans that are considered to be impaired, are reviewed regularly by management and are placed on non-accrual status when the collection of interest or principal is 90 days or more past due, unless the loan or lease is adequately secured and in the process of collection. When a loan or lease is placed on non-accrual status, unless collection of all principal and interest is considered to be assured, uncollected interest accrued in prior years is charged off against the allowance for credit losses. Interest accrued in the current year is reversed against interest income in the current period. Interest payments received on non-accrual loans and leases are generally applied to principal unless the remaining principal balance has been determined to be fully collectible. Accrual of interest is resumed when it can be determined that all amounts due under the contract are expected to be collected and the loan has exhibited a sustained level of performance, generally at least six months. All impaired loans are measured at the present value of expected future cash flows discounted at the loan’s initial effective interest rate. The fair value of collateral of an impaired collateral-dependent loan or an observable market price may be used as an alternative to discounting. If the measure of the impaired loan is less than the recorded investment in the loan, impairment will be recognized as a charge-off through the allowance for credit losses. A loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans are reviewed for impairment on an individual basis. Cash receipts on impaired loans, excluding impaired loans that are on non-accrual status, are applied to principal except when the loan is well collateralized or there are other circumstances that support recognition of interest. Cash receipts on impaired loans that are on non-accrual status are applied to principal. Loan Origination Fees and Costs; Other Lending Fees For Loans and Leases Held for Investment, origination fees and costs incurred to extend credit are deferred and amortized over the term of the loan as an adjustment to yield using the interest method, except where the net amount is immaterial. The Company occasionally originates lines of credit where the customer is charged a non-usage fee if the line of credit is not used. In such instances, we periodically review use of lines on a retrospective basis and recognize non-usage fees in non-interest income. Mortgage Servicing and Transfers of Financial Assets The Bank sells loans to others on a non-recourse basis. Sold loans are not included in the accompanying consolidated balance sheets. The Bank generally retains the right to service the loans as well as the right to receive a portion of the interest income on the loans. At December 31, 2008 and 2007, the Bank was servicing loans for the benefit of others with aggregate unpaid principal balances of $315.5 and $201.8 million, respectively. In 2008 and 2007, $285.6 million and $187.5 million, respectively of loans sold by the Bank are commercial lines of credit, or construction loans, for which balances and related payment streams cannot be reasonably estimated in order to determine the fair value of the servicing assets or liabilities and/or future interest income retained by the Bank. Upon sale, unearned net loan fees and/or costs are recognized in non-interest income and included in gains on sale of loans. BNCCORP, Inc. Annual Report 2008 43 40 The sales of loans are accounted for pursuant to SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”. Premises and Equipment Land is carried at cost. Premises and equipment are reported at cost less accumulated depreciation and amortization. Depreciation and amortization for financial reporting purposes is charged to operating expense using the straight-line method over the estimated useful lives of the assets. Estimated useful lives are up to 40 years for buildings and three to 10 years for furniture and equipment. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life of the improvement. The costs of improvements are capitalized. Maintenance and repairs, as well as gains and losses on dispositions of premises and equipment, are included in non-interest income or expense as incurred. Other Real Estate Owned and Repossessed Property Real estate properties and other assets acquired through loan foreclosures are stated at the lower of carrying amount or fair value less estimated costs to sell. When an asset is acquired, the excess of the recorded investment in the asset over fair value less estimated costs to sell, if any, is charged to the allowance for credit losses. Management performs valuations periodically. Fair value is generally determined based upon appraisals of the assets involved. Subsequent declines in the estimated fair value, net operating results and gains and losses on disposition of the asset are included in other non-interest income. Operating expenses of properties are charged to ORE expense. Impairment of Long-Lived Assets The Company reviews long-lived assets, including property and equipment for impairment periodically or whenever events or changes in circumstances indicate that the carrying amount of any such asset may not be recoverable. If impairment is identified, the assets are written down to their fair value through a charge to non- interest expense. No such impairment losses were recorded during 2008 or 2007. Long-Lived Assets Held for Sale Long-lived assets held for sale are carried at the lower of the carrying amount or fair value less costs to sell. Assets classified as long-lived assets held for sale are available for immediate sale in their present condition and are actively marketed for sale. The Company does not record depreciation expense on long-lived assets held for sale. Securities Sold Under Agreements to Repurchase From time to time, the Bank enters into sales of securities under agreements to repurchase, generally for periods of less than 90 days. These agreements are treated as financings, and the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets as short-term borrowings. The costs of securities underlying the agreements remain in the asset accounts. Fair Values of Financial Instruments The Company is required to disclose the estimated fair value of financial instruments for which it is practicable to estimate fair value. Fair value estimates are subjective in nature, involving uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Non-financial instruments are excluded from fair value of financial instrument disclosure requirements. The following methods and assumptions are used by the Company in estimating fair value disclosures for its financial instruments, all of which are issued or held for purposes other than trading. Cash and Cash Equivalents, Non-interest-Bearing Deposits and Demand Deposits. The carrying amounts approximate fair value due to the short maturity of the instruments. The fair value of deposits with no stated maturity, such as interest checking, savings and money market accounts, is equal to the amount payable on demand at the reporting date. Investment Securities Available for Sale. The fair value of the Company’s securities are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. 41 44 BNCCORP, Inc. Annual Report 2008 Federal Reserve Bank and Federal Home Loan Bank Stock. The carrying amount of FRB and FHLB stock is their cost, which approximates fair value. Loans Held for Sale. The fair value of the Company’s loans held for sale was stated at the lower of cost or market value of the loans at December 31, 2007. In 2008 loans held for sale were accounted for at fair value pursuant to the fair value option permitted by SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities”. See recently issued or adopted accounting pronouncement disclosure. Participating Interests in Mortgage Loans, Loans and Leases Held for Investment. Fair values of these assets are estimated by discounting future cash flow payment streams using rates at which current loans to borrowers with similar credit ratings and similar loan maturities are being made. Accrued Interest Receivable. The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable. Derivative Financial Instruments. The fair value of the Company’s derivatives are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market. Interest-Bearing Deposits. Fair values of interest-bearing deposit liabilities are estimated by discounting future cash flow payment streams using rates at which comparable current deposits with comparable maturities are being issued. The intangible value of long-term customer relationships with depositors is not taken into account in the fair values disclosed. Borrowings and Advances. The carrying amount of short-term borrowings approximates fair value due to the short maturity and the instruments’ floating interest rates, which are tied to market conditions. The fair values of long-term borrowings are estimated by discounting future cash flow payment streams using rates at which comparable borrowings are currently being offered. Accrued Interest Payable. The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable. Guaranteed Preferred Beneficial Interests In Company’s Subordinated Debentures. The fair values of the Company’s subordinated debentures are estimated by discounting future cash flow payment streams using discount rates estimated to reflect those at which comparable instruments could currently be offered. Financial Instruments with Off-Balance-Sheet Risk. The fair values of the Company’s commitments to extend credit and commercial and standby letters of credit are estimated using fees currently charged to enter into similar agreements. Derivative Financial Instruments SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended and interpreted, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As required by SFAS No. 133, the Company records all derivatives at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. BNCCORP, Inc. Annual Report 2008 45 42 All derivative instruments that qualify for specific hedge accounting are recorded at fair value and classified either as a hedge of the fair value of a recognized asset or liability (“fair value” hedge) or as a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability or a forecasted transaction (“cash flow” hedge). All relationships between hedging instruments and hedged items are formally documented, including the risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as hedges to specific assets or liabilities on the balance sheet. Changes in the fair value of a derivative that is highly effective and designated as a fair value hedge and the offsetting changes in the fair value of the hedged item are recorded in income. Changes in the fair value of a derivative that is highly effective and designated as a cash flow hedge are recognized in other comprehensive income until income from the cash flows of the hedged item are recognized. The Company performs an assessment, both at the inception of the hedge and on a quarterly basis thereafter, to determine whether these derivatives are highly effective in offsetting changes in the value of the hedged items. Any change in fair value resulting from hedge ineffectiveness is immediately recorded in income. Revenue Recognition The Company recognizes revenue on an accrual basis for interest and dividend income on loans, investment securities, Federal funds sold and interest bearing cash and cash equivalent accounts. Non-interest income is recognized when it has been realized and has been earned. In accordance with existing accounting and industry standards, the Company considers revenue to be realized or realizable and earned when the following criteria have been met: persuasive evidence of an arrangement exists (generally, there is contractual documentation); delivery has occurred or services have been rendered; the seller’s price to the buyer is fixed or determinable; and collectability is reasonably assured. Additionally, there can be no outstanding contingencies that could ultimately cause the revenue to be passed back to the payor. In instances where these criteria have not been met, receipts are deferred until such time as they can be recognized as revenue. Earnings Per Common Share Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the applicable period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Such potential dilutive instruments include stock options and contingently issuable stock. Note 25 to these consolidated financial statements includes disclosure of the Company’s EPS calculations. Comprehensive Income Comprehensive income is the total of net income and other comprehensive income, which for the Company, is generally comprised of unrealized gains and losses on securities available for sale and unrealized gains and losses on hedging instruments qualifying for cash flow hedge accounting treatment pursuant to SFAS No. 133, as amended. The Company presents consolidated statements of comprehensive income. Cash and Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include cash on hand, cash due from banks and federal funds sold. Share-Based Compensation As of January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment (“FAS 123R”), which requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the grant date. At December 31, 2008, the Company had three stock-based employee compensation plans, which are described more fully in Note 28 to these consolidated financial statements. 46 BNCCORP, Inc. Annual Report 2008 43 RECENTLY ISSUED OR ADOPTED ACCOUNTING PRONOUNCEMENTS The Company adopted FIN 48, “Accounting for Uncertainty in Income Taxes” on January 1, 2007. FIN 48 is an interpretation of SFAS No. 109, “Accounting for Income Taxes”, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit based on the technical merits of the position. The adoption of FIN 48 did not have a material impact on the Company’s results of operations or financial position. See Note 24 to these consolidated financial statements for additional information. Emerging Issues Task Force (“EITF”) 06-04, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (EITF 06-04) requires recognition of a liability for future benefits in accordance with SFAS No. 106, “Employers Accounting for Post Retirement Benefits Other Than Pension” (if, in substance, a postretirement benefit plan exists) or Accounting Principles Board (“APB”) Opinion 12 (if the arrangement is, in substance, an individual deferred compensation contract) based on the substantive agreement with the employee. The EITF is effective for fiscal years beginning after December 15, 2007, with earlier application permitted. The Company adopted EITF 06-04 on January 1, 2008 and recognized a cumulative-effect adjustment to decrease retained earnings by $219,000. SFAS No. 156, “Accounting for Servicing of Financial Assets” – an amendment of SFAS No. 140, requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset. SFAS No. 156 requires that all separately recognized servicing assets and liabilities be initially measured at fair value and permits, but does not require the subsequent measurement of servicing assets and liabilities at fair value. The provisions of SFAS No. 156 were adopted by the Company on January 1, 2007 and did not have a material impact on the Company’s results of operations or financial position. The Company elected to measure the subsequent measurements of the servicing assets and liabilities using the amortization method. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about the use of fair value to measure assets and liabilities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The impact of adopting SFAS No. 157 on January 1, 2008 did not have a material impact on the Company’s results of operations or financial position. In accordance with the provisions of FASB Staff Position, or FSP, No. FAS 157-2 Effective Date of FASB Statement No. 157, we elected to defer implementation of SFAS No. 157, as it relates to our nonfinancial assets and nonfinancial liabilities that are recognized and disclosed at fair value in our consolidated financial statements on a non-recurring basis, until January 1, 2009. We are evaluating the impact, if any, the adoption of SFAS No. 157 for our nonfinancial assets and nonfinancial liabilities will have on our financial position, results of operations or liquidity. In February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, including an amendment of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. This Statement permits entities to measure many financial instruments and other items at fair value and most of the provisions of the Statement apply only to entities that elect the fair value option. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The impact of adopting SFAS No. 159 on January 1, 2008 had no impact on retained earnings. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51”. This Statement amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This Statement applies to all for-profit entities that prepare consolidated financial statements, but affects only those entities that have an outstanding noncontrolling interest in subsidiaries or that deconsolidate a subsidiary. This Statement is effective for financial statements issued for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. The BNCCORP, Inc. Annual Report 2008 47 44 impact of adopting SFAS No. 160 on January 1, 2009 had no impact on the Company’s results of operations or financial position. In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations”. This Statement replaces SFAS No. 141, “Business Combinations” and retains the fundamental requirements of SFAS No. 141 that the purchase method of accounting be used for all business combinations and for an acquirer to be identified for each business combination. This Statement established principles and requirements for how the acquirer recognizes and measures the assets acquired (including goodwill), the liabilities assumed, and any controlling interest in the acquiree. It also determines what information is to be disclosed to enable users of the financial statements to evaluate the nature and financial effect of the business combination. This Statement is effective for financial statements issued for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133”. This Statement applies to all entities and requires enhanced disclosures about an entity’s derivative hedging activities including how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We have not completed our analysis of the Statement but we believe the impact of adopting SFAS No. 161 on January 1, 2009 will not have a material impact on the Company’s results of operations or financial position. REGULATORY ENVIRONMENT BNCCORP and its subsidiaries are subject to regulations of certain state and federal agencies, including periodic examinations by those regulatory agencies. BNCCORP and the Bank are also subject to minimum regulatory capital requirements. At December 31, 2008, capital levels exceeded minimum capital requirements (see Note 18 to these consolidated financial statements). RECLASSIFICATIONS Certain amounts in the financial statements for the prior year have been reclassified to conform to the current year’s presentation. These reclassifications had no effect on net income or stockholders’ equity. NOTE 2. Acquisitions and Divestitures On June 1, 2007, the Company completed the sale of substantially all of the assets of BNC Insurance Services, Inc. (BNC Insurance). Management considered the benefits of the sale including, but not limited to the following: • Monetizes the value of a segment the Company had nurtured; • Strengthens the regulatory capital of Company; • Decreases the risk of impaired revenue due to a decline in contingency income; • Decreases exposure to the cyclicality of the insurance business; and • Permits replacement of a significant portion of the income generated by the agency. The Company initiated actions related to the sale late in 2006 and reached an agreement to sell substantially all of the assets of the insurance segment in March 2007. Stockholders approved the transaction in May 2007. The gross proceeds from sale were $37.25 million and a pre-tax gain on sale of $6.083 million was recognized in the second quarter of 2007. The financial statements of the Company report BNC Insurance in discontinued operations for all periods presented. The gain on sale is also reported in discontinued operations of the Company in 2007. Pre-tax revenues of BNC Insurance were $9.111 million in 2007. 48 BNCCORP, Inc. Annual Report 2008 45 NOTE 3. Restrictions on Cash and Cash Equivalents The Bank is required to maintain reserve balances in cash on hand or with the FRB under the Federal Reserve Act and FRB’s Regulation D required reserve balances were $25,000 as of December 31, 2008 and 2007. NOTE 4. Investment Securities Available For Sale Investment securities have been classified in the consolidated balance sheets according to management’s intent. The Company had no securities designated as trading or held-to-maturity in its portfolio at December 31, 2008 or 2007. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of December 31 (in thousands): 2008 U.S. government agency mortgage-backed securities guaranteed by GNMA U.S. government agency mortgage-backed securities issued by FNMA Collateralized mortgage obligations guaranteed by GNMA Collateralized mortgage obligations issued by FNMA or FHLMC Other collateralized mortgage obligations State and municipal bonds 2007 U.S. government agency mortgage-backed securities guaranteed by GNMA U.S. government agency mortgage-backed securities issued by FNMA Collateralized mortgage obligations guaranteed by GNMA Collateralized mortgage obligations issued by FNMA or FHLMC Other collateralized mortgage obligations State and municipal bonds Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 1,505 $ 39 $ (1) $ 1,543 2,891 23,037 33 177 (7) 2,917 (44) 23,170 37,896 1,128 - 39,024 138,851 13,482 233 541 (9,899) (5) 129,185 14,018 $ 217,662 $ 2,151 $ (9,956) $ 209,857 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $ 1,799 $ 1 $ (16) $ 1,784 3,329 2,394 33 19 (29) 3,333 - 2,413 62,384 933 (11) 63,306 32,830 17,885 312 1,099 (63) - 33,079 18,984 $ 120,621 $ 2,397 $ (119) $ 122,899 BNCCORP, Inc. Annual Report 2008 49 46 The amortized cost and estimated fair market value of available-for-sale securities classified according to their contractual maturities at December 31, 2008, were as follows (in thousands): Amortized Cost Due in one year or less Due after one year through five years Due after five years through ten years Due after ten years Total $ $ 2,480 6,285 38,801 170,096 217,662 $ $ Estimated Fair Value 2,527 6,430 38,648 162,252 209,857 Securities carried at approximately $197.5 million and $118.3 million at December 31, 2008 and 2007, respectively, were pledged as collateral for public and trust deposits and borrowings, including borrowings from the FHLB and repurchase agreements with customers. Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows for the years ended December 31 (in thousands): Sales proceeds Gross realized gains Gross realized losses $ 2008 14,209 256 (9) 2007 $ 106,450 - (3,277) The following table shows the Company’s investments’ gross unrealized losses and fair value; aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2008 and 2007 (in thousands): As of December 31, 2008 Description of Securities U.S. government agency mortgage-backed securities guaranteed by GNMA U.S. government agency mortgage-backed securities issued by FNMA Collateralized mortgage obligations guaranteed by GNMA Other collateralized mortgage Less than 12 months 12 months or more # Fair Value Unrealized Loss # Fair Value Unrealized Loss # Total Fair Value Unrealized Loss - $ - $ - 1 $ 81 $ (1) 1 $ 81 $ (1) - - - 3 1,555 (7) 3 1,555 (7) 2 10,402 (44) - - - 2 10,402 (44) obligations 26 109,322 (9,767) State and municipal bonds 2 892 (5) 1 - 2,490 (132) - - 27 2 111,812 892 (9,899) (5) Total temporarily impaired securities 30 $ 120,616 $ (9,816) 5 $ 4,126 $ (140) 35 $ 124,742 $ (9,956) 50 BNCCORP, Inc. Annual Report 2008 47 As of December 31, 2007 Description of Securities U.S. government agency mortgage-backed securities guaranteed by GNMA U.S. government agency mortgage-backed securities issued by FNMA Collateralized mortgage obligations issued by FNMA or FHLMC Other collateralized mortgage obligations State and municipal bonds Total temporarily impaired securities Less than 12 months 12 months or more Total # Fair Value Unrealized Loss # Fair Value Unrealized Loss # Fair Value Unrealized Loss - $ - $ - 3 $ 1,399 $ (16) 3 $ 1,399 $ (16) - - - 5 2,194 (29) 5 2,194 (29) 2 514 (2) 2 2,499 (9) 4 3,013 (11) 3 - 11,704 (63) - - - - - - - 3 11,704 - - - (63) - 5 $ 12,218 $ (65) 10 $ 6,092 $ (54) 15 $ 18,310 $ (119) In reaching the conclusion that the impairments disclosed in the tables above are temporary and not other-than- temporary in nature, the Company considered the nature of the securities, the associated guarantees and collateralization, the securities ratings and the level of impairment of the securities. As of December 31, 2008, there were nine U.S. government agency mortgage-backed securities with unrealized losses, four issued and guaranteed by GNMA, the other five by FNMA or FHLMC, and there were two general obligation bank- qualified, municipal bonds with underlying ratings of "A" or above. The 27 other collateralized mortgage obligations that were in an unrealized loss position are senior tranches, backed by fixed-rate collateral generated in 2004 or earlier. All but one of these securities have been in an unrealized loss positions for less than twelve months. The weighted average amortized loan-to-value (LTV) of the collateral underlying 15 of the 27 securities in an unrealized loss position is less than 60%. The largest weighted average amortized LTV of any of the securities in an unrealized loss position is 70.4%. All but three of these securities were originally issued in 2003 or in the first half of 2004. The three securities in an unrealized loss position that were issued in 2005 are off of mortgage collateral that was originated in 2001, 2002, 2003 and 2004 and have collateral ages of 61, 63, and 79 months respectively. All of the securities are rated investment grade by Moody’s, Standard & Poor’s, and/or Fitch. Twenty-six of the 27 securities carry “AAA” ratings by two of the three ratings agencies. None of the securities are currently “on- watch” for downgrade from their current ratings. None of the impairments were due to deterioration in credit quality that might result in the non-collection of contractual principal and interest. The cause of the impairments is, in general, attributable to changes in interest rates. Further, we have both the intent and ability to hold these impaired securities for a sufficient period of time to allow for their recovery in market value. For management’s conclusion on other than temporary impairment, please refer to the other than temporary impairment discussion in the critical accounting policies in Note 1 to these consolidated financial statements. NOTE 5. Federal Reserve Bank and Federal Home Loan Bank of Des Moines Stock The carrying amounts of FRB and FHLB stock, which approximate their fair values, consisted of the following as of December 31 (in thousands): Federal Reserve Bank Stock, at cost Federal Home Loan Bank of Des Moines Stock, at cost Total 2008 1,297 4,692 5,989 $ $ 2007 1,297 3,621 4,918 $ $ There is no contractual maturity on these investments; they represent required investments. BNCCORP, Inc. Annual Report 2008 51 48 NOTE 6. Loans and Leases Loan Portfolio Composition The composition of loans and leases, including participating interests in mortgage loans, classified as we present on our regulatory reports was as follows at December 31 (in thousands): Commercial and industrial Real estate: Mortgage Construction Agricultural Consumer Lease financing Other Subtotal Participating interests in mortgage loans Total gross loans held for investment Unearned income and net unamortized deferred fees and costs Loans, net of unearned income and unamortized fees and costs Allowance for credit losses Net loans and leases 2008 $ 138,671 2007 $ 125,555 265,360 108,713 22,023 6,873 1,287 633 543,560 28,584 572,144 (807) 571,337 (8,751) $ 562,586 181,000 167,345 17,074 5,445 1,815 433 498,667 24,357 523,024 (1,111) 521,913 (6,599) $ 515,314 Commercial and industrial loan borrowers are generally small and mid-sized corporations, partnerships and sole proprietors in a wide variety of businesses. Real estate loans are fixed or variable rate and include both amortizing and revolving line-of-credit loans. Real estate mortgage loans include various types of loans for which the Bank holds real property as collateral. Agricultural loans include loans to grain and/or livestock producers, agricultural real estate loans, machinery and equipment and other types of loans. Loans to consumers are both secured and unsecured. Lease financing represents credit to borrowers under direct finance lease obligations. The Bank also extends financing to lease companies, securing the loan with an assignment of lease payments and a security filing against the underlying asset of the lease. These loans are classified as lease financing but are not direct finance lease obligations. Concentrations of Credit The following tables summarize the location of our borrowers as of December 31 (in thousands): 2008 2007 Minnesota North Dakota Arizona Other Totals $ 185,947 173,509 145,643 67,045 $ 572,144 33 % 30 25 12 100 % $ 193,149 154,972 136,371 38,532 $ 523,024 37 % 30 26 7 100 % 52 BNCCORP, Inc. Annual Report 2008 49 Our borrowers use loan proceeds for projects in various geographic areas. The following table summarizes the locations where our borrowers are using loan proceeds as of December 31 (in thousands): North Dakota Arizona Minnesota Texas California Kentucky Wisconsin Idaho New York Georgia South Dakota Arkansas Florida Other Totals 2008 2007 $ 181,073 126,327 106,786 37,032 23,894 11,000 10,301 8,146 7,496 6,559 5,864 5,260 5,228 37,178 $ 572,144 32 % 22 19 6 4 2 2 1 1 1 1 1 1 7 100 % $ 160,506 120,931 130,085 26,966 20,715 9,916 5,573 5,621 4,155 6,566 1,723 5,171 2,862 22,234 $ 523,024 31 % 23 25 5 4 2 1 1 1 1 - 1 1 4 100 % The bank has a concentration of loans exceeding 10% of the total loan portfolio in real estate loans. Significant concentrations within the real estate portfolio as defined by the loan’s purpose code as of December 31 are as follows (in thousands): Land and land development loans Construction loans Totals 2008 61,814 37,746 99,560 $ $ 2007 11 % 7 18 % $ 78,992 15 % 68,849 13 $ 147,841 28 % Construction loans include loans for which construction is complete and the loans will be either sold or refinanced to permanent loans within the following year. Impaired Loans As of December 31, the Bank’s recorded investment in impaired loans and the related valuation allowance was as follows (in thousands): 2008 2007 Recorded Investment Valuation Allowance Recorded Investment Valuation Allowance Impaired loans - Valuation allowance required $ 17,355 $ 1,619 $ 16,397 $ 1,572 No valuation allowance required - - - - Total impaired loans $ 17,355 $ 1,619 $ 16,397 $ 1,572 Impaired loans generally include loans which management believes it is probable that the Bank will not be able to collect all amounts due in accordance with the terms of the loan agreement and which are analyzed for a specific reserve allowance. The Bank generally considers all loans risk-graded substandard and doubtful, as well as non- accrual and restructured loans, as impaired loans. BNCCORP, Inc. Annual Report 2008 53 50 The valuation allowance on impaired loans is included in the Bank’s allowance for credit losses. The average recorded investment in impaired loans, and approximate interest income recognized for such loans, were as follows for the years ended December 31 (in thousands): Average recorded investment in impaired loans $ 17,917 $ 16,228 Average recorded investment in impaired loans as a percentage of average total loans 3.41% 3.26% 2008 2007 Twelve Months Ended December 31, 2008 Twelve Months Ended December 31, 2007 Interest income recognized on impaired loans $ 267 $ 159 Interest income recognized on a cash basis during the time of impairment 169 18 Loans to Related Parties Note 23 to these consolidated financial statements includes information relating to loans to executive officers, directors, principal shareholders and associates of such persons. Leases The Bank extends credit to borrowers under direct finance lease obligations. The direct finance lease obligations are stated at their outstanding principal amount net of unearned income and net unamortized deferred fees and costs. At December 31, 2008, the future minimum annual lease payments for direct finance lease obligations were as follows (in thousands): 2009 2010 2011 2012 2013 Thereafter Total future minimum lease Unguaranteed residual values Total all payments Unearned income Net outstanding principal amount $ $ 486 258 225 24 - - 993 414 1,407 (120) 1,287 Loans Pledged as Collateral Single- and multi-family residential mortgage loans totaling $12.2 and $11.7 million at December 31, 2008 and 2007, respectively, were pledged as collateral for borrowings. Commercial real estate first mortgage loans totaling $58.2 and $68.5 million at December 31, 2008 and 2007, respectively, were pledged as collateral for borrowings. Home equity lines of credit, residential second mortgage loans, and warehouse mortgage loans held for sale of $7.6 million, $7.2 million, and $10.7 million respectively as of December 31, 2008 were pledged as collateral for borrowings. No home equity lines of credit, residential second mortgage loans, and warehouse mortgage loans held for sale were pledged as collateral for borrowings as of December 31, 2007. 54 BNCCORP, Inc. Annual Report 2008 51 NOTE 7. Allowance for Credit Losses Transactions in the allowance for credit losses were as follows for the years ended December 31 (in thousands): Balance, beginning of year Provision for credit losses Loans charged off Loans recovered Balance, end of year 2008 6,599 7,750 (5,946) 348 8,751 $ $ 2007 3,370 3,750 (2,127) 1,606 6,599 $ $ NOTE 8. Other Real Estate Other real estate (ORE) includes property acquired through foreclosure, property in judgment and in-substance foreclosures. ORE is carried at fair value less estimated selling costs. The property is evaluated regularly and any decreases in the carrying amount are included in non-interest expense. ORE consisted of the following at December 31 (in thousands): Other Real Estate Other real estate owned Real estate in judgment In-substance foreclosure 2008 2007 $ 10,189 $ - - - - - Total other real estate owned Allowance for other real estate losses $ 10,189 $ - - - Total other real estate owned, net $ 10,189 $ - NOTE 9. Premises and Equipment, net Premises and equipment, net consisted of the following at December 31 (in thousands): Land and improvements Buildings and improvements Leasehold improvements Furniture, fixtures and equipment Total cost Less accumulated depreciation and amortization Net premises, leasehold improvements and equipment 2008 6,692 12,914 1,795 8,643 30,044 (9,234) 20,810 $ $ 2007 6,692 11,108 1,686 8,085 27,571 (8,123) 19,448 $ $ Depreciation and amortization expense charged to continuing operations totaled approximately $1.4 million and $1.6 million for the years ended December 31, 2008 and 2007, respectively. NOTE 10. Premises and Equipment Held for Sale In October 2007 the Company entered into an exclusive listing agreement with a commercial real estate broker to sell a commercial building which was no longer needed for operating purposes. The Company sold the building in the second quarter of 2008 and recognized a gain of $832,000. BNCCORP, Inc. Annual Report 2008 55 52 NOTE 11. Deposits The scheduled maturities of time deposits as of December 31, 2008 are as follows (in thousands): 2009 2010 2011 2012 2013 Thereafter $ $ 234,695 54,395 12,440 22,305 10,183 5,456 339,474 At December 31, 2008 and 2007, the Bank had $99.7 million and $30.0 million, respectively, of time deposits that had been acquired through a broker. Deposits Received from Related Parties Note 23 to these consolidated financial statements includes information relating to deposits received from executive officers, directors, principal shareholders and associates of such persons. NOTE 12. Short-Term Borrowings The following table sets forth selected information for short-term borrowings (borrowings with an original maturity of less than one year) as of December 31 (in thousands): Federal funds purchased and U. S. Treasury tax and loan retainer $ 9,345 $ 1,876 2008 2007 Repurchase agreements with customers, renewable daily, interest payable monthly, rates ranging from 0.25% to 1.70% in 2008, and 3.15% to 4.00%, in 2007, secured by government agency collateralized mortgage obligations 7,499 3,489 $ 16,844 $ 5,365 The weighted average interest rate on short-term borrowings outstanding as of December 31, 2008 and 2007 was 0.88% and 3.64% respectively. Customer repurchase agreements are used by the Bank to acquire funds from customers where the customers are required, or desire, to have their funds supported by collateral consisting of government, government agency or other types of securities. The repurchase agreement is a promise to sell these securities to a customer at a certain price and repurchase them at a future date at that same price plus interest accrued at an agreed upon rate. The Bank uses customer repurchase agreements in its liquidity plan as well as an accommodation to customers. At December 31, 2008, $7.5 million of securities sold under repurchase agreements, with a weighted average interest rate of 1.27%, maturing in 2009, were collateralized by government agency collateralized mortgage obligations having a carrying value of $20.0 million, a market value of $20.0 million and unamortized principal balances of $19.5 million. As of December 31, 2008, the Bank had established Federal funds purchase programs with two banks, totaling $9 million. At December 31, 2008, the Bank had purchased Federal funds of $7 million under these programs leaving $2 million available. The Federal funds purchase programs, if advanced upon, mature daily with interest rates that float at the Federal funds rate. 56 BNCCORP, Inc. Annual Report 2008 53 NOTE 13. Federal Home Loan Bank Advances FHLB advances consisted of the following at December 31 (in thousands): 2008 2007 Year of Maturity 2008 2009 2013 2015 Amount - $ 62,500 15,000 7,000 84,500 $ Weighted Average Rate - % 0.91 3.99 5.16 1.81 % Amount 61,400 - - - 61,400 $ $ Weighted Average Rate 4.26 % - - - 4.26 % As of December 31, 2008 the Bank had $62.5 million of FHLB advances maturing in January 2009. These advances were renewed in the normal course of business. The Bank retains the option to call the $15 million advance maturing in 2013 without a prepayment penalty, on March 10, 2010 and quarterly thereafter. The Bank retains the option to call the $7 million advance maturing in 2015 without a prepayment penalty, on July 17, 2009 and quarterly thereafter. At December 31, 2008 the advances from the FHLB were collateralized by the Bank’s mortgage loans with unamortized principal balances of approximately $96 million resulting in a FHLB collateral equivalent of $59.5 million. In addition, the advances from the FHLB were collateralized by securities with unamortized principal balances of approximately $150.8 million. The Bank has the ability to draw additional advances of $109.3 million based upon the mortgage loans and securities that are currently pledged, subject to a requirement to purchase additional FHLB stock. NOTE 14. Long-Term Borrowings As of December 31, 2008, BNCCORP had a $20.0 million established line of credit with the Bank of North Dakota. Interest is payable quarterly at 30-day LIBOR plus 2.00%; maturity is February 15, 2010. No funds were drawn on the line as of December 31, 2008 or 2007. NOTE 15. Guaranteed Preferred Beneficial Interest’s in Company’s Subordinated Debentures In July 2007, BNCCORP established a special purpose trust, BNC Statutory Trust III, for the purpose of issuing $15.0 million of floating rate trust preferred securities. The interest rate paid on the securities is equal to three month LIBOR plus 1.40%. The interest rate at December 31, 2008 was 5.2825% and the interest rate reset on January 2, 2009 to 2.835%. The trust preferred securities mature on October 1, 2037. On or after October 1, 2012, the trust preferred securities may be redeemed at par and the corresponding debentures may be prepaid at the option of BNCCORP, subject to Federal Reserve Board approval. BNC Statutory Trust III was used to refinance BNC Statutory Trust II. BNC Statutory Trust II securities had an outstanding balance of $15.0 million and we incurred a prepayment penalty of $1.189 million in 2007 when our obligation to BNC Statutory Trust II was settled. In July 2000, BNCCORP established a special purpose trust, BNC Capital Trust I, for the purpose of issuing $7.5 million of trust preferred securities at 12.045%. The trust preferred securities are subject to mandatory redemption on July 19, 2030. On or after July 19, 2010, the trust preferred securities may be redeemed and the corresponding debentures may be prepaid at the option of BNCCORP, subject to Federal Reserve Board approval, at declining redemption prices. BNCCORP, Inc. Annual Report 2008 57 54 BNCCORP fully and unconditionally guarantees all obligations of the special purpose trusts related to the trust preferred securities. NOTE 16. Stockholders’ Equity BNCCORP and the Bank are subject to certain minimum capital requirements (see Note 18 to these consolidated financial statements). BNCCORP is also subject to certain restrictions on the amount of dividends it may declare without prior regulatory approval in accordance with the Federal Reserve Act. In addition, certain regulatory restrictions exist regarding the ability of the Bank to transfer funds to BNCCORP in the form of cash dividends. Approval of the Office of the Comptroller of the Currency (“OCC”), the Bank’s principal regulator, is required for the Bank to pay dividends to BNCCORP in excess of the Bank’s net profits from the current year plus retained net profits for the preceding two years. At December 31, 2008, approximately $961,000 of retained earnings were available for Bank dividend declaration without prior regulatory approval. BNCCORP repurchased 200,326 shares of its common stock for $2.6 million or $13.03 per share in 2008. In 2007, the Company purchased 94,782 shares of its common stock for $1.7 million or $18.15 per share. On May 30, 2001, BNCCORP’s Board of Directors (the “Board”) adopted a rights plan intended to protect stockholder interests in the event BNCCORP becomes the subject of a takeover initiative that BNCCORP’s Board believes could deny BNCCORP’s stockholders the full value of their investment. This plan does not prohibit the Board from considering any offer that it deems advantageous to its stockholders. BNCCORP has no knowledge that anyone is considering a takeover. The rights were issued to each common stockholder of record on May 30, 2001, and they will be exercisable only if a person acquires, or announces a tender offer that would result in ownership of, 15% or more of BNCCORP’s outstanding common stock. The rights will expire on May 30, 2011, unless redeemed or exchanged at an earlier date. NOTE 17. Derivatives The Company entered into an interest rate floor agreement during the first quarter of 2006. The $50.0 million prime rate interest rate floor has an effective date of January 9, 2006 and a maturity date of January 9, 2010. The floor is designated as a cash flow hedge. The terms of the floor result in the Company receiving payments when the prime interest rate is below the strike rate of 7.0%. At December 31, 2008 the prime rate was 3.25% and the Company was receiving payments under the terms of the agreement. At December 31, 2007 the prime rate was 7.25% and the Company was not entitled to receive a payment under the terms of the agreement. The floor was used to hedge the variable cash flows associated with $50.0 million of the Company’s existing variable-rate loans. In 2008 we received $863,000 of payments on the floor. At December 31, 2008, the fair value of the floor was $1.9 million, which was included in other assets. The change in unrealized gain of $1.3 million, net, during the year ended December 31, 2008, for the derivative designated as a cash flow hedge, is separately disclosed in the statement of changes in comprehensive income. There was $105,000 of hedge ineffectiveness on the cash flow hedge that was recognized during the year. The entire gain on the derivative was included in the assessment of the effectiveness. 58 BNCCORP, Inc. Annual Report 2008 55 At December 31, 2007, the fair value of the floor was $761,000, which was included in other assets. The change in unrealized gains of $690,000, net, during the year ended December 31, 2007, for the derivative designated as a cash flow hedge, is separately disclosed in the statement of changes in comprehensive income. No hedge ineffectiveness on the cash flow hedge was recognized during the year. The entire gain on the derivative was included in the assessment of the effectiveness. In our mortgage banking operations, the Company makes commitments to originate and sell loans. Commitments to originate and commitments to sell residential loans are considered to be derivatives pursuant to SFAS No. 133. Commitments to originate and sell residential loans are entered into concurrently in order to create economic hedges for changes in interest rates. The commitments are not formally designated as hedges. Because the commitments are derivatives, the value of the commitments is recorded at fair value. At December 31, 2008 the fair value of commitments to originate residential loans was $429,000, which is recorded in other assets. The change in fair value of the commitment to originate loans in 2008 was $429,000, this change was recognized in the income statement. At December 31, 2008 the fair value of the commitments to sell residential loans was $697,000, which is recorded in other liabilities. The change in fair value of the commitments to sell residential loans in 2008 was $697,000, this change was recognized in the income statement. At December 31, 2007 commitments to originate and sell residential loans were $0 and the change in fair value of the commitment to originate loans was $0. NOTE 18. Regulatory Capital BNCCORP and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, BNCCORP and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications of BNCCORP and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by the regulations to ensure capital adequacy require BNCCORP and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Under current regulatory capital regulations, BNCCORP’s subordinated debentures qualify as Tier 1 capital for purposes of the consolidated capital calculations up to 25% of Tier 1 capital prior to the deduction of intangible assets. The remainder of the subordinated debentures qualify as Tier 2 capital provided that the total of Tier 2 capital does not exceed Tier 1 capital. As of December 31, 2008, $19.2 million of the subordinated debentures qualified as Tier 1 capital with the remaining $3.8 million qualifying as Tier 2 capital. As of December 31, 2007, $19.4 million of the subordinated debentures qualified as Tier 1 capital with the remaining $3.7 million qualifying as Tier 2 capital. BNCCORP, Inc. Annual Report 2008 59 56 As of December 31, 2008, the most recent notifications from the OCC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table that follows. There are no conditions or events since that notification that management believes have changed the institution’s category. Actual capital amounts and ratios of BNCCORP and the Bank as of December 31 are also presented in the tables (dollars in thousands): 2008 Total Capital (to risk-weighted assets): Consolidated BNC National Bank Tier 1 Capital (to risk-weighted assets): Consolidated BNC National Bank Tier 1 Capital (to average assets): Consolidated BNC National Bank 2007 Total Capital (to risk-weighted assets): Consolidated BNC National Bank Tier 1 Capital (to risk-weighted assets): Consolidated BNC National Bank Tier 1 Capital (to average assets): Consolidated BNC National Bank Actual Amount Ratio For Capital Adequacy Amount Ratio To be Well Capitalized Amount Ratio $ 88,949 87,956 12.95 % $ 12.81 54,943 54,948 $ ≥8.0 % ≥8.0 N/A 68,685 N/A ≥10.0 % 76,585 79,368 11.15 11.56 27,472 27,474 ≥4.0 ≥4.0 76,585 79,368 9.01 9.34 33,994 33,982 ≥4.0 ≥4.0 N/A 41,211 N/A 42,478 N/A ≥6.0 N/A ≥5.0 $ 87,338 87,240 14.26 % $ 14.26 48,991 48,959 $ ≥8.0 % ≥8.0 N/A 61,199 N/A ≥10.0 % 77,021 80,641 77,021 80,641 12.58 13.18 12.01 12.57 24,496 24,479 25,648 25,668 ≥4.0 ≥4.0 ≥4.0 ≥4.0 N/A 36,719 N/A 32,085 N/A ≥6.0 N/A ≥5.0 On January 16, 2009, BNC announced that it received net proceeds of approximately $20.1 million through the sale of shares of non-voting senior preferred stock to the U.S. Department of the Treasury under the Capital Purchase Program. The Treasury Department also received a warrant exercisable for shares of an additional class of BNCCORP, Inc. preferred stock which has an aggregate liquidation preference of approximately $1.0 million. The Treasury Department exercised this warrant at the closing of the transaction. The proceeds of the sale will further increase the Company’s capital ratios and strengthen its capital position. See management’s Discussion and Analysis for pro forma capital information. 60 BNCCORP, Inc. Annual Report 2008 57 NOTE 19. Fair Value of Financial Instruments The estimated fair values of the Company’s financial instruments are as follows as of December 31 (in thousands): Assets: Cash and cash equivalents Investment securities available for sale Federal Reserve Bank and Federal Home Loan Bank of Des Moines stock Loans held for sale Participating interests in mortgage loans Loans and leases held for investment, net Accrued interest receivable Derivative financial instruments Other assets Liabilities and Stockholders’ Equity: Deposits, noninterest-bearing Deposits, interest-bearing Borrowings and advances Accrued interest payable Guaranteed preferred beneficial interests in Company’s subordinated debentures Other liabilities Stockholders’ equity Financial instruments with off-balance-sheet risk: Commitments to extend credit Standby and commercial letters of credit Mortgage banking commitments to fund loans Mortgage banking commitments to sell loans 2008 2007 Carrying Amount Fair Value Carrying Amount Fair Value 10,569 $ 209,857 $ 10,569 209,857 $ 14,856 122,899 $ 14,856 122,899 5,989 13,403 28,584 534,002 3,263 1,896 807,563 53,935 $ 861,498 $ 68,996 606,325 101,344 1,679 23,025 801,369 6,182 53,947 $ 861,498 5,989 13,403 28,584 533,008 3,263 1,896 806,569 4,918 - 4,918 - 24,357 492,251 3,290 761 $ 663,332 24,357 490,957 3,290 761 662,038 37,553 $ 699,591 68,996 608,275 101,833 1,679 $ 72,234 469,640 66,765 2,843 $ 72,234 470,297 66,760 2,843 $ $ 12,382 793,165 $ 23,075 634,557 5,304 20,906 $ 633,040 59,730 $ 699,591 $ $ 300 65 26,343 13,832 40,540 $ $ 562 91 - - 653 BNCCORP, Inc. Annual Report 2008 61 58 NOTE 20. Fair Value Measurements The following table summarizes the financial assets and liabilities of the Company for which fair values are determined on a recurring basis as of December 31, 2008 (in thousands): ASSETS Securities available for sale Loans held for sale Commitments to originate mortgage loans Interest rate floor Total assets at fair value LIABILITIES Commitments to sell mortgage loans Total liabilities at fair value Total Level 1 Level 2 Level 3 $ $ 209,857 13,403 429 1,896 225,585 $ - - - - $ - $ $ 209,857 13,403 429 1,896 225,585 $ - - - - $ - $ $ 697 697 $ - $ - $ $ 697 697 $ - $ - Changes in the fair value of assets and liabilities determined on a recurring basis had no net impact on our Consolidated Statement of Income for the period ending December 31, 2008. See Note 1 to these consolidated financial statements for definitions of Level 1, Level 2 and Level 3 inputs. The Company may also be required from time to time to measure certain other financial assets at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. These adjustments to fair value usually result from the application of the lower of cost or market accounting or write-down of individual assets. For assets measured at fair value on a nonrecurring basis that were still held at December 31, 2008, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios as of December 31, 2008 (in thousands): Impaired Loans(1) Total Carrying Value at December 31, 2008 Total 29,340 29,340 $ $ Level 1 - - $ $ Level 2 29,340 29,340 $ $ Level 3 $ $ - - (1) Represents the carrying value and related write-downs of loans based on the appraised value of the collateral. NOTE 21. Financial Instruments with Off-Balance-Sheet Risk In the normal course of business, the Company is a party to various financial instruments with off-balance-sheet risk, primarily to meet the needs of its customers as well as to manage its interest rate risk. These instruments, which are issued by the Company for purposes other than trading, carry varying degrees of credit, interest rate or liquidity risk in excess of the amounts reflected in the consolidated balance sheets. Commitments to Extend Credit Commitments to extend credit are agreements to lend to a customer, provided there is no violation of any condition in the contract, and are legally binding and generally have fixed expiration dates or other termination clauses and may require payment of a fee. The contractual amount represents the Bank’s exposure to credit loss in the event of default by the borrower; however, at December 31, 2008, based on current information, no losses were anticipated as a result of these commitments. The Bank manages this credit risk by using the same credit policies it applies to loans. Collateral is obtained to secure commitments under contract based on management’s credit assessment of the borrower. The collateral may include marketable securities, receivables, inventory, equipment or real estate. Since the Bank expects many of the commitments to expire without being drawn, total commitment amounts do not necessarily represent the Bank’s future liquidity requirements related to such commitments. 59 62 BNCCORP, Inc. Annual Report 2008 In our mortgage banking operations we commit to extend credit for purposes of selling residential loans. We underwrite these commitments to determine if each loan meets criteria established by the secondary market for residential loans. Forward commitments represent commitments to sell loans to third party investors and are entered into in the normal course of business. The Company’s participating interests in mortgage loans is related to one counterparty relationship. As of December 31, 2008, there was a $28.6 million limit to our loan commitment with this relationship. Standby and Commercial Letters of Credit Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commercial letters of credit are issued on behalf of customers to ensure payment or collection in connection with trade transactions. In the event of a customer’s nonperformance, the Bank’s credit loss exposure is the same as in any extension of credit, up to the letter’s contractual amount. At December 31, 2008, based on current information, no losses were anticipated as a result of these commitments. Management assesses the borrower’s credit to determine the necessary collateral, which may include marketable securities, real estate, accounts receivable and inventory. Since the conditions requiring the Bank to fund letters of credit may not occur, the Bank expects our liquidity requirements related to such letters of credit to be less than the total outstanding commitments. The contractual amounts of these financial instruments were as follows as of December 31 (in thousands): 2008 2007 Fixed Rate Variable Rate Fixed Rate Variable Rate Commitments to extend credit $ 46,527 $ 96,831 $ 15,497 $ 187,653 Standby and commercial letters of credit 244 6,265 273 8,859 Forward commitments 13,136 - - - NOTE 22. Guarantees and Contingent Consideration Guaranteed Preferred Beneficial Interests In Company’s Subordinated Debentures BNCCORP, concurrent with the issuance of preferred securities by BNC Capital Trust I and by BNC Statutory Trust III, fully and unconditionally guaranteed all obligations of the special purpose trusts related to the trust preferred securities (See Note 15 to these consolidated financial statements for a description of the trusts). There are no recourse provisions associated with these guarantees that would enable BNCCORP to recover from third parties any of the amounts paid under the guarantees and there are no assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantees, BNCCORP could obtain and liquidate to recover all or a portion of the amounts paid under the guarantees. Performance and Financial Standby Letters of Credit As of December 31, 2008 and 2007, the Bank had outstanding $4.3 million and $4.8 million of performance standby letters of credit and $30.6 million and $38.2 million of financial standby letters of credit. Performance standby letters of credit are irrevocable obligations to the beneficiary on the part of the Bank to make payment on account of any default by the account party in the performance of a nonfinancial or commercial obligation. Financial standby letters of credit are irrevocable obligations to the beneficiary on the part of the Bank to repay money for the account of the account party or to make payment on account of any indebtedness undertaken by the account party, in the event that the account party fails to fulfill its obligation to the beneficiary. Under these arrangements, the Bank could, in the event of the account party’s nonperformance, be required to pay a maximum of the amount of issued letters of credit. The Bank has recourse against the account party up to and including the amount of the performance standby letter of credit. The Bank evaluates each account party’s creditworthiness on a case-by-case basis and the amount of collateral obtained varies and is based on management’s credit evaluation of the account party. BNCCORP, Inc. Annual Report 2008 63 60 NOTE 23. Related-Party/Affiliate Transactions The Bank has entered into transactions with related parties, such as opening deposit accounts for and extending credit to, employees of the Company. In the opinion of management, such transactions have been fair and reasonable to the Bank and have been entered into under terms and conditions substantially the same as those offered by the Bank to unrelated parties. In the normal course of business, loans are granted to, and deposits are received from, executive officers, directors, principal stockholders and associates of such persons. The aggregate dollar amount of these loans, which exceeded $60,000, was $2.2 million and $1.9 million at December 31, 2008 and 2007, respectively. Originations in 2008 and 2007 totaled $237,000 and $1.5 million, respectively. Loan paydowns in 2008 and 2007 were $28,000 and $902,000, respectively. The total amount of deposits received from these parties was $1.1 million and $1.8 million at December 31, 2008 and 2007, respectively. Loans to, and deposits received from, these parties were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collection. The Federal Reserve Act limits amounts of, and requires collateral on, extensions of credit by the Bank to BNCCORP, and with certain exceptions, its non-bank affiliates. There are also restrictions on the amounts of investment by the Bank in stocks and other subsidiaries of BNCCORP and such affiliates and restrictions on the acceptance of their securities as collateral for loans by the Bank. As of December 31, 2008, BNCCORP and its affiliates were in compliance with these requirements. NOTE 24. Income Taxes The expense (benefit) for income taxes on continuing operations consists of the following for the years ended December 31 (in thousands): 2008 2007 Continuing operations:- Current: Federal State Deferred: Federal State $ $ 1,499 396 1,895 (958) (200) (1,158) 737 $ (1,133) (270) (1,403) (1,057) (268) (1,325) (2,728) Total from continuing operations $ Income tax expense on discontinued operations was $3.067 million for the year ended December 31, 2007 64 BNCCORP, Inc. Annual Report 2008 61 The expense (benefit) for federal income taxes on continuing operations expected at the statutory rate differs from the actual expense (benefit) for the years ended December 31 (in thousands): Tax expense (benefit) at 34% statutory rate State taxes (net of Federal benefit) Tax-exempt interest $ 2008 1,005 142 (267) $ 2007 (1,971) (262) (283) Increase in cash surrender values of bank-owned life insurance (179) (172) Tax benefit as a result of the lapse of an uncertain tax positions Other, net (25) 61 737 $ (62) 22 (2,728) $ Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that result in significant portions of the Company’s deferred tax assets and liabilities are as follows as of December 31 (in thousands): Deferred tax asset: Loans, primarily due to differences in accounting for credit losses Difference between book and tax amortization of branch premium acquisition costs Difference between book and tax amortization of acquired intangibles Unrealized loss on securities available for sale Expenses and write downs on other real estate owned Other Deferred tax asset Deferred tax liability: Unrealized gain on cash flow hedges Leases, primarily due to differences in accounting for leases Premises and equipment, primarily due to differences in original cost basis and depreciation Other Deferred tax liability Valuation allowance Net deferred tax asset 2008 2007 $ 3,585 $ 2,856 117 37 2,965 904 - 7,608 511 373 577 296 1,757 (227) 5,624 $ 206 59 - - 37 3,158 945 334 563 - 1,842 (249) 1,067 $ The valuation allowance primarily represents the tax benefits of a certain state net operating loss carryforward which may expire without being utilized. During 2008, the valuation allowance decreased $22,000 due to the expiration of a portion of these benefits. In assessing the realizability of deferred tax assets, management believes it is more likely than not that the deferred taxes will be realized. The Company adopted FIN 48 on January 1, 2007. Although the implementation of FIN 48 did not result in a cumulative affect to retained earnings at the date of adoption, the Company did have an unrecognized tax benefit of approximately $218,000 at January 1, 2007. BNCCORP, Inc. Annual Report 2008 65 62 At December 31, 2008, the Company had an unrecognized tax benefit of $131,000. If this benefit was recognized, it would affect the Company’s effective tax rate. The Company recognizes interest as a component of tax expense. We had approximately $18,000 of interest accrued at December 31, 2008 and no penalties. Interest included in tax expense for 2008 is approximately $2,000. A reconciliation of unrecognized tax benefits at December 31 is as follows (in thousands): Balance at January 1 Change in unrecognized tax benefits in the current year Balance at December 31 2008 $ 156 (25) $ 2007 218 (62) $ 131 $ 156 The Company files consolidated federal and unitary state income tax returns where allowed. Tax years ending December 31, 2005 through 2007 remain open to federal examination, although there are no examinations in progress at this time. Tax years ending December 31, 2004 through 2007 remain open to state examinations. It is reasonably possible the unrecognized tax benefit discussed above may be reduced by $39,000 within the next twelve months. This amount includes $8,000 of interest and no penalties. NOTE 25. Earnings Per Share The following table shows the amounts used in computing EPS and the effect of weighted average number of shares of potential dilutive common stock issuances: Net income (loss) per share was calculated as follows: Denominator for basic earnings per share: Average common shares outstanding Dilutive common stock options Denominator for diluted earnings per share Numerator: Net income (loss) attributable to continuing operations Numerator: Net income attributable to discontinued operations Numerator: Net income attributable to common shareholders Net income per share Basic earnings (loss) per share from continuing operations Basic earnings per share from discontinued operations Basic earnings per common share Diluted earnings (loss) per share from continuing operations Diluted earnings per share from discontinued operations Diluted earnings per common share 2008 2007 3,291,697 27,528 3,319,225 3,456,993 58,859 3,515,852 2,218 - 2,218 $ $ (3,069) 5,049 1,980 0.67 - 0.67 $ $ (0.89) 1.46 0.57 0.67 - 0.67 $ $ (0.89) 1.46 0.57 $ $ $ $ $ $ Pursuant to SFAS No. 128, no contingent shares are included in the computation of the diluted per share amounts because a loss exists in continuing operations in 2007. At December 31, 2008 and 2007 options totaling 12,200 and 54,000, respectively were outstanding but not included in the computation of diluted EPS because their exercise prices were higher than the average price of the Company’s common stock. Exercise prices ranged from $7.00 to $8.75. 66 BNCCORP, Inc. Annual Report 2008 63 NOTE 26. Benefit Plans BNCCORP has a qualified, tax-exempt 401(k) savings plan covering all employees of BNCCORP and its subsidiaries who meet specified age and service requirements. Under the plan, eligible employees may elect to defer up to 50% of compensation each year not to exceed the dollar limit set by law. At their discretion, BNCCORP and its subsidiaries may provide matching contributions to the plan. In 2008 and 2007, BNCCORP and its subsidiaries made matching contributions of up to 50% of employee deferrals up to a maximum employer contribution of 5% of employee compensation. Generally, all participant contributions and earnings are fully and immediately vested. The Company makes its matching contribution during the first calendar quarter following the last day of each calendar year and an employee must be employed by the Company on the last day of the calendar year in order to receive the current year’s employer match. The anticipated matching contribution is expensed monthly over the course of the calendar year based on employee contributions made throughout the year. The Company made matching contributions of $387,000 and $378,000 for 2008, and 2007, respectively. Under the investment options available under the 401(k) savings plan, prior to January 28, 2008 employees could elect to invest their salary deferrals in BNCCORP common stock. At December 31, 2008, the assets in the plan totaled $11.5 million and included $938,000 (138,805 shares) invested in BNCCORP common stock. On January 28, 2008 the Company voluntarily delisted from the NASDAQ Global Market and deregistered its common stock under the Securities Exchange Act of 1934 (as amended). As a result, the participants are prohibited from making new investments of the Company’s common stock in the plan. NOTE 27. Commitments and Contingencies Employment Agreements and Noncompete Covenants The Company has entered into an employment agreement with its President and Chief Executive Officer (the “President”). The President will be paid a minimum annual salary throughout the term of the agreement and annual incentive bonuses as may, from time to time, be determined by the Board. The President will also be provided with benefits under any employee benefit plan maintained by BNCCORP for its employees generally, or for its senior executive officers in particular, on the same terms as are applicable to other senior executives of BNCCORP. Under the agreement, if the President’s status as an employee with the Company is terminated for any reason other than death, disability, cause, as defined in the agreement, or if he terminates his employment for good reason, as defined in the agreement, or following a change in control of BNCCORP, as defined in the agreement, then the President will be paid a lump-sum amount equal to three times his current annual compensation. In December 2007, the Chairman of the Board announced his retirement. The former Chairman received an award of $1.160 million upon retirement from the Company which was reflected in accrued expenses on the consolidated balance sheet as of December 31, 2007. Leases The Bank has entered into operating lease agreements for certain facilities and equipment used in its operations. Rent expense for the years ended December 31, 2008 and 2007 was $1.063 million and $830,000, respectively, for facilities, and $39,000 and $51,000, respectively, for equipment and other items. At December 31, 2008, the total minimum annual base lease payments for operating leases were as follows (in thousands): 2009 2010 2011 2012 2013 Thereafter $ 1,256 1,138 866 621 121 1,560 BNCCORP, Inc. Annual Report 2008 67 64 NOTE 28. Share-Based Compensation The Company has three share-based plans for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the 1995 Stock Incentive Plan, the aggregate number of options and shares granted can not exceed 250,000 shares. Under the 2002 Stock Incentive Plan, the aggregate number of shares can not exceed 125,000 shares. Under the 2006 Stock Incentive Plan, the aggregate number of shares can not exceed 200,000 shares. Pursuant to each plan, the compensation committee may grant options at prices equal to the fair value of the stock at the grant date. Total shares available and maximum restricted shares available as of December 31, 2008 are as follows: 1995 Stock Incentive Plan 2002 Stock Incentive Plan 2006 Stock Incentive Plan Total Total Shares Available 58,751 107,250 136,600 302,601 Maximum Restricted Shares Available 58,751 7,250 136,600 202,601 The Company recognized share-based compensation expense of $342,000 and $312,000 for the twelve months ended December 31, 2008 and 2007, respectively all of which related to restricted stock. At December 31, 2008, the Company had $352,000 of unamortized restricted stock compensation. At December 31, 2007 the Company had $552,000 of unamortized restricted stock compensation. Restricted shares of stock granted generally have vesting and amortization periods of at least three years Following is a summary of restricted stock transactions for the years ended December 31: 2008 2007 Number Restricted Stock Shares 51,766 19,500 (26,434) (7,500) 37,332 Weighted Average $ Grant Date Fair Value 12.50 11.03 12.46 9.60 Number Restricted Stock Shares 100,500 - (34,734) (14,000) 51,766 Weighted Average Grant Date Fair Value $ 13.07 - 13.15 15.05 Nonvested, beginning of year Granted Vested Forfeited Nonvested, end of year No stock options were granted during 2008 or 2007 and the Company had no unrecognized share-based compensation expense related to stock options during these periods. 68 BNCCORP, Inc. Annual Report 2008 65 Following is a summary of stock option transactions for the years ended December 31: 2008 2007 Outstanding, beginning of year Granted Exercised Forfeited Outstanding, end of year Exercisable, end of year Weighted average fair value of Granted Exercised Forfeited Options to Purchase Shares Weighted Average Exercise Price Options to Purchase Shares 107,700 - (8,000) (55,500) 44,200 44,200 $ $ $ 11.76 - 5.94 17.04 6.34 6.34 115,000 - (6,000) (1,300) 107,700 107,700 $ $ $ - 2.80 7.53 $ $ $ - 2.99 7.60 Weighted Average Exercise Price 11.49 - 6.15 17.00 11.76 11.76 $ $ $ Following is a summary of the status of options outstanding at December 31, 2008: Options with exercise prices ranging from: $5.94 to $8.75 Outstanding Options Weighted Average Remaining Number Contractual Life Weighted Average Exercise Price Exercisable Options Weighted Average Exercise Price Number 44,200 44,200 2.3 years $ 6.34 $ 44,200 44,200 6.34 BNCCORP, Inc. Annual Report 2008 69 66 NOTE 29. Condensed Financial Information-Parent Company Only Condensed financial information of BNCCORP on a parent company only basis is as follows: Parent Company Only Condensed Balance Sheets As of December 31 (In thousands, except per share data) Assets: Cash and cash equivalents Investment in subsidiaries Receivable from subsidiaries Deferred charges and intangible assets, net Other Total assets Liabilities and stockholders’ equity: Subordinated debentures Payable to subsidiaries Accrued expenses and other liabilities Total liabilities Preferred stock, $.01 par value – 2,000,000 shares authorized; no shares issued or outstanding Common stock, $.01 par value – 10,000,000 shares authorized; 3,299,163 and 3,491,337 shares issued and outstanding Capital surplus – common stock Retained earnings Treasury stock (357,738 and 150,116 shares) Accumulated other comprehensive income (loss), net of income taxes Total stockholders’ equity Total liabilities and stockholders’ equity 2008 2007 1,766 76,526 570 154 446 79,462 23,115 487 1,913 25,515 $ $ $ 954 83,254 545 154 525 85,432 23,112 100 2,490 25,702 - - 33 26,628 36,104 (5,020) (3,798) 53,947 79,462 $ 35 26,355 34,105 (2,424) 1,659 59,730 85,432 $ $ $ $ 70 BNCCORP, Inc. Annual Report 2008 67 Parent Company Only Condensed Statements of Income For the Years Ended December 31 (In thousands) Income: Management fee income Interest Other Total income Expenses: Interest Salaries and benefits Legal and other professional Depreciation and amortization Other Total expenses Loss before income tax benefit and equity in income of subsidiaries Income tax benefit Loss before equity in income of subsidiaries Equity in income of subsidiaries Net income 2008 2007 $ 1,599 $ 1,730 17 76 1,692 1,728 829 443 3 610 3,613 (1,921) 646 (1,275) 3,493 40 65 1,835 2,212 2,392 635 4 1,924 7,167 (5,332) 2,078 (3,254) 5,234 $ 2,218 $ 1,980 BNCCORP, Inc. Annual Report 2008 71 68 Parent Company Only Condensed Statements of Cash Flows For the Years Ended December 31 (In thousands) Operating activities: Net income Adjustments to reconcile net income to net cash used in operating activities: Equity in income of subsidiaries Depreciation and amortization Deferred income taxes Change in prepaid expenses and other receivables Change in accrued expenses and other liabilities Net cash used in operating activities Investing activities: Increase in investment in subsidiaries Net cash provided by investing activities Financing activities: Repayments of long term borrowings Proceeds from issuance of share-based compensation Purchase of treasury stock Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplemental cash flow information: Interest paid Income tax payments received from the subsidiary bank, net of income taxes paid 2008 2007 $ 2,218 $ 1,980 (3,493) 6 110 (61) (408) (1,628) 4,765 4,765 - 273 (2,598) (2,325) 812 954 1,766 $ (5,234) 340 (395) 37 1,255 (2,017) 4,675 4,675 (1,167) 298 (1,720) (2,589) 69 885 954 $ $ 1,675 $ 2,314 $ 2,173 $ 3,322 72 BNCCORP, Inc. Annual Report 2008 69 Corporate Data Investor Relations Gregory K. Cleveland, CPA President/CEO 602-852-3526 Timothy J. Franz, CPA Chief Financial Officer 612-305-2213 General Inquiries: BNCCORP, Inc. 322 East Main Avenue Bismarck, North Dakota 58501 Telephone (701) 250-3040 Facsimile (701) 222-3653 Annual Meeting The 2009 annual meeting of stockholders will be held on Wednesday, June 17, 2009, at 8:30 a.m. (Central Daylight Time) at BNC National Bank, Second Floor Conference Room, 322 East Main Avenue, Bismarck, ND 58501. Independent Public Accountants KPMG LLP 233 South 13th Street Suite 1600 Lincoln, NE 68508 Securities Listing BNCCORP, Inc.’s common stock is traded on the Pink Sheets under the symbol: “BNCC.” There were 73 record holders of the Company’s common stock at March 6, 2009. COMMON STOCK PRICES For the Years Ended December 31, 2008(1) 2007(2) High Low $13.89 $11.75 $13.00 $9.05 $11.00 $7.80 $8.90 $5.15 High Low $18.00 $12.98 $19.15 $15.16 $18.50 $17.25 $17.31 $12.60 First Quarter Second Quarter Third Quarter Fourth Quarter (1) The quotes represent the high and low closing sales prices as reported by Pink Sheets. (2) The quotes represent the high and low closing sales prices as reported by the NASDAQ Stock Market. Stock Transfer Agent and Registrar American Stock Transfer & Trust Company 59 Maiden Lane, Plaza Level New York, NY 10038 (800) 937-5449 DIRECTORS BNCCORP, Inc. Mark W. Sheffert Chairman of the Board of BNCCORP, Inc. Chairman and Chief Executive Officer, Manchester Companies, Inc. Gregory K. Cleveland, CPA President and Chief Executive Officer Tracy Scott, CPA Retired Co-Founder of BNCCORP, Inc. Bradley D. Bonga Founder and President/CEO Bonga and Associates, LLC Gaylen Ghylin, CPA EVP, Secretary & CFO Tiller Corporation d/b/a Barton Sand & Gravel Co., Commercial Asphalt Co. and Barton Enterprises, Inc. Richard M. Johnsen, Jr. Chairman of the Board and Chief Executive Officer, Johnsen Trailer Sales, Inc. Michael O’Rourke Attorney/Author Stephen H. Roman Partner First Strategic LLC DIRECTORS BNC National Bank Gregory K. Cleveland Shawn Cleveland Timothy J. Franz David Hoekstra Mark E. Peiler Scott Spillman B. Timothy Swanson SUBSIDIARIES BNC National Bank Headquarters: 2425 East Camelback Road Suite 100 Phoenix, AZ 85016 Branches: Bismarck Main 322 East Main Avenue Bismarck, ND 58501 Bismarck South 219 South 3rd Street Bismarck, ND 58504 Bismarck North 801 East Century Avenue Bismarck, ND 58503 Primrose Assisted Living Apartments 1144 College Drive Bismarck, ND 58501 Waterford on West Century 1000 West Century Avenue Bismarck, ND 58503 Crosby 107 North Main Street Crosby, ND 58730 Ellendale 83 Main Street Ellendale, ND 58436 Garrison 92 North Main Garrison, ND 58540 Kenmare 103 1st Avenue SE Kenmare, ND 58746 Linton 104 North Broadway Linton, ND 58552 Stanley 210 South Main Stanley, ND 58784 Watford City 205 North Main Watford City, ND 58854 Minneapolis 333 South Seventh Street Minneapolis, MN 55402 Golden Valley 650 North Douglas Drive Golden Valley, MN 55422 The Heathers Estate 2900 North Douglas Drive Crystal, MN 55422 The Heathers Manor 3000 North Douglas Drive Crystal, MN 55422 Scottsdale 17045 N. Scottsdale Road Scottsdale, AZ 85255 Ice Den 9375 East Bell Road, Suite 102 Scottsdale, AZ 85260 Glendale 20175 North 67th Avenue Glendale, Arizona 85308 Scottsdale Mortgage 8330 East Hartford Drive Scottsdale, Arizona 85255 Wichita 7200 West 13th, Suite 3 Wichita, KS 67212 Overland Park 7007 College Boulevard, Suite 330 Overland Park, KS 66211 Davenport 3709 Harrison Street Davenport, IA 52806 Belton 17122 BelRay Place Belton, MO 64012 EXECUTIVE OFFICERS BNCCORP and Subsidiaries Gregory K. Cleveland, CPA President and Chief Executive Officer Timothy J. Franz, CPA Chief Financial Officer Shawn Cleveland, CPA Chief Operating Officer, BNC National Bank Dave Hoekstra, CPA Chief Credit Officer and President – BNC National Bank, North Dakota Market Mark E. Peiler, CFA Senior Vice President – Chief Investment Officer Scott Spillman President – BNC National Bank, Arizona Market Timothy Swanson President – BNC National Bank, Minnesota Market Clint Bowling Executive Vice President – Commercial Real Estate BNC National Bank, Arizona Market Brian Whitemarsh Executive Vice President – Commercial Real Estate BNC National Bank, Minnesota Market BNCCORP, Inc. Annual Report 2008 73 BNCCORP, Inc. BNCCORP, Inc. 

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